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December 21, 2015 by wolverine03 (/member/wolverine03/37563)
2015 2016
8.33 EPS
Shares Out. (in M):
86 P/E
Market Cap (in M):
718 P/FCF
Net Debt (in M):
8,308 EBIT
9,026 TEV/EBIT
Borrow Cost:
Available 0-15% cost
Quality Rating:

(2 votes)
Performance Rating:

(1 votes)

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
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

and acquired Bally for $5. and with no meaningful debt paydown possible over the next several years.  The trouble with overpaying for assets of course. and unfortunately. and potentially pricing as units turnover. primarily in North America and include regional and tribal casinos. waiting for industry pressures or an eventual refinancing to tip the Company into insolvency. essentially an indictment that they have overpaid for both WMS and Bally. diversify the product mix.  For what it is worth.$0.  As discussed later. riverboat casinos. gaming content. there are probably far more intelligent gambles in the market than this. the North American slot market has been relatively stagnant at 940k of total units in the installed base. because there is none): Gaming Segment – The gaming segment products are installed at various facilities. so growth in this segment is driven largely by replacement cycles.  The key benefits of economies of scale and potential pricing power don’t seem to have materialized.  The rationale for both deals was to allow the combined companies to benefit from economies of scale. the large debt position of the Company leaves little margin for error.  Sales in this segment are mostly classified as either “product” sales or “services”. and become a large player in the gaming business. drive cost savings/synergies. SGMS appears to be a ticking time bomb.  I have focused on the main areas that drive operations and EBITDA (not cash flow. described below:          Product sales – Majority of sales are from gaming machines sold to casino operators. two recent acquisitions have transformed the business into a leading provider of gaming technology (slot machines) for casino operators. Business Description Scientific Games Corporation is a leading provider of technology-based products and services and content for the worldwide gaming and lotto industries.  Very briefly. market share gains. and traditional facilities in Las Vegas and other marquee destinations. gaming machines are sold for about $15k per unit and are considered capex to the casino operator. the Company took a $535mm impairment charge (with no tax benefit) to lower the value of their gaming segment.  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. the byproduct of these deals was to dramatically leverage the balance sheet of SGMS.  Gross margins for SGMS are approximately 50%.  Typically. in Q3 of 2015. casino management systems and other table came products.1bn in November of 2014. the key components of the Company’s operating segments are below.  I suppose it is fitting if you want to be long SGMS in that it is nothing more than a gamble…but even then. the sale is made and life goes on. is that none of the debt goes away with the asset impairment.  Ultimately.  SGMS acquired WMS for approximately $1. creating the current problem and setting up a good case for a terminal short.  While SGMS was previously mostly a lotto gaming business.5bn in October of 2013.  The primary products for the Company include slot machines. primarily in North America. . instant and draw-based lottery games and systems.

  Importantly.  Key competitors in the lotto segment include Gtech. but puts up little/no upfront money in exchange for a cut of the revenue. with key competitors including IGT.  For the lottery systems business. requiring large roll-outs of equipment and systems everywhere when new contracts are won. but this is incredibly deceiving. the vast majority of the revenue consists of instant games.  The business is characterized by the constant flow of new games.  Doing so gives the Company credit for participation revenue without any of the real costs. while ongoing support and systems are included as services revenue. the Company generates revenue from video lottery systems. manufactures. typically under multi-year contracts where revenue is equal to a percentage of the lottery’s total retail sales.  Games are typically either WAP. table products including shufflers and chip sorters.  SGMS designs. Konami. looking at EBITDA for the gaming segment is completely nonsensical.  For this segment. casino-management technology and systems. and typical arrangements are for SGMS and other gaming companies to earn 20% of the daily win from the machine. and a newest and best mentality from the gaming operators. which are amortized through depreciation. or standalone participation games which are machines located within a single casino.  The revenue is roughly 75-80% margin. the Company manufactures lottery systems at the point of sale. .  This is just one reason why the Company’s fundamentals are far worse than what they appear to be on an EBITDA basis alone. except for Canada. the machines can be swapped out at any time by the casino operator. though it should be noted that gaming systems cannot be shipped into the US from other countries.  SGMS is responsible for the capex associated with the gaming machine. and the overall business is capital intensive.  Revenue from point-of-sale units are included as product sales revenue.         Services – Most gaming technology companies are now pushing “participation” games. Competition in the gaming segment has generally been fierce.  Because the “costs” are now capitalized and amortized through the P&L.  For this reason. and distributes instant lottery tickets and lottery game systems to various government jurisdictions across the world.          Other – In addition to slot machine product sales and services. and Aristocrat.  Revenue is typically either on a price-per-unit basis or participation basis for instant lottery games. Lotto Segment – The lottery segment is exactly what it sounds like. which are networked games linked across multiple casinos and which typically have a large jackpot payoff. which is the bulk of services revenue. shifting the cost of an unprofitable game back to the gaming technology company and potentially making this form of revenue far more capital intensive.  The instant lottery business is typically a contract-based business with three to five year terms and renewal options. 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.  Participation games are when the casino operator essentially allocates floor space to the gaming technology company.

