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SCIENTIFIC GAMES CORP SGMS

December 21, 2015 by wolverine03 (/member/wolverine03/37563)

2015 2016
Price:
8.33 EPS
0
0
Shares Out. (in M):
86 P/E
0
0
Market Cap (in M):
718 P/FCF
0
0
Net Debt (in M):
8,308 EBIT
0
0
TEV:
9,026 TEV/EBIT
0
0
Borrow Cost:
Available 0-15% cost
Quality Rating:

(2 votes)
Performance Rating:

(1 votes)

Description
DISCLAIMER: The author of this posting and related persons or entities ("Author") currently
holds a long position in this security. The Author makes no representation that it will continue
to hold positions in the securities of the issuer. The Author is likely to buy or sell long or short
securities of this issuer and makes no representation or undertaking that Author will inform
Value Investors Club, the reader or anyone else prior to or after making such transactions.
While the Author has tried to present facts it believes are accurate, the Author makes no
representation as to the accuracy or completeness of any information contained in this note.
The views expressed in this note are the only the opinion of the Author. The reader agrees
not to invest based on this note and to perform his or her own due diligence and research
before taking a position in securities of this issuer. Reader agrees to hold Author harmless
and hereby waives any causes of action against Author related to the below note.
Scientific Games Corporation
Summary
I believe Scientific Games Corporation (SGMS or the Company) is a compelling short
investment opportunity due to its incredibly high leverage, poor free cash flow conversion,
and challenging industry backdrop. Though many may view SGMS as cheap on an EBITDA
multiple basis, or even a leveraged FCF basis, I believe both approaches are flawed, as
discussed below. With over $8bn of debt and limited free cash flow generation, I believe the
SGMS equity is likely a terminal short over the next several years. In a best case for the
Company, the equity should still be far lower in my view. My target price for SGMS equity is

$0. Ultimately, the large debt position of the Company leaves little margin for error, and with
no meaningful debt paydown possible over the next several years, SGMS appears to be a
ticking time bomb, waiting for industry pressures or an eventual refinancing to tip the
Company into insolvency. The thesis is very simple: This is a low ROIC business in a
competitive industry which generates very little free cash flow and has mountains of debt. I
suppose it is fitting if you want to be long SGMS in that it is nothing more than a gamblebut
even then, there are probably far more intelligent gambles in the market than this.
Business Description
Scientific Games Corporation is a leading provider of technology-based products and
services and content for the worldwide gaming and lotto industries. The primary products for
the Company include slot machines, gaming content, instant and draw-based lottery games
and systems, casino management systems and other table came products. While SGMS was
previously mostly a lotto gaming business, two recent acquisitions have transformed the
business into a leading provider of gaming technology (slot machines) for casino operators,
primarily in North America. SGMS acquired WMS for approximately $1.5bn in October of
2013, and acquired Bally for $5.1bn in November of 2014. The rationale for both deals was to
allow the combined companies to benefit from economies of scale, drive cost
savings/synergies, diversify the product mix, and become a large player in the gaming
business. The key benefits of economies of scale and potential pricing power dont seem to
have materialized, and unfortunately, the byproduct of these deals was to dramatically
leverage the balance sheet of SGMS, creating the current problem and setting up a good case
for a terminal short. For what it is worth, in Q3 of 2015, the Company took a $535mm
impairment charge (with no tax benefit) to lower the value of their gaming segment,
essentially an indictment that they have overpaid for both WMS and Bally. The trouble with
overpaying for assets of course, is that none of the debt goes away with the asset
impairment. Very briefly, the key components of the Companys operating segments are
below. I have focused on the main areas that drive operations and EBITDA (not cash flow,
because there is none):

Gaming Segment The gaming segment products are installed at various facilities, primarily
in North America and include regional and tribal casinos, riverboat casinos, and traditional
facilities in Las Vegas and other marquee destinations. Sales in this segment are mostly
classified as either product sales or services, described below:
Product sales Majority of sales are from gaming machines sold to casino operators.
Typically, gaming machines are sold for about $15k per unit and are considered capex
to the casino operator. Gross margins for SGMS are approximately 50%, the sale is
made and life goes on. As discussed later, the North American slot market has been
relatively stagnant at 940k of total units in the installed base, so growth in this segment
is driven largely by replacement cycles, market share gains, and potentially pricing as
units turnover.

