Description

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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 gamble…but 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 don’t 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 Company’s 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 Company’s 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 lottery’s 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 fast-growing 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 doesn’t even pick up the key expense related to the Company’s 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 Company’s 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 I’ve 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 doesn’t 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 Company’s own numbers seem to suggest that this hasn’t materialized, and the future outlook doesn’t seem to be much better.  If you have access, I’d 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 doesn’t 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

“Many of our younger customers do not play slot machines, which is where we derive the majority of our revenue.  In the event that our customers do not use slot machines, this may have an adverse effect on our results of operations.”

But, if you don’t believe any of this, 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. 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 Isn’t 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 isn’t 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 doesn’t 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.  Wouldn’t a more appropriate analysis include either equity income, or cash distributions from JVs?  Yes, but that wouldn’t make the EBITDA valuation as good…A 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 haven’t 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 haven’t 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 isn’t 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 isn’t 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.

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