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




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

and the future outlook doesn’t seem to be much better.  The key takeaways are as follows:          The industry total installed based has largely stagnated.  Within that number.  The survey contains the responses from 141 casino slot managers in 26 different states.  Goldman has visibility into the industry adding only about 6.  Regional and tribal casinos.  Additionally. and has a lot of information on pricing trends. the industry has generally slowed the pace of new casino openings and casinos in other areas have closed.  All of a sudden.100 slots in 2017. this “recurring” revenue from participation games doesn’t look so stable.     Industry Challenges The bull case for SGMS continues to revolve partially around the eventual pick-up in replacement demand.  Still. and purchase intent. 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: .200 slots in 2016 and 1. it appears as though gaming operators continue to pull back on participation games (which are higher IRR for gaming technology companies). which is their annual slot survey.  Additionally. though they have stabilized lately. and continue to move existing slot machine assets to new casinos that are being opened as opposed to expanding slot numbers in the aggregate.  However. I’d point everybody to a report by Goldman Sachs from August 2015. as these underlying organic trends become more obvious as the Company laps the acquisitions.  If you have access. have experienced relatively weak revenue trends over time. which make up a large portion of the total slot market. market share trends. The North American slot industry has largely stagnated around 940k total machines in service. various industry data points and the Company’s own numbers seem to suggest that this hasn’t materialized.would accelerate. I think people will start to pay closer attention.

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

  IGT and SGMS appear to be losing share. and we're significantly up over 2 years ago. that's all equipment on the gaming floor. competitors in the industry seem to be using pricing to hold onto existing market share and units. half of our maintenance capital just to slots and equipment. So this year. And last question. because the industry appears to have stagnated. I think we would call a cyclical low for us in terms of maintenance capital. I don't see that changing very much at all just because EBITDA is going up. We've had a fairly. it seems as though Aristocrat continues to take market share and has the most interest in its products. merely being flat and generating little/no cash flow doesn’t seem like a good outcome for SGMS’ long-term prospects. 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. So I think it's going to stay as is from a slot product standpoint.   .Q2 2016 Transcript – 12/2/15 Vikram Awasthi Q: “Okay. That's not just slots.” BYD .what I think is a fairly healthy amount of maintenance capital that keep our properties current and modern and competitive.  This seems to be the exact opposite of the desired effect of industry consolidation. I think we'll be fairly stable on a go-forward basis. give or take. Where is that spend compared to last year? And what are you looking for in used slots and gaming equipment moving forward?” Eric L. I think you mentioned earlier that you had some spend on slots and gamings.  Regardless.  Importantly. we are up over last year. same as this year.  Based on GS’ latest slot survey. very good. once again. but not significantly younger from here. I don't see that going up at all.Q2 2015 Call – 7/23/15 Keith E. Hausler A: “We've historically said we'll allocate.” ISLE . fairly consistent budget for buying new product for our slot floors. Smith A: “Sure. Smith Q: “No. a little bit of a bank shot. Can you just comment about what you expect your slot budget -.Q: “All right.your slot purchase budget to be like next year?” Keith E. We have a -. at the current valuation. which 2 years ago. Our goal is to get the average age of the slot floors incrementally younger.” I think this is direct evidence of a challenging industry backdrop that is likely to get worse before it gets better.