Services Most gaming technology companies are now pushing participation games,
which is the bulk of services revenue. Participation games are when the casino
operator essentially allocates floor space to the gaming technology company, but puts
up little/no upfront money in exchange for a cut of the revenue. SGMS is responsible
for the capex associated with the gaming machine, and typical arrangements are for
SGMS and other gaming companies to earn 20% of the daily win from the machine.
Importantly, the machines can be swapped out at any time by the casino operator,
shifting the cost of an unprofitable game back to the gaming technology company and
potentially making this form of revenue far more capital intensive. Games are typically
either WAP, which are networked games linked across multiple casinos and which
typically have a large jackpot payoff, or standalone participation games which are
machines located within a single casino. The revenue is roughly 75-80% margin, but
this is incredibly deceiving. Because the costs are now capitalized and amortized
through the P&L, looking at EBITDA for the gaming segment is completely
nonsensical. Doing so gives the Company credit for participation revenue without any
of the real costs, which are amortized through depreciation. This is just one reason why
the Companys fundamentals are far worse than what they appear to be on an EBITDA
basis alone.
Other In addition to slot machine product sales and services, the Company generates
revenue from video lottery systems, casino-management technology and systems, table
products including shufflers and chip sorters.
Competition in the gaming segment has generally been fierce, with key competitors including
IGT, Konami, and Aristocrat. The business is characterized by the constant flow of new
games, and a newest and best mentality from the gaming operators. For this reason, R&D is
high and companies must continue to search for good content in the hopes that casinos will
want the newest round of gaming products.

Lotto Segment The lottery segment is exactly what it sounds like. SGMS designs,
manufactures, and distributes instant lottery tickets and lottery game systems to various
government jurisdictions across the world. The instant lottery business is typically a
contract-based business with three to five year terms and renewal options. Revenue is
typically either on a price-per-unit basis or participation basis for instant lottery games. For
the lottery systems business, the Company manufactures lottery systems at the point of sale,
typically under multi-year contracts where revenue is equal to a percentage of the lotterys
total retail sales. Revenue from point-of-sale units are included as product sales revenue,
while ongoing support and systems are included as services revenue. For this segment, the
vast majority of the revenue consists of instant games, and the overall business is capital
intensive, requiring large roll-outs of equipment and systems everywhere when new contracts
are won. Key competitors in the lotto segment include Gtech, though it should be noted that
gaming systems cannot be shipped into the US from other countries, except for Canada.

Interactive Segment Though not very large, the interactive segment for SGMS is fastgrowing at the moment. The Company provides interactive gaming products for both free
social gaming (think Facebook), and by hosting games for online casino operators in
jurisdictions where it is legal. For the second revenue stream, the Company earns a
percentage of net gaming revenue generated by the games they host. Social gaming revenue
is a participation revenue stream that is earned when purchased coins and other random
things people buy with social gaming.

Capitalization/Historical Results


Why Does this Opportunity Exist?
I believe the short opportunity in SGMS exists for the following reasons:
Acquisitions obfuscate underlying organic growth trends that are negative.
The constant hope that the replacement cycle of new equipment will save SGMS and
other gaming technology companies. In reality, industry pressures continue to mount.
The misperception that the Lottery business is a good one.
An over-reliance on EBITDA based valuations, despite terrible FCF conversion, a very
capital intensive business, and the fact that EBITDA doesnt even pick up the key
expense related to the Companys participation revenue. Further, a reliance on
leveraged FCF multiples here is nonsensical, as any business leveraged this much will
look cheap when it has unsustainable amounts of financial leverage.
A major change in markets. Debt is no longer a good thing, and what was previously a
great deal using only debt financing is now probably a bad deal using way too much
leverage.
I discuss them below, one by one.
Organic Growth is Negative
Although the headline figures posted above appear to show growth for the Company, the
reality is that the Companys core business is shrinking organically, and largely in its most
profitable segment of WAP participation games. M&A transactions have definitely enabled
the Company to achieve synergies in the consolidated cost structures, but it appears as
though underlying trends of the business have not led to any meaningful pricing power or
negotiating leverage with customers. Ultimately, SGMS and other gaming technology
companies are simply at the whim of casino operator demand, and with an industry that is
not growing total volume, it seems no company has material pricing power or leverage.
Below Ive again pasted the organic trends for WAP units and other participation games. This
trend is likely accelerating because as regional casinos have at least stabilized, many of them
are shifting from participation games back to outright purchases, which is a negative for
gaming technology companies. During periods of difficult demand, casino operators typically
shift to participation games because of the low upfront cost. Because WAP units have higher
revenue per unit, these organic declines are particularly concerning. It is also worth noting
that these organic declines have already occurred despite consumer headwinds that only
seem to be appearing in the last few months. To the extent the consumer slowdown hurts
casino revenue, I would imagine declines in slot machines, and the average revenue per unit,

