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SCIENTIFIC GAMES CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following MD&A is intended to enhance the reader's understanding of our operations and current business environment. This MD&A should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" for the fiscal year ended December 31, 2013 and the "Business" section included in our 2013 Annual Report on Form 10-K. This MD&A contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and should be read in conjunction with the disclosures and information contained and referenced under "Forward-Looking Statements" included in this Quarterly Report on Form 10-Q. As used in this MD&A, the terms "we," "us," "our" and the "Company" mean Scientific Games Corporation together with its consolidated subsidiaries. Our MD&A is organized into the following sections: • BUSINESS OVERVIEW • CONSOLIDATED RESULTS • BUSINESS SEGMENT RESULTS • RECENTLY ISSUED ACCOUNTING GUIDANCE • CRITICAL ACCOUNTING ESTIMATES • LIQUIDITY, CAPITAL SOURCES AND WORKING CAPITAL BUSINESS OVERVIEW We are a leading diversified supplier of technology-based products and services to the gaming and lottery industries. The Company's portfolio includes instant and draw-based lottery games; gaming machines and game content; server-based lottery and gaming systems; sports betting technology; loyalty and rewards programs; and interactive products and services. We also gain access to technologies and pursue global expansion through strategic acquisitions, equity investments and licensing agreements. Pending Acquisition of Bally On August 1, 2014, we entered into a merger agreement pursuant to which we agreed to acquire Bally, a leading supplier of gaming machines, table game products, systems, and interactive gaming solutions, for $83.30 in cash per common share. The aggregate transaction value is approximately $5.1 billion, including the refinancing of approximately $1.8 billion of existing Bally net debt. We received early termination of the waiting period under the HSR Act in August 2014, which satisfied one of the conditions to closing the merger. The closing of the merger remains subject to approval of the merger by Bally stockholders, receipt of certain gaming regulatory approvals and other customary closing conditions. The merger agreement contains certain termination rights for both Scientific Games and Bally and further provides that, in connection with termination of the merger agreement under specified circumstances, (1) we may be required to pay to Bally a termination fee of $105.0 million if all the conditions to closing have been met and the merger is not consummated because of a breach by our lenders of their obligations to finance the transaction, (2) we may be required to pay to Bally a termination fee of $105.0 million if the parties are unable to obtain the gaming regulatory approvals that are conditions to closing and (3) Bally may be required to pay us a termination fee of $80.0 million under specified circumstances, including, but not limited to, a change in the Bally board's recommendation of the merger or in connection with Bally's termination of the merger agreement to enter into a written definitive agreement for a "superior proposal" (as defined in the merger agreement). In connection with the merger agreement, we entered into a commitment letter pursuant to which the lenders party thereto have agreed to provide the Debt Financing. The funding of the Debt Financing is contingent on the satisfaction of certain conditions set forth in the commitment letter. The merger is not conditioned on our obtaining the proceeds of any financing, including the Debt Financing. In connection with the contemplated financing, on October 1, 2014, we entered into an amendment to our existing credit agreement to, among other things, permit the Bally acquisition and the transactions related thereto, and, effective as of the completion of the Bally acquisition (and the satisfaction of the other conditions contemplated by the amendment), increase the Company's existing revolving credit facility by $267.6 million. Under the terms of the amendment, the existing term loans under the credit agreement (1) prior to the consummation of the Bally acquisition, will continue to bear interest at 3.25% per annum for eurodollar (LIBOR) loans and 2.25% per annum for base rate loans, subject to a eurodollar (LIBOR) rate floor of 1.00% or a base rate floor of 2.00%, as applicable, and (2) from and after the consummation 48 -------------------------------------------------------------------------------- of the Bally acquisition, will bear interest at 5.00% per annum for eurodollar (LIBOR) loans and 4.00% per annum for base rate loans, subject to a eurodollar (LIBOR) rate floor of 1.00% or a base rate floor of 2.00%. In addition, on October 1, 2014, SGMS Escrow Corp. entered into an escrow credit agreement providing for $2.0 billion of new term loans, the net proceeds of which are expected to provide a portion of the funds to be used to finance the Bally acquisition. Upon the consummation of the Bally acquisition, the term loans under the Escrow Credit Agreement will be assumed by SGI and become incremental term loans under our existing credit agreement. The term loans under the Escrow Credit Agreement (and, when assumed by SGI, the existing credit agreement) bear interest at 5.00% per annum for eurodollar (LIBOR) loans and 4.00% per annum for base rate loans, subject to a eurodollar (LIBOR) rate floor of 1.00% or a base rate floor of 2.00%, as applicable. The term loans under the Escrow Credit Agreement were funded into escrow, less original issue discount, by the lenders on October 17, 2014 and began accruing interest, initially at the LIBOR loan rate plus the applicable margin referred to above, beginning on October 18, 2014. For additional information regarding the acquisition financing, please see the section entitled "Contemplated Financing for Bally Acquisition" in Note 12 (Long-term and Other Debt) in this Quarterly Report on Form 10-Q , as well as the full text of our existing credit agreement, the commitment letter, the amendment to our credit agreement and the Escrow Credit Agreement, copies of which are filed as Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on October 18, 2013, Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on August 4, 2014, and Exhibit 10.1 and Exhibit 10.2 to our Current Report on Form 8-K filed with SEC on October 7, 2014, respectively. The foregoing summaries of the terms of the existing credit agreement, the commitment letter, the amendment to the existing credit agreement and the Escrow Credit Agreement are qualified in their entirety by reference to the respective exhibit. For additional information regarding the pending transaction, please see the full text of the merger agreement, a copy of which is filed as exhibit 2.1 to our Current Report on Form 8-K filed with the SEC on August 4, 2014. The Bally acquisition is expected to be completed in the fourth quarter of 2014. However, no assurance can be given that the transaction will be completed. In connection with the pending Bally acquisition, we incurred $5.6 million in acquisition-related fees and expenses during the three months ended September 30, 2014 and expect to continue to incur additional acquisition-related fees and expenses in the fourth quarter of 2014. Upon closing of the acquisition of Bally, we expect to incur approximately $170 million of financing fees in connection with the term loans and revolving credit facility under the Escrow Credit Agreement and with respect to the remaining financing commitments under the commitment letter for the acquisition of Bally. We also anticipate incurring fees related to our additional financing activities during the balance of the quarter ending December 31, 2014. Impact of WMS Acquisition and Other Items On October 18, 2013, the Company acquired WMS for $1,485.9 million. WMS is one of the largest global gaming suppliers with a diversified suite of products and strong content creation capabilities. For additional information regarding the WMS acquisition, please see Note 3 (Acquisitions and Dispositions) in this Quarterly Report on Form 10-Q. Our consolidated results of operations for the three and nine months ended September 30, 2014 were significantly impacted by the inclusion of the results of operations of WMS in our consolidated and Gaming segment results of operations. Results for the three and nine months ended September 30, 2013 do not include results of operations for WMS. We remain focused on successfully integrating WMS and Scientific Games and achieving anticipated cost synergies by implementing our integration plans, although we expect that incremental costs and capital expenditures will be required relating to our integration activities. Segments We report our operations in three business segments: Instant Products, Lottery Systems and Gaming. The Instant Products and Lottery Systems business segments are managed by a single executive and the Gaming business segment is managed by a different executive, both of whom report to our chief executive officer (who is the "chief operating decision maker" under applicable accounting rules). Our interactive operating segment is aggregated with our gaming operating segment and is presented within the Gaming business segment. See "Business Segment Results" below and Note 2 (Reportable Business Segment Information) in this Quarterly Report on Form 10-Q for additional business segment information. In addition, effective in the fourth quarter of 2013, we revised our business and operating segments to reflect the reorganization of our business following the WMS acquisition and the financial information regularly reviewed by our chief executive officer. Based on that review, we moved our video