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Scientific Games Corp. (SGMS - Analyst Report) reported disappointing second-quarter 2014 results. The company posted an adjusted loss of 40 cents per share in the second quarter of 2014, much wider than the Zacks Consensus Estimate of loss of 22 cents and the year-ago loss of 14 cents per share. Since Aug 5, share price has declined 14.5%.

Second-quarter adjusted loss per share included 31 cents related to loss on the early extinguishment of debt, 9 cents related to Scientific Games’ share of an estimated net shortfall accrual recorded by its Northstar Illinois joint venture, and 6 cents in employee termination and restructuring expense.

Revenues

Revenues surged 77.4% year over year to $417 million and were in line with the Zacks Consensus Estimate. The year-over-year increase in revenues can be attributed to strong growth across all the segments.

Gaming Segment – Revenues soared to $209.1 million from $40.6 million in the year-ago quarter, due to revenue contribution by WMS Gaming ($169.6 million), acquired in Oct 2013. Revenues from services jumped $92.8 million year over year, while product sales revenues increased $75.7 million from the year-ago quarter.

Services revenues benefited from additional WMS revenues and favorable foreign currency translation in the company’s U.K. gaming business. Interactive services revenues were $32.3 million driven by higher growth in the average Daily Active Users (DAU) in the social casinos.

The Blade game machine continued to perform well during the quarter. Scientific Games expanded The Gold Fish Social Slots game app (launched in March) on multiple mobile platforms during the quarter. The company also entered into five game content agreements with online operators, and went live on several sites, including Bwin.party sites in Europe and online casino sites in New Jersey.

Instant Products Group – Revenues increased 6.5% year over year to $138.5 million in the quarter, driven by 7% increase in revenues from instant games, partially offset by 11.4% decline in product sales. This was primarily due to higher lottery retail sales by the company’s U.S. and certain international customers.

Revenues also benefited from sales of instant games to Northstar New Jersey joint venture. Scientific Games began selling instant games in Greece in May 2014. The company has a 16.5% equity interest in Hellenic Lotteries, the joint venture that operates the Greek State Lotteries, for which it has exclusive responsibility for design, production and supply of instant games.

Total instant game retail sales of the company’s U.S. customers grew 4.9%, led by higher retail sales in those jurisdictions where Scientific Games provides instant games and value-added services on a participation basis.

The Multi-State Lottery Association (MUSL) announced the first ever $5 national draw game, the Monopoly Millionaires Club, developed by Scientific Games. The game is expected to launch in the fourth quarter of 2014 and includes plans for an associated national TV game show.

Scientific Games won a contract to be the exclusive supplier of both instant lottery games and the lottery system to the consortium that won a 10-year concession to operate the Turkey National Lottery.

Lottery Systems Group – Revenues increased 7.6% year over year to $69.3 million, reflecting higher sports betting revenues and product sales revenues. Services revenues climbed 2.6%, while product sales revenues improved 24.5% from the year-ago quarter.

During the quarter, the company amended a contract with the National Lottery of Panama to provide the country's first online lottery game, Pega 3, a Pick 3 game, expected to launch later this year.

Margins

Attributable earnings before interest, taxes, depreciation and amortization (EBITDA) increased from $84.5 million in the year-ago quarter to $132.1 million in the reported quarter.

Gaming Segment Attributable EBITDA increased from $17.0 million to $72.8 million in the quarter. Instant Products Group Attributable EBITDA inched up 1.3% from the year-ago quarter. Lottery Systems Attributable EBITDA declined 7.6% on a year-over-year basis.

Operating expenses increased from $89.2 million in the year-ago quarter to $216 million in the reported quarter. This was mainly on account of an increase in research & development expenses (up $23.4 million year over year), selling, general & administrative expenses (up $50.5 million year over year) and depreciation & amortization (up $52.9 million year over year).

Gaming Segment operating loss was $1.8 million much narrower than a loss of $8.4 million reported in the year-ago quarter. Instant Products Group operating income increased 12.2% from the year-ago quarter. Lottery Systems operating income declined 45.2% on a year-over-year basis.

Consolidated operating income (excluding employee termination and restructuring expenses) plunged 31.5% year over year in the reported quarter.

Scientific Games reported a net loss of $33.8 million or 40 cents compared with net loss of $11.9 million or 14 cents in the year-ago quarter.

 


Balance Sheet & Cash Flow

Scientific Games exited the second quarter with $101 million in cash and cash equivalents compared with $169.1 million in the prior quarter.

Cash flow from operations was $23.8 million. Free cash outflow was $31.3 million in the reported quarter compared with $23.7 million in the previous quarter.

Acquisition

Scientific Games recently announced that it will acquire slot-machine maker, Bally Technologies (BYI - Snapshot Report) for $3.3 billion in cash ($83.30 per share). Including refinancing of Bally’s existing net debt, the purchase price would amount to $5.1 billion. The transaction is expected to close in early 2015.

Scientific Games expects to achieve $220 million of cost synergies and $25 million of capital expenditure savings by the end of the second year post acquisition. The company expects to incur $75 million of costs to achieve the cost synergies and $40 million in capital costs to complete the integration of the companies.

Our Take

The domestic lottery industry is undergoing a transition, which involves increasing involvement of private vendors in state lottery management, higher prize payouts and the introduction of tiered pricing for national jackpot games. All these are expected to add impetus to the sagging U.S. lottery industry. We believe that Scientific Games is well positioned to benefit from these transitions in the long run.

The acquisitions of WMS Industries and Bally Technologies will diversify Scientific Games’ product portfolio and expand its global footprint. The addition of WMS expands Scientific Games’ footprint in interactive business, which will boost the top line over the long run.

The acquisition of Bally Technologies eliminates one of the nearest competitors, which will help in expanding market share. Further, the company is expected to gain a number of synergies from this acquisition, going forward.

However, we believe that this acquisition will put Scientific Games’ balance sheet under further pressure, as the company is opting for debt financing for the buyout. This may hurt profitability due to lower top-line growth.

Sluggish casino market that continues to face weak consumer spending and increasing competition from Internet-based game providers is expected to remain a major headwind in the near term. Further, Scientific Games’ legacy business continues to disappoint amid significant competition from the likes of Computer Sciences Corp. (CSC - Analyst Report) and GTech S.p.A. in the long run.

Currently, Scientific Games has a Zacks Rank #3 (Hold).

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