Scientific Games Wins Lottery Deal - Analyst Blog

Scientific Games Corp.'s (SGMS) joint venture, Northstar Lottery Group, LLC, has been selected as the private manager of Illinois Lottery for the next ten years, after it won a competitive procurement process.

Under the agreement signed between Illinois Department of revenue and Northstar, the company will manage the day-to-day operations of the Lottery. Northstar is a joint venture between Scientific Games and GTECH Corporation, a subsidiary of Lottomatica Group S.p.A.. Scientific Games owns a 20.0% equity interest in the joint venture.     

Northstar will look after the lottery game development and portfolio management, and will also be responsible for retailer recruitment and training, call center operations, supply of goods and services, subcontractor and vendor selection and management, advertising, branding, and overall marketing strategy, over the assigned period.  

Northstar expects Illinois Lottery sales to increase to $4.5 billion by 2016 from $2.2 billion in 2010. Under the terms of the agreement, Northstar will receive annual incentive compensation payments. The incentive is based on the extent the company is able to spur Illinois Lottery's net income, above certain target levels, subject to a maximum of 5.0% of the year's net income.

However, if Northstar fails to cross the target, the company will have to pay the shortfall from the set target, subject to a similar cap. Northstar will be reimbursed for most of its operating expenses under the arrangement.

During the first five years of the agreement, Northstar expects to generate a profit of approximately $5.2 billion for the state.

Scientific Games will be responsible for the design, development, manufacturing, warehousing and distribution of instant lottery tickets and will be compensated based on a percentage of retail sales. Scientific Games will also be entitled to its pro rata share of Northstar's earnings.

Scientific Games believes this new business model will transform the industry going forward. We are, however, skeptical about this performance-based business model considering the currently sluggish macro environment in the U.S., particularly in Illinois, which is yet to recover from the economic downturn.

Recently, Scientific Games won a ten-year contract from the Louisiana Lottery Corporation in a competitive procurement process. The company also won a five-year contract from the Ontario Lottery and Gaming Corporation, in December 2010, to supply instant lottery tickets and printing services.

We believe the company's diversified product offerings, international development activities, recurring revenue business model and strong growth from the Internet-based business will drive the stock in the long run.

However, near-term revenue weakness and increasing competition from International Game Technology (IGT) compel us to remain on the sidelines. Currently, Scientific Games has a Zacks #5 Rank, which implies a short-term Sell rating.

 
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