systems operating segment from the Lottery Systems business segment to the Gaming business segment. This change, which was effective as of December 31, 2013, had no impact on the Company's 49-------------------------------------------------------------------------------- consolidated financial statements for any periods. Business segment information for the three and nine months ended September 30, 2013 has been adjusted to reflect this change. Discontinued Operations On March 25, 2013, we completed the sale of our installed base of gaming machines in our pub business, as discussed in Note 3 (Acquisitions and Dispositions) in this Quarterly Report on Form 10-Q. The results of our discontinued pub operations for the three and nine months ended September 30, 2013 are presented in the Consolidated Statements of Operations and Comprehensive (Loss) Income in accordance with ASC 205-20, Presentation of Financial Statements - Discontinued Operations. For the three and nine months ended September 30, 2013, we recorded a loss from discontinued operations of $0.1 million and $1.6 million, respectively. There were no results of operations for the discontinued pub business for the three or nine months ended September 30, 2014. Foreign Exchange Our results are impacted by changes in foreign currency exchange rates from the translation of foreign functional currencies into U.S. dollars and the re-measurement of foreign currency transactions. The impact of foreign currency exchange rate fluctuations represents the difference between current rates and prior-period rates applied to current activity. We derived approximately 49% and 53% of our revenue from sales to customers outside of the U.S. in 2013 and 2012, respectively. We have exposure to foreign currency volatility, particularly the British Pound Sterling and the Euro, which represented $59.6 million, or 14.3%, and $35.3 million, or 8.5%, respectively, of our revenue for the three months ended September 30, 2014 and $175.6 million, or 14.4%, and $77.6 million, or 6.4%, respectively, of our revenue for the nine months ended September 30, 2014. We also have foreign currency exposure related to certain of our equity investments. Our earnings from our Euro-denominated equity investment in LNS were $4.0 million and $14.6 million for the three and nine months ended September 30, 2014, respectively. See "Quantitative and Qualitative Disclosures About Market Risk" in Item 7A of our 2013 Annual Report on Form 10-K for further information regarding our foreign exchange exposures. 50 -------------------------------------------------------------------------------- Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013 CONSOLIDATED RESULTS Variance for the Three Months Ended Three Months Ended (in millions) September 30, September 30, 2014 2013 2014 vs. 2013 Revenue: Instant games $ 130.8 $ 129.7 $ 1.1 0.8 % Services 182.8 80.7 102.1 126.5 % Product sales 102.0 24.0 78.0 325.0 % Total revenue 415.6 234.4 181.2 77.3 % Operating expenses: Cost of instant games (1) 69.7 70.6 (0.9 ) (1.3 )% Cost of services (1) 69.6 42.6 27.0 63.4 % Cost of product sales (1) 59.9 13.3 46.6 350.4 % Selling, general and administrative 95.6 45.6 50.0 109.6 % Research and development 26.3 1.4 24.9 n/m Employee termination and restructuring 1.9 - 1.9 n/m Depreciation and amortization 100.4 35.2 65.2 185.2 % Operating (loss) income (7.8 ) 25.7 (33.5 ) n/m Other income (expense): Interest expense (45.7 ) (25.2 ) (20.5 ) 81.3 % Earnings (loss) from equity investments (14.0 ) 3.4 (17.4 ) n/m Other income, net 3.1 - 3.1 n/m Net (loss) income from continuing operations before income taxes (64.4 ) 3.9 (68.3 ) n/m Income tax expense (5.4 ) (4.3 ) (1.1 ) 25.6 % Net loss from continuing operations $ (69.8 ) $ (0.4 ) $ (69.4 ) n/m "n/m" - not meaningful (1) Exclusive of depreciation and amortization. Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013 Revenue Consolidated revenue increased in each of our categories of revenue: instant games, services and product sales. The inclusion of revenue from WMS increased consolidated revenue by $162.5 million. Consolidated revenue also reflected favorable foreign currency translation of $3.5 million. Instant games revenue increased $1.1 million reflecting higher revenue from our participation contracts in U.S. and certain international jurisdictions and higher revenue from our U.S. price-per-unit contracts. These increases were partially offset by lower revenue from our licensing and player loyalty programs and our international price-per-unit contracts. Services revenue, which includes our participation-based and other services revenue from our U.S.-based lottery systems and Gaming segment, increased $102.1 million, primarily reflecting the inclusion of WMS services revenue of $98.5 million. The $78.0 million increase in product sales revenue included $64.1 million of WMS product sales revenue, with the remaining increase attributable to higher hardware and software sales to our international and U.S. lottery customers. Cost of Revenue Consolidated cost of revenue increased primarily as a result of higher revenue. Cost of instant games revenue decreased 1% compared to the increase in instant games revenue of 1% due to a more profitable mix of revenue. Cost of services increased 63% compared to an increase in services revenue of 127%, reflecting a more profitable revenue mix 51-------------------------------------------------------------------------------- primarily attributable to WMS services revenue. Cost of product sales increased 350% compared to an increase in sales revenue of 325%, primarily reflecting the inclusion of WMS product sales. SG&A SG&A increased $50.0 million, which reflected $41.8 million of SG&A attributable to WMS and $3.1 million of higher acquisition-related fees and expenses related to the pending Bally acquisition. R&D R&D increased $24.9 million primarily related to the inclusion of WMS in our financial results. Employee Termination and Restructuring Employee termination and restructuring costs increased $1.9 million, $1.5 million of which was attributable to WMS integration activities. For additional information regarding these charges, see Note 4 (Restructuring Plans) in this Quarterly Report on Form 10-Q. D&A D&A increased $65.2 million, of which $58.9 million was attributable to WMS. Excluding the increase attributable to WMS, D&A reflected an increase in amortization of capitalized internally developed software assets in the current-year period, partially offset by accelerated D&A recorded in the prior year for the write-down of used gaming machines and a change in the estimated useful lives of certain gaming machines. Other Income and Expense Interest expense increased $20.5 million due to the additional indebtedness incurred to finance the WMS acquisition. This increase was slightly offset by a reduction in interest expense as a result of the refinancing of the 2019 Notes with the 2021 Notes in June 2014. For additional information regarding our indebtedness, see Note 12 (Long-term and Other Debt) in this Quarterly Report on Form 10-Q. Earnings from equity investments decreased $17.4 million primarily was due to the $19.7 million non-cash impairment charge we recorded to write down our Northstar Illinois equity investment as we understand that the Governor's office of the State of Illinois directed the Illinois Department of Lottery to end the PMA with Northstar Illinois. For additional information regarding our equity investments, see Note 11 (Equity Method Investments) in this Quarterly Report on Form 10-Q. Income Tax Expense The effective income tax rates on the net (loss) income from continuing operations of (8.4)% and 109.5% for the three months ended September 30, 2014 and 2013, respectively, were determined using an estimated annual effective tax rate after considering any discrete items for such periods. Due to a valuation allowance against our U.S. deferred tax assets, the effective tax rates for the three months ended September 30, 2014 and 2013 did not include the benefit of the current-year U.S. tax loss. As a result, income tax expense for the three months ended September 30, 2014 and 2013 primarily related to income tax expense in foreign jurisdictions. Our effective income tax rate on foreign earnings was impacted by the mix of income and the statutory tax rates in our foreign jurisdictions, which ranged from a low of 0% to a high of 35%. The foreign jurisdictions that had the most impact on our foreign income tax benefit (expense) in the period include Austria, Canada, Ireland, and the U.K. 52 -------------------------------------------------------------------------------- BUSINESS SEGMENTS RESULTS INSTANT PRODUCTS Our Instant Products segment is primarily comprised of our global instant lottery games business. We generate revenue from the manufacture and sale of instant lottery games, as well as the provision of value-added services such as game design, sales and marketing support, specialty games and promotions, inventory management and warehousing and fulfillment services. In addition, we provide licensed games, promotional entertainment and internet-based marketing services to the lottery industry. These revenues are presented as instant games revenue in our Consolidated Statement of Operations and Comprehensive Statement of (Loss) Income. Revenue generated from the sale of phone cards that we manufacture is presented as product sales revenue in our Consolidated Statement of Operations and Comprehensive Statement of (Loss) Income. Our equity investments in LNS (Italy), Northstar Illinois, Northstar New Jersey, CSG (China) and Hellenic Lotteries (Greece) are included in the Instant Products segment. Current Year Update In January 2014, we completed the installation of a new, state-of-the-art instant lottery game printing press at our Alpharetta, Georgia