would accelerate. All of a sudden, this recurring revenue from participation games doesnt
look so stable. Additionally, as these underlying organic trends become more obvious as the
Company laps the acquisitions, I think people will start to pay closer attention.

Industry Challenges
The bull case for SGMS continues to revolve partially around the eventual pick-up in
replacement demand. However, various industry data points and the Companys own
numbers seem to suggest that this hasnt materialized, and the future outlook doesnt seem
to be much better. If you have access, Id point everybody to a report by Goldman Sachs from
August 2015, which is their annual slot survey. The survey contains the responses from 141
casino slot managers in 26 different states, and has a lot of information on pricing trends,
market share trends, and purchase intent. The key takeaways are as follows:
The industry total installed based has largely stagnated. The North American slot
industry has largely stagnated around 940k total machines in service. Within that
number, it appears as though gaming operators continue to pull back on participation
games (which are higher IRR for gaming technology companies), and continue to move
existing slot machine assets to new casinos that are being opened as opposed to
expanding slot numbers in the aggregate. Additionally, the industry has generally
slowed the pace of new casino openings and casinos in other areas have closed.
Goldman has visibility into the industry adding only about 6,200 slots in 2016 and 1,100
slots in 2017. Regional and tribal casinos, which make up a large portion of the total
slot market, have experienced relatively weak revenue trends over time, though they
have stabilized lately. Still, low single digit growth is a far cry from anything that might
trigger a new wave of slot machine purchases. Below are a few exhibits illustrating this
point:

Additionally, I believe the following quotes from recent casino conference calls were
interesting:
BYD - Q3 2015 Call 10/22/15
James Kayler

Q: All right, very good. And last question, a little bit of a bank shot. Can you just comment about what
you expect your slot budget -- your slot purchase budget to be like next year?
Keith E. Smith
A: Sure, same as this year.
BYD - Q2 2015 Call 7/23/15
Keith E. Smith
Q: No, I think maintenance capital will stay pretty much where we've had it budgeted and where it's
been over the last year or 2. We have a -- what I think is a fairly healthy amount of maintenance capital
that keep our properties current and modern and competitive. I don't see that going up at all. So I think
it's going to stay as is from a slot product standpoint. We've had a fairly, once again, fairly consistent
budget for buying new product for our slot floors. I don't see that changing very much at all just because
EBITDA is going up.
ISLE - Q2 2016 Transcript 12/2/15
Vikram Awasthi
Q: Okay. I think you mentioned earlier that you had some spend on slots and gamings. Where is that
spend compared to last year? And what are you looking for in used slots and gaming equipment moving
forward?
Eric L. Hausler
A: We've historically said we'll allocate, give or take, half of our maintenance capital just to slots and
equipment. That's not just slots, that's all equipment on the gaming floor. So this year, we are up over
last year, and we're significantly up over 2 years ago, which 2 years ago, I think we would call a cyclical
low for us in terms of maintenance capital. I think we'll be fairly stable on a go-forward basis. Our goal is
to get the average age of the slot floors incrementally younger, but not significantly younger from here.

I think this is direct evidence of a challenging industry backdrop that is likely to get
worse before it gets better. Regardless, at the current valuation, merely being flat and
generating little/no cash flow doesnt seem like a good outcome for SGMS long-term
prospects.

IGT and SGMS appear to be losing share. Based on GS latest slot survey, it seems as
though Aristocrat continues to take market share and has the most interest in its
products. Importantly, because the industry appears to have stagnated, competitors in
the industry seem to be using pricing to hold onto existing market share and units. This
seems to be the exact opposite of the desired effect of industry consolidation.