A prolonged reduction in customer spending on new gaming machine units.”   But.  It appears at least Pinnacle Entertainment agrees with me:   PNK – Latest 10-K “Many of our younger customers do not play slot machines.  The reality is that the next leg of gaming is going to be online.  Although there is no great data on this.  In the event that our customers do not use slot machines. a lack of new casino openings. and the younger generation of gamblers is focused on table games. economic and political conditions . this may have an adverse effect on our results of operations. we can all go to the typical slot floor only to see the 75 year old grandmother playing the nickel slots by herself. below is the Company’s 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. and restaurants which is partially why casinos continue to shift investment dollars towards these ventures.           Younger demographics are likely to hurt the industry long term. if you don’t believe any of this. which is where we derive the majority of our revenue. bars/clubs.

especially in light of too much debt and too little free cash flow. (3) restrained investment in new gaming machines and table products by our existing customers.  While I do not expect them to lose any or even most of the contracts.impacting unit sales and participation game revenues in certain international jurisdictions.42% on the previous contract.  In addition. one wonders if these lottery contracts are even worth bidding on going forward.  However. I do not believe the Lottery segment is nearly as good or as stable as the market thinks.. the crux of the SGMS short thesis rests on the overleveraged capital structure.  The latest example in the market is the Italian renewal by IGT. resulting in lower demand for new gaming machines.  Additionally. 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. (4) a competitive market resulting in pricing pressures which negatively impacted our revenues from shipments of new gaming machines and our gaming operations business. eight contracts disclosed in the 2014 10-K make up nearly 1/3 of total lottery revenue: .  With falling prices.  For SGMS. which will be reset to a 6% sales fee from an annual average of 6. 2015 and could continue to negatively impact our results of operations.”   The Lottery Business Isn’t Great To be very clear.  Retail sales of US lottery tickets continues to decline and should be a leading indicator for the lotto segment. (2) fewer new casino openings and expansions than in the prior-year period and casino closures in the prior year. the Company has a number of lottery contracts coming up for renewal in the next several years.. and cost reduction initiatives undertaken by certain of our customers during the quarter have all negatively impacted our SG gaming reporting unit. and slowing growth. the new contract will require hundreds of millions of dollars in minimum fees and capital expenditures to upgrade systems.”   “We believe that challenging market conditions in the gaming industry adversely impacted our Gaming results for the three and nine months ended September 30. and challenges in the gaming segment. limited free cash flow. the reality is that these contracts are tendered by governments and there will almost certainly be pricing pressure associated with any renewal.

  Not surprisingly.”  But. 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. and the JV debt are not included. but that wouldn’t make the EBITDA valuation as good…A good exhibit from DB.  Another example is including the JV EBITDA.  Additionally. using EBITDA is flawed for many reasons. the Company uses several add-backs for its “Attributable EBITDA” figures they sell to the street. because participation games are capitalized and then amortized over time. anybody looking at SGMS should be focused on EBITDA-CapEx.  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. more often than not it will not track true free cash flow over time. despite the fact that the JV capex. unleveraged free cash flow. if capital expenditures are high and necessary for maintaining the operation.  For SGMS. the JV interest expense. or. but what is most egregious is that it doesn’t factor in the costs necessary to generate participation revenue. when the add-backs are completely bogus.  At the very least. what good is EBITDA if it isn’t a representative metric of the true costs to running the business. 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. and if there is little/no free cash flow to equity?  As already discussed. and my own reconciliation of FCF are pasted below: .  Wouldn’t a more appropriate analysis include either equity income. or cash distributions from JVs?  Yes.  As noted above. because of the extreme leverage.


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

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

directorship.        I do not hold a position with the issuer such as employment. or consultancy. leverage. and liquidity even worse          A liquidity event in the case of a recession or materially worse industry fundamentals Messages . 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. I and/or others I advise hold a material investment in the issuer's securities.

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