facility, which provides increased capacity for the production of our instant games. In November 2013, we were awarded a new price-per-unit contract with Loto-Québec, which we expect to take effect in the fourth quarter of 2014 and that will represent a significantly smaller portion of such customer's instant lottery game business than our prior contract with Loto-Quebec, which expired in January 2014. We understand that a contract has been awarded to one of our competitors for certain categories of instant games that we provided under the recently expired contract. We have continued to provide instant lottery games to Loto-Québec since the expiration of our prior contract. In April 2014, we entered into a three-year price-per-unit instant games contract to continue serving as the primary supplier to La Française des Jeux ("FDJ"), the operator of the French National Lottery and the second largest instant game lottery in the world, which includes options for FDJ to extend the contract for three additional one-year periods. In May 2014, Hellenic Lotteries commenced sales of lottery games in Greece under its 12-year concession, which provides exclusive rights to the production, operation and management of instant games and certain traditional lotteries in Greece. We own a 16.5% equity interest in Hellenic Lotteries and are its exclusive supplier of instant games under a participation contract. In October 2014, the MONOPOLY MILLIONAIRES' CLUBTM ("MMC") was launched by lotteries in 23 states through the Multi-State Lottery Association ("MUSL"). MMC was created by the Company and is the first $5 multi-state draw game in the United States. The Company is also producing a weekly one-hour MONOPOLYTM-themed television game show associated with the MMC draw game, which we expect will air in February 2015. The initial term of our MMC agreement with MUSL runs through September 6, 2016 and automatically renews for additional one-year periods thereafter unless terminated according to its terms. Our revenue from MMC will be based on a percentage of retail sales. In December 2013, we initiated a plan to exit our instant lottery game operations in Mexico. In February 2014, we exited the operations and simultaneously entered into a three-year agreement to supply instant lottery games to a distributor in Mexico. In June 2014, we initiated a plan to exit our paper roll conversion operations in the U.S., which are immaterial to our operations. Under the terms of a PMA, Northstar Illinois is entitled to receive annual incentive compensation payments from the lottery to the extent it is successful in increasing the Illinois lottery's net income (as defined in the PMA) above specified target levels, subject to a cap of 5% of the applicable year's net income, and is responsible for annual payments to the lottery to the extent such targets are not achieved, subject to a similar cap. During the three months ended June 30, 2014, we understand that Northstar Illinois recorded a liability related to an estimated shortfall payment for the lottery's fiscal year ended June 30, 2014. We recorded a charge of $8.0 million, representing our 20% share of that liability, in earnings (loss) from equity investments in our Consolidated Statements of Operations and Comprehensive (Loss) Income during the three months ended June 30, 2014. During the three months ended September 30, 2014, we contributed $13.5 million to Northstar Illinois primarily to fund our pro rata share of shortfall payments that are payable to the lottery under the PMA. Northstar Illinois and the State have disagreed regarding the State's calculation of net income for each of the lottery fiscal years during the term of the PMA. In August 2014, we understand that the Governor's office of the State of Illinois directed the Illinois Department of Lottery to end the PMA with Northstar Illinois. Although an agreement has not yet been reached between Northstar Illinois and the lottery, in light of the direction by the Governor's office to the lottery to end the PMA with Northstar Illinois and the status of discussions among the parties, in the September 2014 quarter, the Company recorded a non-cash impairment charge of $19.7 million to write down its investment in Northstar Illinois. 53 -------------------------------------------------------------------------------- Retail sales of instant lottery games can be a key performance indicator of our instant games revenue, although there may not always be a direct correlation between retail sales and our instant games revenue due to the type of contract (e.g., participation contracts versus price-per-unit contracts), the impact of changes in our customer contracts, the performance of our games and player loyalty business or other factors. Based on third-party data, our U.S. customers' total instant lottery games retail sales increased 7.0% and 5.3% for the three and nine months ended September 30, 2014 compared to the prior-year periods, driven by several factors, including strong performance in those states where we provide instant game product management services. Retail sales of instant games in Italy decreased 3.0% and 2.7% for the three and nine months ended September 30, 2014 compared to the prior-year periods. Italy retail sales are generally impacted by the level of marketing spending and timing of the launch of new games. 54--------------------------------------------------------------------------------Results of Operations and Key Performance Indicators for Instant Products Variance for the Three Months Ended Three Months Ended (in millions) September 30, September 30, 2014 2013 2014 vs. 2013 Revenue: Instant games $ 130.8 $ 129.7 $ 1.1 0.8 % Product sales 3.2 3.1 0.1 3.2 % Total revenue 134.0 132.8 1.2 0.9 % Operating expenses: Cost of instant games (1) 69.7 70.6 (0.9 ) (1.3 )% Cost of product sales (1) 2.4 2.2 0.2 9.1 % Selling, general and administrative 12.2 11.5 0.7 6.1 % Research and development 0.5 0.1 0.4 n/m Employee termination and restructuring 0.4 - 0.4 n/m Depreciation and amortization 8.9 9.2 (0.3 ) (3.3 )% Operating income $ 39.9 $ 39.2 $ 0.7 1.8 % Earnings (loss) from equity investments $ (15.4 ) $ 5.2 $ (20.6 ) (396.2 )% Key Performance Indicators: Instant games by revenue type: Participation contracts $ 70.2 $ 62.0 $ 8.2 13.2 % Price-per-unit contracts 48.4 46.3 2.1 4.5 % Licensing and player loyalty 12.2 21.4 (9.2 ) (43.0 )% Total instant games revenue $ 130.8 $ 129.7 $ 1.1 0.8 % Instant games revenue by geography: U.S. (2) $ 82.6 $ 82.8 $ (0.2 ) (0.2 )% International (2) 48.2 46.9 1.3 2.8 % Total instant games revenue $ 130.8 $ 129.7 $ 1.1 0.8 % U.S. lottery customers' retail sales of instant games $ 9,298 $ 8,689 $ 609 7.0 % Italy retail sales of instant games (in Euros) € 2,185 € 2,253 € (68 ) (3.0 )% "n/m" - not meaningful (1) Exclusive of depreciation and amortization. (2) Amounts reflect a reclassification of $2.8 million from International to U.S. in the prior-year. Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013 Revenue The increase in instant games revenue of $1.1 million was primarily due to $9.2 million of higher revenue from our participation contracts in the U.S. and certain international jurisdictions, including our contracts with Northstar New Jersey and Hellenic Lotteries, partially offset by a decrease of $1.0 million due to our exit from the Provoloto business. The increase was also due to $4.0 million of higher revenue from our U.S. price-per-unit contracts, partially offset by a decrease of $1.9 million from our international price-per-unit contracts including our contract with LNS. The increase in instant games revenue was also offset by a $9.2 million decrease in revenue from our licensing and player loyalty programs primarily due to a higher number of contracts in the prior-year period. The increase in revenue also included a favorable impact from foreign currency translation of $0.7 million. 55 -------------------------------------------------------------------------------- Operating Income Operating income increased $0.7 million primarily due to higher revenue and lower D&A, partially offset by an increase in SG&A reflecting higher compensation and legal expenses, as well as higher R&D and restructuring costs. Earnings (loss) from equity investments The decrease in earnings from equity investments of $20.6 million was primarily due to the $19.7 million non-cash impairment charge we recorded to write down our Northstar Illinois equity investment as we understand that the Governor's office of the State of Illinois directed the Illinois Department of Lottery to end the PMA with Northstar Illinois. For additional information regarding our equity investments, see Note 11 (Equity Method Investments) in this Quarterly Report on Form 10-Q. LOTTERY SYSTEMS Our Lottery Systems business segment provides customized computer software, software support, equipment and data communication services, sports wagering systems and keno to lotteries. In the U.S., we typically provide the necessary equipment, software and maintenance services on a participation basis under long-term contracts that typically have an initial term of at least five years. Internationally, we typically sell point-of-sale terminals and/or computer software to lottery authorities and may provide ongoing fee-based systems maintenance and software support services. Our equity investment in GLB is included in the Lottery Systems segment. Current Year Update In March 2014, we executed an eight-year contract with the North Dakota Lottery, an existing customer, to implement and operate a lottery system and to provide a range of related services and marketing support. The contract commenced in July 2014 and may be extended by the lottery for an additional two-year period. In May 2014, we signed an amendment to our contract with Loteria Nacional de Beneficencia