Younger demographics are likely to hurt the industry long term. Although there is no
great data on this, we can all go to the typical slot floor only to see the 75 year old
grandmother playing the nickel slots by herself. The reality is that the next leg of
gaming is going to be online, and the younger generation of gamblers is focused on
table games, bars/clubs, and restaurants which is partially why casinos continue to
shift investment dollars towards these ventures. It appears at least Pinnacle
Entertainment agrees with me:

PNK Latest 10-K

Manyofouryoungercustomersdonotplayslotmachines,whichiswherewederivethe
majorityofourrevenue.Intheeventthatourcustomersdonotuseslotmachines,thismay
haveanadverseeffectonourresultsofoperations.

But, if you dont believe any of this, below is the Companys disclosure regarding industry
conditions in their latest 10Q filing from the period ended 9/30/15:
Market-related factors negatively impacting gaming machine unit demand and the number
of gaming machines leased by our customers coupled with fewer than anticipated new
casino openings and expansions have resulted in continued declines in our gaming machine
sales and participation game revenues. A prolonged reduction in customer spending on new
gaming machine units, a lack of new casino openings, economic and political conditions

impacting unit sales and participation game revenues in certain international jurisdictions,
and cost reduction initiatives undertaken by certain of our customers during the quarter have
all negatively impacted our SG gaming reporting unit.

We believe that challenging market conditions in the gaming industry adversely impacted
our Gaming results for the three and nine months ended September 30, 2015 and could
continue to negatively impact our results of operations. These challenges included: (1) lower
demand in the Illinois VLT market than in the prior year as that market matures and fewer
new locations were licensed by the gaming regulatory agency, (2) fewer new casino openings
and expansions than in the prior-year period and casino closures in the prior year, resulting
in lower demand for new gaming machines; (3) restrained investment in new gaming
machines and table products by our existing customers; (4) a competitive market resulting
in pricing pressures which negatively impacted our revenues from shipments of new
gaming machines and our gaming operations business;..

The Lottery Business Isnt Great

To be very clear, the crux of the SGMS short thesis rests on the overleveraged capital
structure, limited free cash flow, and challenges in the gaming segment. However, I do not
believe the Lottery segment is nearly as good or as stable as the market thinks. Retail sales
of US lottery tickets continues to decline and should be a leading indicator for the lotto
segment. In addition, the Company has a number of lottery contracts coming up for renewal
in the next several years. While I do not expect them to lose any or even most of the
contracts, the reality is that these contracts are tendered by governments and there will
almost certainly be pricing pressure associated with any renewal. The latest example in the
market is the Italian renewal by IGT, which will be reset to a 6% sales fee from an annual
average of 6.42% on the previous contract. Additionally, the new contract will require
hundreds of millions of dollars in minimum fees and capital expenditures to upgrade
systems. With falling prices, and slowing growth, one wonders if these lottery contracts are
even worth bidding on going forward, especially in light of too much debt and too little free
cash flow. For SGMS, eight contracts disclosed in the 2014 10-K make up nearly 1/3 of total
lottery revenue:


EBITDA and Leveraged FCF-Based Valuations are Flawed
I understand the bull case that if this just trades at 9x EBITDA it will more than double. But,
what good is EBITDA if it isnt a representative metric of the true costs to running the
business, if capital expenditures are high and necessary for maintaining the operation, and if
there is little/no free cash flow to equity? As already discussed, using EBITDA is flawed for
many reasons, but what is most egregious is that it doesnt factor in the costs necessary to
generate participation revenue. As noted above, because participation games are capitalized
and then amortized over time, using EBITDA for the gaming segment gives the Company
credit for participation-based revenue without any of the true expense which would be
captured through depreciation. At the very least, anybody looking at SGMS should be
focused on EBITDA-CapEx, or, because of the extreme leverage, unleveraged free cash flow.
Additionally, the Company uses several add-backs for its Attributable EBITDA figures they
sell to the street. Not surprisingly, when the add-backs are completely bogus, more often
than not it will not track true free cash flow over time. For SGMS, even the disclosed free
cash flow metric given in the quarterly press releases does not include a $40mm annual
license payment that they run through financing activities. Another example is including the
JV EBITDA, despite the fact that the JV capex, the JV interest expense, and the JV debt are
not included. Wouldnt a more appropriate analysis include either equity income, or cash
distributions from JVs? Yes, but that wouldnt make the EBITDA valuation as goodA good
exhibit from DB, and my own reconciliation of FCF are pasted below:

