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Game On For Scientific Games (SGMS)

 March 08, 2013 12:22 PM

(By Kevin Donovan) When not honing our black jack skills, we recently whiled away the hours looking for a stock that has yet to participate in this year's ebullient rally but deserves a calculated gamble.  We alighted on lottery and gaming solutions company Scientific Games Corp. (SGMS), a special situation name that has drawn boos from the Street for a recent acquisition.

The Street has been skeptical of this minnow swallowing the whale story (Scientific Games has a market cap of about $800 million, half as much as WMS), but if you're a sporting sort, the combination of Scientific Games and interactive gaming leader WMS Industries is a tempting play on online gaming.

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Scientific Games said last month it agreed in an all-cash deal to buy WMS for $26 a share, about $1.5 billion, a 59% premium to the share price when the deal was announced on Jan. 31.  Including an estimated $90 million in synergies, the deal values WMS at 4.4 times trailing-12-months EBITDA, according to Scientific Games.  That valuation is reasonable, we believe, considering competitor International Games Technology's share price is about 7.37 times EBITDA. The acquisition will funded 100% with new debt and is expected to be consummated by year-end.

The few Wall Street analysts who cover the company by and large panned the acquisition decision, citing the difficulties of a much smaller company buying a larger one, the increased debt of the new entity and the problems of realizing synergies between two companies engaged in different gaming business sectors.

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But we think the biggest risk is that the combination might be derailed by legal action.  Which means we view the acquisition as a forward-looking move that should reward shareholders as online gaming inevitably spreads across U.S. Jurisdictions.  New Jersey recently legalized online gaming within its border by its Atlantic City casinos, and gambling concerns in Las Vegas have laid the groundwork for online gaming in Nevada. 

Scientific Games currently garners most of its revenue from its instant lottery ticket machines with only 18% of revenue coming from interactive gaming.  Buying WMS Industries would boost gaming revenue to 53% of the mix with instant ticket systems falling to 31% from 54% of revenue.

In the meantime, Scientific Games anticipates $110 million of cash flow savings from the deal – $90 million in cost savings and $20 million in capex savings.  It is also counting on $100 million of tax savings through 2017 using net operating loss carryforwards.  The deal is expected to be immediately accretive to EPS and cash flow.

In the immediate future, Scientific Games is slated to report fourth-quarter results on Monday.  Analysts expect the company to have turned profitable with an average forecast of $0.05 per share compared with a loss of $0.09 in the year-ago quarter and a loss of $0.30 in the third quarter.

Scientific Games, based in New York, NY, provides gaming solutions to lottery and gaming organizations worldwide.  It designs and sells instant
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