of Panama (the National Lottery of Panama) to provide Panama's first draw-based lottery game, which is expected to launch in the second quarter of 2015. In September 2014, Puerto Rico joined Powerball. All retailers who sell lottery tickets in Puerto Rico are now eligible to sell Powerball tickets as well. We are the exclusive instant lottery game validation network provider to the CSL under an agreement that expires in January 2016. Under the terms of this agreement, the participation rate we receive decreased by 0.1% in January 2014. We have seen a decline in our instant lottery game validation revenue and our joint venture's instant lottery game printing revenue as CSL's retail sales of instant lottery games have declined, which we believe is due in part to competition from other lottery products. We are currently seeking opportunities to continue providing our value-added services relating to the CSL, as well as additional business development opportunities to maintain our revenue and profit relating to our China lottery business following the expiration of the our current CSL agreement. To the extent we are not able to do so, our operating results relating to our China lottery business will be adversely affected. In June 2013, the Colorado Lottery awarded a new lottery systems contract to one of our competitors. We have continued to provide lottery systems services to the Colorado Lottery under our existing contract through October 2014. We believe that our U.S. lottery customers' retail sales is a key performance indicator of our Lottery Systems services revenue, although there may not always be a direct correlation between retail sales and our Lottery Systems services revenue due to the terms of our contracts, the impact of changes in our customer contracts or other factors. We believe the level of jackpots of the Powerball and Mega Millions multi-state draw lottery games, and the number of drawings conducted before a jackpot is won, may have an impact on U.S. retail sales and, therefore, on our services revenue in any given period. Our Lottery Systems services revenue is also impacted by retail sales of instant lottery games where we provide instant lottery game validation services on a standalone basis or as part of a Lottery Systems contract. Our Lottery Systems product sales revenue primarily relates to sales of equipment to international customers that are not subject to long-term contracts. 56 --------------------------------------------------------------------------------Results of Operations and Key Performance Indicators for Lottery Systems Variance for the Three Months Ended Three Months Ended (in millions) September 30, September 30, 2014 2013 2014 vs. 2013 Revenue: Services $ 48.2 $ 48.6 $ (0.4 ) (0.8 )% Product sales 30.5 13.6 16.9 124.3 % Total revenue 78.7 62.2 16.5 26.5 % Operating expenses: Cost of services (1) 30.4 27.1 3.3 12.2 % Cost of product sales (1) 24.6 7.3 17.3 237.0 % Selling, general and administrative 5.6 5.3 0.3 5.7 % Research and development 0.9 0.9 - n/m Depreciation and amortization 16.0 13.4 2.6 19.4 % Operating income $ 1.2 $ 8.2 $ (7.0 ) (85.4 )% Earnings from equity investments $ 0.1 $ 0.1 $ - 0.0 % Key Performance Indicators: Services revenue by geography: U.S. (2) $ 27.6 $ 27.7 $ (0.1 ) (0.4 )% International 20.6 20.9 (0.3 ) (1.4 )% Total services revenue $ 48.2 $ 48.6 $ (0.4 ) (0.8 )% Product sales by geography: U.S. $ 1.5 $ 1.0 $ 0.5 50.0 % International 29.0 12.6 16.4 130.2 % Total product sales revenue $ 30.5 $ 13.6 $ 16.9 124.3 % U.S. lottery customers' retail sales (3) $ 2,065 $ 2,100 $ (35 ) (1.7 )% "n/m" - not meaningful (1) Exclusive of depreciation and amortization. (2) U.S. services revenue excludes revenue from Puerto Rico. (3) U.S. lottery customers' retail sales primarily include retail sales of draw games, keno and instant games validated by the relevant system. The retail sales metric for the Lottery Systems segment previously disclosed for earlier periods included draw game retail sales only. We believe the revised metric more clearly correlates to our U.S. Lottery Systems services revenue, since we are generally compensated based on total retail sales generated by the relevant lottery system and not just draw game retail sales. The prior-year period retail sales information presented above has been revised to conform to the revised metric. Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013 Revenue Lottery Systems services revenue was essentially flat when compared to the prior-year period with a decline in revenue associated with the Powerball draw game reflecting the award of two large Powerball jackpots in the prior-year period, partially offset by higher revenue from instant ticket validations. The $16.9 million increase in Lottery Systems product sales revenue, which can fluctuate due to its non-recurring nature, primarily reflected higher international sales of hardware and software of $16.4 million and higher U.S. sales of $0.5 million. Operating Income Operating income declined $7.0 million primarily due to a less profitable mix of revenue and an increase in D&A related to higher capitalized software assets. 57 --------------------------------------------------------------------------------GAMING Our Gaming business segment is comprised of our gaming operating segment and our interactive operating segment. Our gaming operating segment designs, develops, manufactures, distributes and markets a comprehensive portfolio of gaming products. We lease gaming machines, systems and content and sell new and used gaming machines, VLTs, conversion kits and parts to commercial casinos, Native American casinos, wide-area gaming operators, such as LBO, arcade and bingo operators in the U.K. and continental Europe, and gaming operators affiliated with governments, such as lotteries and gaming regulators. Our interactive operating segment is comprised of our social gaming business in which we sell virtual coins for use on our social gaming sites and our real-money gaming business where we earn a percentage of net gaming revenue generated by play of our games on legalized real-money gaming websites operated by third parties. Our equity investments in RCN and ITL are part of our Gaming business segment. Our equity investment in Sportech was included in our Gaming segment until its sale in January 2014. We generate Gaming revenue from product sales and services. Our product sales consist of video and mechanical reel gaming machines, VLTs, conversion kits (including game, hardware and operating system conversions), parts and game content to casinos and wide-area and other gaming operators. Our services revenue includes revenue earned from leased gaming machines, other services and our interactive business. Current Year Update Our Gaming revenue increased in the third quarter of 2014 compared to the prior-year period, primarily due to the inclusion of WMS' revenue. However, we believe that challenging market conditions in the gaming industry adversely impacted our Gaming results for the third quarter of 2014 relative to WMS' results for the prior-year period and could continue to negatively impact our results of operations. These challenges included: (1) fewer new casino openings and expansions than in the prior year resulting in lower demand for new gaming machines; (2) increased competition, resulting in pricing pressure and negatively impacting our share of shipments of new gaming machines; (3) a decline in gaming operators' gross gaming revenues in the nine months ended September 30, 2014, which we believe resulted in a decrease in capital spending by gaming operators on new gaming machines; (4) government actions in Argentina, which limited our ability to import our products for sale in Argentina; and (5) industry challenges in Mexico, including fewer gaming operators, resulting in a decline in shipments of gaming machines to customers in Mexico. In March 2014, the U.K. government announced a proposed change to the machine games duty, or MGD, for certain gaming machines supplied to LBOs. The change, which is anticipated to go into effect in March 2015, raises the MGD rate from 20% to 25% of the net win generated by such gaming machines. We expect that this tax change will negatively impact our LBO customers' businesses and our U.K. gaming business. In April 2014, the U.K. government announced its intention to impose restrictions on betting shops and high stakes play, including requiring retail premises to submit planning applications and seek permission before converting their locations to betting shops, requiring customers wagering stakes of fifty Pounds or more to use account-based play or to load cash "over the counter" prior to play, and allowing players to set limits on the time or money they want to spend before commencing play. These changes, which are expected to be implemented in the second half of 2015, could negatively impact our U.K. gaming business. The UKGC is currently considering proposed changes to various social responsibility conditions (which are mandatory conditions of each gaming license) under the UKGC's Licensing Codes and Conditions of Practice ("LCCPs"). The proposed changes relate to land based and online gaming activities, including additional requirements regarding interactions between gaming providers and customers, additional customer self-exclusion provisions and controls on play and enhanced rules on advertising. If the proposed changes are incorporated as LCCPs, they could adversely impact our U.K. customers' business. In May 2014, the U.K. government passed the Gambling (Licensing and Advertising) Act 2014 (the "Act"). The Act, which is scheduled to take effect in November 2014, expands the licensing regime in the U.K. to require any gaming operator that transacts with or advertises to British consumers to obtain an operating license from the UKGC. In addition, the UKGC has separately announced a regulatory change, which will take effect in March 2015, requiring any party that manufactures, adapts, installs or supplies gambling software to such operators to obtain a remote gambling software license from the UKGC. As a result of these changes, the Company and certain of its customers will be required to obtain additional licenses and, while the U.K. government has indicated that current gaming operators will be able to obtain transitional approval to continue to operate while their license applications are pending, there can be no assurance that we or our customers will obtain the necessary licenses. Separately, legislation has been introduced in the U.K. that will impose a new remote gaming duty, or RGD, on gaming operators of 15% of the net win generated by transactions with U.K. customers. The new RGD is expected to take effect in December 2014. We anticipate that this tax change will impact our U.K. customers' businesses and, therefore, could negatively impact our business. 