Interestingly, although the DB analyst published an exhibit essentially showing how

meaningless EBITDA is for SGMS, the valuation target of $9 is justified on an EBITDA-multiple
basis. I suspect that if any analyst were to value this on a DCF or any reasonable level of
sustainable free cash flow, the equity is worthless or close to it. Even on a leveraged free
cash flow basis, while it is certainly possible for the Company to have a year or two in the
$100mm - $200mm free cash flow range, does this really even matter? SGMS has over $8bn
of debt. All those dollars are going to debt paydown, and even then, this will have excessive
leverage by the time it must refinance. This is assuming their end markets do not weaken.
Best case, this will have $7bn in debt when they have to reprice substantial portions of their
indebted balance sheet. Looking at this on a leveraged free cash flow basis makes no
sense. I havent run the analysis, but I suspect leveraging any Company which has incredibly
poor free cash flow conversion and is leveraged at more than 8x on an EBITDA basis will look
cheap on a made up leveraged free cash flow metric on some number they havent achieved
yet, but hope to in 2017. Is that really a bull case?
Debt is a Bad Thing
In case you have been hiding under a rock (because you own a bunch of leveraged stuff!),
debt is no longer a good thing. Having over 8x of debt on a made-up EBITDA number is an
even worse thing. Below is the current debt structure of SGMS, along with the current
coupon, annual interest expense, and current yield/interest expense for the bonds. I have
assumed no changes to pricing for the revolver and term loan, though I think it is fair to say a
lot of their interest expense is likely to be higher when they must refinance. Will they be
paying 20+% coupons in the future? Probably not. I did this to illustrate though just how bad
of a problem they are in, that interest expense is likely to continue to be a burden on free cash
flow to equity in the future, and that what I think the market is really telling us is that this
Company may not make it.

Interestingly, when conducting its recent impairment test, SGMS used a 9% cost of capital
when valuing the gaming segment. Needless to say, with any reasonable cost of capital
based on the reality of the financial markets and their business, my guess is the entire
goodwill balance would have been impaired.
Valuation
Valuation here is more art than science given that nothing will make sense if you actually
have to look at free cash flow. As I stated in my intro, I believe the equity is worthless under
almost any scenario. The Company is still expected to achieve another $50mm of run-rate
synergies next year, but even given this, it seems like it will be difficult to offset the many
pressures in their business and their overleveraged balance sheet. Street analysts are
projecting revenue growth next year, despite current organic declines and what appear to be
mounting industry pressures. Looking at leveraged FCF to equity makes little sense, as what
little FCF they will generate is going to debt paydown and isnt being returned to equity
holders. Even assuming no industry pressures and that the Company hits expected numbers,
they will still have well over $7bn of debt in three years when the maturities get more
onerous. Realistically, I think this is in trouble far before that, as nearly any industry pressure
will deliver the death blow to what is an obviously over-leveraged balance sheet. Instead of
just saying this is worth $0, if we look at a scenario where we assume 10x EBITDA-CapEx on
a 2016E EBITDA number that includes tons of add-backs and is unlikely to materialize
(~$1140mm Adj. EBITDA - $320mm of capex), the equity would still be worth $0. Nevermind,
this is worth $0.
Conclusion
A series of acquisitions meant to rationalize the industry appears to have crippled SGMS. I
believe the overleveraged balance sheet, challenging industry environment, and limited free
cash flow generation have left SGMS in a precarious position that they likely cannot get out
of. In my opinion, this is a great short opportunity until the equity is essentially worthless.
Risks
This short probably isnt for the faint of heart. There are likely to be market rally days
where leveraged securities rise a lot. Ultimately, the problem here is far too much debt,
and even if they hit their numbers there is simply not enough free cash flow here to be
able to deleverage meaningfully basically ever.
Industry trends could magically become much better very soon. If trends improved
meaningfully, EBITDA and FCF would grow, though I doubt it would grow materially
enough to change the answer.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst
Lapping acquisitions over the next several quarters should help show the organic
growth trends of the business are very weak.
Continued disappointments in the core business which make free cash flow, leverage,
and liquidity even worse
A liquidity event in the case of a recession or materially worse industry fundamentals

Messages

Messages
Subject
dislcaimer
Entry
12/21/2015 06:36 PM
Member
wolverine03
Sorry..disclaimer is an old copy/paste. I am short.