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Scientific Games Corp. (SGMS - Analyst Report) reported third quarter 2011 earnings per share (EPS) of 8 cents, which comprehensively beat the Zacks Consensus Estimate of 5 cents. However, EPS in the reported quarter declined 20.0% from 10 cents per share in the year-ago quarter.

Operating Performance

Attributable EBITDA rose to $81.7 million from $75.0 million in the year-ago quarter. Joint venture EBITDA was $22.8 million in the reported quarter compared with $15.0 million in the prior-year period, primarily due to higher EBITDA generated by the company's Italian and Chinese joint ventures.

Operating income in the quarter was $22.4 million (including stock-based compensation but excluding employee termination and restructuring costs) compared with $24.5 million (including stock-based compensation but excluding employee termination and restructuring costs, write-down of assets held for sale) in the year-earlier quarter.

The slight decline in operating income was on the back of higher selling, general and administrative expense (SG&A), which increased 30.8% year over year to $47.7 million in the quarter. The increase in SG&A expense was driven by headcount, consultant and incentive compensation expenses in the quarter.

Revenue

Total revenue (excluding racing business, which was divested in October 2010) increased 16.7% year over year to $222.7 million, primarily driven by strong instant ticket sales and higher sales of lottery systems and terminals, which fully offset lower service revenues. Including racing business, total revenue inched up 0.7% year over year in the quarter.

Instant ticket revenues rose 9.2% year over year to $126.7 million, while sales of lottery systems and terminals increased 18.7% year over year to $14.6 million. However, service revenue decreased 12.3% year over year to $81.4 million.

Scientific Games' U.S. instant ticket retail sales increased 5.6% year over year in the quarter. U.S. lottery systems customers' retail sales spiked 0.5% year over year in the third quarter. China Sports Lottery instant ticket retail sales surged 24.1% year over year, while instant ticket retail sales in Italy jumped 10.8% in the reported quarter.

Segment-wise, Printed Products Group revenues climbed 11.0% year over year to $129.6 million primarily due to higher contribution from U.S. customers ($7.3 million), higher sales to international customers ($0.9 million), and favorable foreign exchange ($2.5 million).

Lottery Systems Group revenues increased 12.9% year over year to $59.6 million primarily due to higher sales of software and hardware to international customers ($2.0 million), increased hardware sales in the U.S. ($0.7 million) and favorable foreign currency translation ($0.8 million).

Diversified Gaming Group revenues (excluding racing business) surged 59.0% year over year, driven by a 42% year-over-year growth in global installed base of server-based gaming terminals. Incremental revenue from the Barcrest acquisition ($2.8 million) and favorable foreign currency ($1.6 million) also boosted growth during the quarter.

Balance Sheet

Scientific Games exited the quarter with $86.9 million in cash and cash equivalents compared with $127.3 million in the prior quarter. Total debt remained flat year over year at $1.39 billion.

Total capital expenditures in the third quarter were $24.2 million. Free cash flow in the reported quarter was $30.8 million versus $26.6 million in the previous quarter.

During the quarter, Scientific Games acquired Barcrest for approximately $48.4 million in cash. The acquisition will expand Scientific Games total installed base to over 35,000 server-based terminals worldwide.

Recommendation

We believe the company’s diversified product offerings; international development activities (China, Italy), recurring revenue business model and strong growth from the Internet-based business will drive the stock over the long term.

However, intense competition from International Game Technology (IGT - Analyst Report) and privately held Intralot S.A. and Lottomatica S.p.A, a leveraged balance sheet, lower lottery revenues, loss of contracts and a slowing trend in the domestic market and China will continue to temper near-term results.

We maintain our Neutral rating over the long term (6-12 months). Currently, Scientific Games has a Zacks #3 Rank, which implies a short-term Hold rating.

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