58 -------------------------------------------------------------------------------- In April 2014, we entered into a three-year contract extension with the Delaware lottery, which contemplates the placement of a minimum of 400 of our VLTs at charitable gaming organizations in Delaware. In June 2014, we signed a ten-year contract with the Independent Gaming Corporation Limited of South Australia to supply our SGVideoTM central monitoring and control system, which will monitor approximately 12,500 gaming machines in more than 550 locations throughout South Australia. Operations under the contract are expected to commence in the fourth quarter of 2014. Our interactive product portfolio expanded with the addition of a second social casino gaming site, Gold Fish® Social Slots, which became available on Facebook in the first quarter of 2014 and on mobile devices in the second quarter of 2014. We expanded our interactive real-money gaming business by entering into several new game content agreements with online operators and went live on several sites, including with bwin.party in Europe and certain online gaming sites in New Jersey. In January 2014, we completed the sale of our 20% equity interest in Sportech for cash proceeds of £27.8 million, or $44.9 million, resulting in a gain of approximately £9 million, or $14.5 million. Results of Operations and Key Performance Indicators for Gaming All results for 2013 presented herein include no results of operations of WMS, which was acquired in October 2013. Variance for the Three Months Ended Three Months Ended (in millions) September 30, September 30, 2014 2013 2014 vs. 2013 Revenue: Services $ 134.6 $ 32.1 $ 102.5 n/m Product sales 68.3 7.3 61.0 n/m Total revenue 202.9 39.4 163.5 n/m Operating expenses: Cost of services (1) 39.2 15.5 23.7 n/m Cost of product sales (1) 32.9 3.8 29.1 n/m Selling, general and administrative 42.4 6.3 36.1 n/m Research and development 24.9 0.4 24.5 n/m Employee termination and restructuring 1.5 - 1.5 n/m Depreciation and amortization 69.8 12.4 57.4 n/m Operating (loss) income $ (7.8 ) $ 1.0 $ (8.8 ) n/m Earnings (loss) from equity investments $ 1.3 $ (1.9 ) $ 3.2 n/m "n/m" - not meaningful (1) Exclusive of depreciation and amortization. 59 -------------------------------------------------------------------------------- (in millions, except for unit and per unit (or user) information) Variance for the Three Months Ended Three Months Ended September 30, September 30, 2014 2013 2014 vs 2013 Key Performance Indicators: Services revenue: WAP and premium participation products $ 57.5 $ - $ 57.5 n/m Other leased and participation products 30.6 26.6 4.0 15.0 % Interactive gaming products and services 38.5 - 38.5 n/m Other services 8.0 5.5 2.5 45.5 % Total services revenue $ 134.6 $ 32.1 $ 102.5 n/m WAP and premium participation units (1): Installed base at period end 9,054 - 9,054 n/m Average installed base 8,678 - 8,678 n/m Average daily revenue per unit $ 71.95 $ - $ 71.95 n/m Other leased and participation units (2): Installed base at period end 26,711 26,829 (118 ) (0.4 )% Average installed base 26,667 26,641 26 0.1 % Average daily revenue per unit $ 12.49 $ 10.87 $ 1.62 14.9 % Interactive gaming products and services - social casino: Average Monthly Active Users (MAU) (3) 5.7 - 5.7 n/m Average Daily Active Users (DAU) (4) 1.6 - 1.6 n/m Average revenue per daily active user (ARPDAU) (5) $ 0.23 $ - $ 0.23 n/m Product sales revenue: New gaming machine sales $ 48.2 $ 1.6 $ 46.6 n/m Other product sales 20.1 5.7 14.4 n/m Total product sales revenue $ 68.3 $ 7.3 $ 61.0 n/m Product sales: U.S. and Canadian new unit shipments 1,933 - 1,933 n/m International new unit shipments 1,362 276 1,086 n/m Total new unit shipments 3,295 276 3,019 n/m Average sales price per new unit $ 14,638 $ 5,818 $ 8,820 n/m "n/m" - not meaningful (1) WAP and premium participation products are comprised of WMS participation gaming machines (WAP, LAP and standalone units) generally available only as leased units (2) Other leased and participation units are comprised principally of Scientific Games legacy server-based gaming machines, primarily in the U.K., and other leased WMS units (3) MAU = Monthly Active Users, a count of unique visitors to our sites during a month (4) DAU = Daily Active Users, a count of unique visitors to our sites during a day (5) ARPDAU = Average revenue per DAU is calculated by dividing revenue for a period by the DAU for the period by the number of days for the period 60--------------------------------------------------------------------------------Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013 Revenue The $102.5 million increase in Gaming services revenue includes $98.5 million from WMS. Services revenue from our U.K. gaming customers was essentially flat compared to the prior-year period due to the loss of our Betfred contract in December 2013 and lower services revenue from our international gaming customers, offset by favorable foreign currency translation of $2.6 million. Our installed base of WAP and premium participation units declined to 9,054 units as of September 30, 2014 from 9,437 units reported by WMS at September 30, 2013. The average daily revenue per WAP and premium participation unit increased 8% over the amount reported by WMS in the prior-year period despite challenging gaming industry conditions, reflecting the positive performance of our new games. Our average installed base of other leased and participation units rose to 26,667 units, reflecting the addition of 2,114 other leased units within the WMS footprint, partially offset by a decline in our U.K. gaming installed base that largely resulted from the loss of our Betfred contract. Average daily revenue for our other leased and participation units increased 15% compared to the prior-year period, due to an increase in average daily revenue of the existing units, as well as the addition of the WMS gaming machines. Gaming services revenue also increased due to the inclusion of revenue from our interactive gaming business, which increased relative to the amount WMS reported in the prior-year period primarily due to an increase of 0.7 million average DAU to 1.6 million average DAU for our social casinos for the three-month period ended September 30, 2014. The $61.0 million increase in product sales revenue included $64.1 million from WMS. New gaming machine shipments by WMS declined approximately 26% relative to the amount reported by WMS in the prior-year period, reflecting the challenging gaming industry conditions discussed above and fewer units shipped for new casino openings. Excluding the impact of WMS revenue, product sales of our VLT machines were down slightly for the three months ended September 30, 2014. Operating (Loss) Income The $7.8 million operating loss reflected a $8.5 million operating loss attributable to WMS, which was partially offset by lower D&A of $1.0 million in our U.K. gaming business reflecting accelerated D&A recorded in the prior-year period related to the write-down of used gaming machines and a change in the estimated useful lives of certain gaming machines. 61-------------------------------------------------------------------------------- Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013 CONSOLIDATED RESULTS Variance for the Nine Months Ended Nine Months Ended (in millions) September 30, September 30, 2014 2013 2014 vs. 2013 Revenue: Instant games $ 392.4 $ 379.0 $ 13.4 3.5 % Services 538.9 247.7 291.2 117.6 % Product sales 289.3 62.3 227.0 364.4 % Total revenue 1,220.6 689.0 531.6 77.2 % Operating expenses: Cost of instant games (1) 212.5 210.3 2.2 1.0 % Cost of services (1) 200.7 135.0 65.7 48.7 % Cost of product sales (1) 161.2 39.3 121.9 310.2 % Selling, general and administrative 282.6 139.1 143.5 103.2 % Research and development 77.0 4.7 72.3 n/m Employee termination and restructuring 12.4 0.3 12.1 n/m Depreciation and amortization 290.5 111.1 179.4 161.5 % Operating (loss) income (16.3 ) 49.2 (65.5 ) (133.1 )% Other (expense) income: Interest expense (142.9 ) (75.3 ) (67.6 ) 89.8 % Earnings (loss) from equity investments (7.8 ) 13.0 (20.8 ) (160.0 )% Loss on early extinguishment of debt (25.9 ) - (25.9 ) n/m Gain on sale of equity interest 14.5 - 14.5 n/m Other (expense) income, net 9.2 (0.8 ) 10.0 n/m Net loss from continuing operations before income taxes (169.2 ) (13.9 ) (155.3 ) n/m Income tax expense (18.0 ) (11.2 ) (6.8 ) 60.7 % Net loss from continuing operations $ (187.2 ) $ (25.1 ) $ (162.1 ) 645.8 % "n/m" - not meaningful (1) Exclusive of depreciation and amortization. Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013 Revenue Consolidated revenue increased in each of our categories of revenue: instant games, services and product sales. The inclusion of revenue from WMS increased consolidated revenue by $488.7 million. Consolidated revenue also reflected favorable foreign currency translation of $8.8 million. Instant games revenue increased $13.4 million reflecting higher revenue from our participation contracts in U.S. and certain international jurisdictions and higher revenue from our U.S. price-per-unit contracts. These increases were partially offset by lower revenue from our international price-per-unit contracts, lower revenue from our licensing and player loyalty programs and a decrease in revenue due to our exit from the Provoloto business. Services revenue, which includes our participation-based and other services revenue from our Lottery Systems and Gaming segments, increased $291.2 million, primarily reflecting the inclusion of WMS services revenue of $284.9 million. The $227.0 million increase in product sales revenue included $203.9 million of WMS product sales revenue, with the remaining increase due to higher hardware and software sales to our international and U.S. lottery customers. 62 -------------------------------------------------------------------------------- Cost of Revenue Consolidated cost of revenue increased primarily as a result of higher revenue. Cost of instant games revenue increased 1% compared to the increase in instant games revenue of 4%. Cost of services increased 49% compared to an increase in services revenue of 118%, reflecting a more profitable revenue mix primarily attributable to WMS services revenue. Cost of product sales increased 310% compared to an increase in sales revenue of 364%, primarily reflecting the inclusion of WMS product sales. SG&A SG&A increased $143.5 million, which reflected $134.5 million of SG&A attributable to WMS, higher compensation expense of $3.9 million, and higher legal expenses of $3.1 million. R&D R&D increased $72.3 million primarily related to the inclusion of WMS in our financial results. Employee Termination and Restructuring Employee termination and restructuring costs included $8.9 million related to WMS integration activities, $1.6 million related to the exit from our instant lottery game operations in Mexico and related to the exit from our paper roll conversion operations in the U.S. as well as $1.9 million of costs related to corporate. For additional information regarding these charges, see Note 4 (Restructuring Plans) in this Quarterly Report on Form 10-Q. D&A D&A increased $179.4 million, of which $163.0 million was attributable to WMS. Excluding the increase attributable to WMS, D&A reflected an increase in amortization of capitalize internally developed software assets in the current-year period, partially offset by accelerated D&A recorded in the prior year for the write-down of used gaming machines and a change in the estimated useful lives of certain gaming machines. Other Income and Expense Interest expense increased $67.6 million due to the additional indebtedness incurred to finance the WMS acquisition. This increase was slightly offset by a reduction in interest expense as a result of the refinancing of the 2019 Notes with the 2021 Notes in June 2014. For additional information regarding our indebtedness, see Note 12 (Long-Term and Other Debt) in this Quarterly Report on Form 10-Q. Earnings from equity investments decreased primarily due to the $19.7 million non-cash impairment charge to write down our Northstar Illinois equity investment and the $8.0 million charge we recorded related our share of an estimated net shortfall payment accrued by Northstar Illinois. For additional information regarding our equity investments, see Note 11 (Equity Method Investments) in this Quarterly Report on Form 10-Q. We recorded a loss on early extinguishment of debt of $25.9 million related to the tender and redemption premiums and the write-off of deferred financing costs in connection with the purchase and redemption of our 2019 Notes in June 2014. In January 2014, we completed the sale of our 20% equity interest in Sportech for cash proceeds of £27.8 million, or $44.9 million, resulting in a gain of approximately £9 million, or $14.5 million. Income Tax Expense The effective income tax rates on the loss from continuing operations of (10.7)% and (80.5)% for the nine months ended September 30, 2014 and 2013, respectively, were determined using an estimated annual effective tax rate after considering any discrete items for such periods. Due to a valuation allowance against our U.S. deferred tax assets, the effective tax rates for the nine months ended September 30, 2014 and 2013 did not include the benefit of the current-year U.S. tax loss. As a result, income tax expense for the nine months ended September 30, 2014 and 2013 primarily related to income tax expense in foreign jurisdictions. 63-------------------------------------------------------------------------------- Our effective income tax rate on foreign earnings was impacted by the mix of income and the statutory tax rates in our foreign jurisdictions, which ranged from a low of 0% to a high of 35%. The foreign jurisdictions that had the most impact on our foreign income tax benefit (expense) in the period include Austria, Canada, Ireland, and the U.K. BUSINESS SEGMENTS RESULTS INSTANT PRODUCTS Results of Operations and Key Performance Indicators for Instant Products Variance for the Nine Months Ended Nine Months Ended (in millions) September 30, September 30, 2014 2013 2014 vs. 2013 Revenue: Instant games $ 392.4 $ 379.0 $ 13.4 3.5 % Product sales 9.4 10.1 (0.7 ) (6.9 )% Total revenue 401.8 389.1 12.7 3.3 % Operating expenses: Cost of instant games (1) 212.5 210.3 2.2 1.0 % Cost of product sales (1) 6.5 7.2 (0.7 ) (9.7 )% Selling, general and administrative 38.9 35.5 3.4 9.6 % Research and development 1.0 0.4 0.6 150.0 % Employee termination and restructuring 1.6 0.3 1.3 n/m Depreciation and amortization 26.2 27.0 (0.8 ) (3.0 )% Operating income $ 115.1 $ 108.4 $ 6.7 6.2 % Earnings (loss) from equity investments $ (12.4 ) $ 15.8 $ (28.2 ) (178.5 )% Key Performance Indicators: Instant games by revenue type: Participation contracts $ 206.9 $ 187.5 $ 19.4 10.3 % Price-per-unit contracts 144.7 147.0 (2.3 ) (1.6 )% Licensing and player loyalty 40.8 44.5 (3.7 ) (8.3 )% Total instant games revenue $ 392.4 $ 379.0 $ 13.4 3.5 % Instant games revenue by geography: U.S. $ 252.6 $ 237.7 $ 14.9 6.3 % International 139.8 141.3 (1.5 ) (1.1 )% Total instant games revenue $ 392.4 $ 379.0 $ 13.4 3.5 % U.S. lottery customers' retail sales of instant games $ 29,030 $ 27,575 $ 1,455 5.3 % Italy retail sales of instant games (in Euros) € 6,976 € 7,173 € (197 ) (2.7 )% "n/m" - not meaningful (1) Exclusive of depreciation and amortization. 64--------------------------------------------------------------------------------Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013 Revenue Instant games revenue increased $13.4 primarily due to $22.8 million of higher revenue from our participation contracts in the U.S. and certain international jurisdictions, including our contracts with Northstar New Jersey and Hellenic Lotteries, partially offset by a decrease in revenue of $3.4 million due to our exit from the Provoloto business and $4.3 of higher revenue from our U.S. price-per-unit contracts. The increase in instant games revenue was partially offset by a $6.6 million decline in revenue from our international price-per-unit contracts, including our contract with LNS and a decrease of $3.7 million from our licensing and player loyalty programs primarily reflecting more contracts in the prior-year. Operating Income Operating income increased $6.7 million primarily due to a higher and more profitable mix of revenue and a decrease in D&A, partially offset by an increase in SG&A reflecting higher compensation and legal expenses, as well as higher employee termination and restructuring costs. LOTTERY SYSTEMS Results of Operations and Key Performance Indicators for Lottery Systems Variance for the Nine Months Ended Nine Months Ended (in millions) September 30, September 30, 2014 2013 2014 vs. 2013 Revenue: Services $ 149.3 $ 146.1 $ 3.2 2.2 % Product sales 63.3 35.2 28.1 79.8 % Total revenue 212.6 181.3 31.3 17.3 % Operating expenses: Cost of services (1) 90.4 82.0 8.4 10.2 % Cost of product sales (1) 50.8 22.4 28.4 126.8 % Selling, general and administrative 17.1 16.0 1.1 6.9 % Research and development 1.7 3.1 (1.4 ) (45.2 )% Depreciation and amortization 44.6 38.8 5.8 14.9 % Operating income $ 8.0 $ 19.0 $ (11.0 ) (57.9 )% Earnings from equity investments $ 1.3 $ 0.7 $ 0.6 85.7 % Key Performance Indicators: Services revenue by geography: U.S. (2) $ 82.8 $ 83.1 $ (0.3 ) (0.4 )% International 66.5 63.0 3.5 5.6 % Total services revenue $ 149.3 $ 146.1 $ 3.2 2.2 % Product sales by geography: U.S. $ 6.3 $ 4.1 $ 2.2 53.7 % International 57.0 31.1 25.9 83.3 % Total product sales revenue $ 63.3 $ 35.2 $ 28.1 79.8 % U.S. lottery customers' retail sales (3) $ 6,310 $ 6,384 $ (74 ) (1.2 )% (1) Exclusive of depreciation and amortization. (2) U.S. services revenue excludes revenue from Puerto Rico. (3) U.S. lottery customers' retail sales primarily include retail sales of draw games, keno and instant games validated by the relevant system. The retail sales metric for the Lottery Systems segment presented in prior periods included draw game retail sales only. We believe the revised metric more clearly 65-------------------------------------------------------------------------------- correlates to our U.S. Lottery Systems services revenue, since we are generally compensated based on total retail sales generated by the relevant lottery system and not just draw game retail sales. The prior-year period retail sales information presented above conforms to the revised metric. Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013 Revenue Lottery Systems services revenue increased $3.2 million primarily due to an increase in sports betting services revenue from our international operations, new iGaming contracts launched in the fourth quarter of 2013 and higher revenue from instant ticket validations. These increases were partially offset by a decline in revenue under our agreement with the CSL primarily reflecting the decrease in our participation rate and a decline in revenue associated with the Powerball draw game reflecting three large Powerball jackpots in the prior-year period. The increase in service revenue also included a favorable impact from foreign currency translation of $1.0 million. The $28.1 million increase in Lottery Systems product sales revenue, which can fluctuate due to its non-recurring nature, primarily reflected higher international sales of hardware and software of $25.9 million and higher U.S. sales of $2.2 million. The increase in product sales revenue also included a favorable impact from foreign currency translation of $0.6 million. Operating Income Operating income declined $11.0 million primarily due to a less profitable mix of revenue, an increase in D&A related to higher capitalized software assets and higher SG&A, partially offset by a reduction in R&D. GAMING Results of Operations and Key Performance Indicators for Gaming All results for 2013 presented herein do not include results of operations for WMS, which was acquired in October 2013. Variance for the Nine Months Ended Nine Months Ended (in millions) September 30, September 30, 2014 2013 2014 vs. 2013 Revenue: Services $ 389.6 $ 101.6 $ 288.0 n/m Product sales 216.6 17.0 199.6 n/m Total revenue 606.2 118.6 487.6 n/m Operating expenses: Cost of services (1) 110.3 53.0 57.3 n/m Cost of product sales (1) 103.9 9.7 94.2 n/m Selling, general and administrative 132.9 19.3 113.6 n/m Research and development 74.3 1.2 73.1 n/m Employee termination and restructuring 8.9 - 8.9 n/m Depreciation and amortization 200.2 44.8 155.4 n/m Operating loss $ (24.3 ) $ (9.4 ) $ (14.9 ) n/m Earnings (loss) from equity investments $ 3.3 $ (3.5 ) $ 6.8 n/m "n/m" - not meaningful (1) Exclusive of depreciation and amortization. 66 -------------------------------------------------------------------------------- (in millions, except for unit and per unit (or user) information) Variance for the Nine Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 vs 2013 Key Performance Indicators: Services revenue: WAP and premium participation products $ 172.9 $ - $ 172.9 n/m Other leased and participation products 91.1 83.0 8.1 9.8 % Interactive gaming products and services 101.6 - 101.6 n/m Other services 24.0 18.6 5.4 29.0 % Total services revenue $ 389.6 $ 101.6 $ 288.0 n/m WAP and premium participation units (1): Installed base at period end 9,054 - 9,054 n/m Average installed base 8,931 - 8,931 n/m Average daily revenue per unit $ 70.91 $ - $ 70.91 n/m Other leased and participation units (2): Installed base at period end 26,711 26,829 (118 ) (0.4 )% Average installed base 27,628 26,234 1,394 5.3 % Average daily revenue per unit $ 12.08 $ 11.59 $ 0.49 4.2 % Interactive gaming products and services - social casino: Average Monthly Active Users (MAU) (3) 5.3 - 5.3 n/m Average Daily Active Users (DAU) (4) 1.4 - 1.4 n/m Average revenue per daily active user (ARPDAU) (5) $ 0.22 $ - $ 0.22 n/m Product sales revenue: New gaming machine sales $ 157.9 $ 7.6 $ 150.3 n/m Other product sales 58.7 9.4 49.3 n/m Total product sales revenue $ 216.6 $ 17.0 $ 199.6 n/m Product sales: U.S. and Canadian new unit shipments 6,522 74 6,448 n/m International new unit shipments 4,390 1,121 3,269 n/m Total new unit shipments 10,912 1,195 9,717 n/m Average sales price per new unit $ 14,470 $ 6,360 $ 8,110 n/m "n/m" - not meaningful (1) WAP and premium participation products are comprised of WMS participation gaming machines (WAP, LAP and standalone units) generally available only as leased units (2) Other leased and participation units are comprised principally of Scientific Games legacy server-based gaming machines, primarily in the U.K., and other leased WMS units (3) MAU = Monthly Active Users, a count of unique visitors to our sites during a month (4) DAU = Daily Active Users, a count of unique visitors to our sites during a day (5) ARPDAU = Average revenue per DAU is calculated by dividing revenue for a period by the DAU for the period by the number of days for the period 67--------------------------------------------------------------------------------Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013 Revenue The $288.0 million increase in Gaming services revenue included $284.9 million from WMS and a favorable impact from foreign currency translation of $4.5 million, partially offset by $5.4 million of lower services revenue primarily due to the loss of our Betfred contract in December 2013 and lower services revenue from our international gaming customers. Our installed base of WAP and premium participation units declined to 9,054 units as of September 30, 2014 from 9,437 units reported by WMS at September 30, 2013. The average daily revenue per WAP and premium participation unit increased 5% over the amount reported by WMS in the prior-year period despite challenging gaming industry conditions, reflecting the positive performance of our new games. Our average installed base of other leased and participation units rose to 27,628 units, reflecting the addition of 2,395 other leased units within the WMS footprint, partially offset by a decline in the U.K. gaming installed base that largely resulted from the loss of our Betfred contract. Average daily revenue for our other leased and participation units increased 4% compared to the prior-year period, primarily due to the addition of the WMS units. Gaming services revenue also included revenue from our interactive gaming business, which increased as a result of the WMS acquisition and also increased as compared to the amount WMS reported in the prior year period primarily due to the increase of 0.7 million average DAU to 1.4 million average DAU for our social casinos for the three-month period ended September 30, 2014. The $199.6 million increase in product sales revenue included $203.9 million from WMS. Compared to what WMS reported in the prior-year period, new gaming machine shipments by WMS declined approximately 33%, reflecting the challenging gaming industry conditions discussed above. Excluding the impact of WMS revenue, product sales revenue was lower by $4.3 million for the nine months ended September 30, 2014 primarily from our U.K Gaming business. Operating Loss The $14.9 million increase in operating loss primarily reflected an operating loss of WMS of $27.2 million, which was partially offset by a more profitable mix of business and improvement in our cost structure in our U.K. business, including lower SG&A of $4.2 million and lower D&A of $7.0 million primarily due to accelerated D&A recorded in the prior-year period related to the write-down of used gaming machines and a change in the estimated useful lives of certain gaming machines. Recently Issued Accounting Guidance For a description of recently issued accounting pronouncements, see Note 1 (Description of the Business and Summary of Significant Accounting Policies) in this Quarterly Report on Form 10-Q. 68 --------------------------------------------------------------------------------CRITICAL ACCOUNTING ESTIMATES For a description of our policies regarding our critical accounting estimates, see "Critical Accounting Estimates" in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" included in our 2013 Annual Report on Form 10-K. We consider the following accounting estimates to be the most critical to fully understand and evaluate our reported financial results. The list below is not intended to be a comprehensive list of all of our accounting policies. Our significant accounting policies are described in Note 1 (Description of the Business and Summary of Significant Accounting Policies) in our 2013 Annual Report on Form 10-K. • Income taxes and deferred income taxes • Valuation of investments, long-lived and intangible assets and goodwill • Business combinations • Revenue recognition • Notes receivable • Performance-based compensation • Inventory • Restructuring There have been no significant changes in our critical accounting estimate policies or the application of those policies to our consolidated financial statements from those presented in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" included in our 2013 Annual Report on Form 10-K. LIQUIDITY, CAPITAL RESOURCES AND WORKING CAPITAL Sources of Liquidity As of September 30, 2014, our principal sources of liquidity, other than cash flows provided by operating activities, were cash and equivalents and amounts available under our revolving credit facility discussed below under "Credit Agreement and Other Debt." As of September 30, 2014, our available cash and equivalents and borrowing capacity totaled $391.7 million including cash and cash equivalents of $132.5 million and availability of $259.2 million under our revolving credit facility, compared to $411.0 million as of December 31, 2013 (including cash and cash equivalents of $153.7 million and availability of $257.3 million under our prior revolving credit facility). There were no borrowings outstanding under our revolving credit facility as of September 30, 2014; however, we had $40.8 million in outstanding letters of credit as of September 30, 2014, which reduces our capacity to borrow under our revolving credit facility. The amount of our available cash and equivalents fluctuates principally based on borrowings or repayments under our credit facilities, investments, acquisitions and changes in our working capital position. The borrowing capacity under our revolving credit facility will depend on the amount of outstanding borrowings and letters of credit issued and will also depend on us remaining in compliance with the covenants under our credit agreement, including the maintenance of applicable financial ratios. We were in compliance with the covenants under our credit agreement as of September 30, 2014. We believe that our cash flow from operations, available cash and equivalents and available borrowing capacity under our revolving credit facility will be sufficient to meet our liquidity needs for the foreseeable future; however, there can be no assurance that this will be the case. We believe that substantially all cash held outside the U.S. is free from legal encumbrances or similar restrictions that would prevent it from being available to meet our global liquidity needs. Total cash held by our foreign subsidiaries was $84.5 million as of September 30, 2014. To the extent that a portion of our foreign cash was required to meet liquidity needs in the U.S. (which we do not currently anticipate), we might incur a tax liability to repatriate it, the timing and amount of which would depend on a variety of factors. A significant amount of the cash held by our foreign subsidiaries as of September 30, 2014 could be transferred to the U.S. as intercompany loan repayments or tax-free basis reductions. Our lottery contracts are periodically subject to renewal or re-bid and there can be no assurance that we will be successful in sustaining our cash flow from operations if our contracts are not renewed or replaced or are renewed on less favorable terms, or if we are unable to enter into new contracts. In addition, lottery customers in the U.S. generally require service providers to provide performance bonds in connection with the relevant contract. As of September 30, 2014, our outstanding performance bonds totaled $191.9 million. Our ability to obtain performance bonds on commercially reasonable terms is subject to our financial condition and to prevailing market conditions, which may be impacted by economic and 69-------------------------------------------------------------------------------- political events. Although we have not experienced difficulty in obtaining such bonds to date, there can be no assurance that we will continue to be able to obtain performance bonds on commercially reasonable terms or at all. If we need to refinance all or part of our indebtedness at or before maturity, there can be no assurance that we will be able to obtain new financing or to refinance any of our indebtedness on commercially reasonable terms or at all. Cash Flow Summary Variance for the Nine Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 vs. 2013 Net cash provided by operating activities $ 233.4 $ 95.6 $ 137.8 Net cash used in investing activities (129.9 ) (116.8 ) (13.1 ) Net cash used in financing activities (118.0 ) (13.6 ) (104.4 ) Effect of exchange rates on cash and cash equivalents (6.7 ) (0.7 ) (6.0 ) Decrease in cash and cash equivalents $ (21.2 ) $ (35.5 ) $ 14.3 Cash flows from operating activities Net cash provided by operating activities for the nine months ended September 30, 2014 increased $137.8 million over the prior-year period reflecting favorable changes in current assets and liabilities of $81.4 million, net of effects of acquisitions, due primarily to the acquisition of WMS and a $51.3 million increase in net earnings after adjustments for non-cash items, a $25.9 million loss on early extinguishment of debt less a $14.5 million gain on sale of an equity interest and a decrease in distributions received from our equity investments of $6.3 million. Cash flows from investing activities The increase in net cash used in investing activities of $13.1 million primarily reflected an increase in capital expenditures of $64.0 related to contracts in our Lottery Systems business, property, plant and equipment additions and capital expenditures in our Gaming business, a change in restricted cash of $31.9 million and a reduction of $10.4 million in proceeds from asset disposals in the prior year. These increases in net cash used in investing activities were partially offset by a decrease in capital contributions to our equity investments of $21.7 million primarily reflecting contributions made to the Greece lottery in the third quarter of 2013 and Northstar Illinois in the fourth quarter of 2013, an increase of $26.0 million in distributions from our equity investments and the proceeds from the sale of our equity interest in Sportech of $44.9 million in the first quarter of 2014. Cash flows from financing activities The increase in net cash used in financing activities was primarily due to common stock repurchases of $29.5 million in the first quarter of 2014, an increase in financing fees of $20.8 million related to the issuance of the 2021 Notes and the repurchase and redemption of the 2019 Notes, an increase in the redemption of common stock under our stock-based compensation plans of $17.0 million, a $19.8 million increase in net payments on long-term indebtedness, an increase in contingent earnout payments of $10.2 million and payments on license obligations of $7.0. Credit Agreement and Other Debt As of September 30, 2014, our total debt was comprised principally of $2,282.8 million (excluding an unamortized discount of $9.9 million) outstanding under our term loan facilities under the credit agreement discussed below, $250.0 million in aggregate principal amount of our 2018 Notes, $300.0 million in aggregate principal amount of our 2020 Notes, $350.0 million (excluding an unamortized discount of $2.3 million) in aggregate principal amount of our 2021 Notes and $38.7 million in capital leases related to our U.K. gaming operations. We use interest rate swap derivatives to diversify our debt portfolio between fixed and variable rate instruments. For additional information regarding our interest rate risk and interest rate hedging instruments, see "Quantitative and Qualitative Disclosures About Market Risk" in Item 7A in our 2013 Annual Report on Form 10-K. Senior Secured Credit Facilities We are party to a credit agreement dated as of October 18, 2013, by and among SGI, as the borrower, the Company, as a guarantor, Bank of America, N.A., as administrative agent, and the lenders and other agents party thereto providing for senior secured credit facilities in an aggregate principal amount of $2,600.0 million, including a $300.0 million revolving credit facility, which has dollar and multi-currency tranches, and a $2,300.0 million term loan facility. The term loan facility was used, in part, to finance the consideration paid in the WMS acquisition, to repay all indebtedness under our and WMS' prior 70 -------------------------------------------------------------------------------- credit agreements and to pay related acquisition and financing fees and expenses. Up to $200.0 million of the revolving credit facility is available for issuances of letters of credit. The term loan is scheduled to mature on October 18, 2020 and the revolving credit facility is scheduled to mature on October 18, 2018 (subject to accelerated maturity under certain circumstances). SGI is required to pay commitment fees to revolving lenders on the actual daily unused portion of the revolving commitments at a rate of 0.50% per annum through maturity, subject to a step-down to 0.375% based upon certain first lien net leverage ratios. The credit facilities contain customary events of default (subject to customary grace periods and materiality thresholds). Upon the occurrence of certain events of default, the obligations under the credit facilities may be accelerated and the commitments may be terminated. Senior Subordinated Notes 2021 Notes On June 4, 2014, SGI issued $350.0 million in aggregate principal amount of 2021 Notes at a price of 99.321% of the principal amount thereof in a private offering to qualified institutional buyers in accordance with Rule 144A under the Securities Act and to persons outside the United States under Regulation S under the Securities Act. The 2021 Notes were issued pursuant to the 2021 Notes Indenture. The 2021 Notes bear interest at the rate of 6.625% per annum, which accrues from June 4, 2014 and is payable semiannually in arrears on May 15 and November 15 of each year, commencing on November 15, 2014. The 2021 Notes mature on May 15, 2021, unless earlier redeemed or repurchased, and are subject to the terms and conditions set forth in the 2021 Notes Indenture. In connection with the issuance of the 2021 Notes, the Company capitalized financing costs of $7.3 million. The 2021 Notes are unsecured senior subordinated obligations of SGI and are subordinated to all of SGI's existing and future senior debt, rank equally with all of SGI's existing and future senior subordinated debt and rank senior to all of SGI's future debt that is expressly subordinated to the 2021 Notes. The 2021 Notes are guaranteed on an unsecured senior subordinated basis by the Company and all of its 100%-owned U.S. subsidiaries (other than SGI). The 2021 Notes are structurally subordinated to all of the liabilities of the Company's non-guarantor subsidiaries. The 2021 Notes Indenture contains certain covenants that, among other things, limit the Company's ability, and the ability of certain of its subsidiaries, to incur additional indebtedness, pay dividends or make distributions or certain other restricted payments, purchase or redeem capital stock, make investments or extend credit, engage in certain transactions with affiliates, consummate certain asset sales, effect a consolidation or merger, or sell, transfer, lease or otherwise dispose of all or substantially all assets, or create certain liens and other encumbrances on assets. The 2021 Notes Indenture contains events of default customary for agreements of its type (with customary grace periods and maturity thresholds, as applicable). 2019 Notes On June 4, 2014, SGI completed a tender offer pursuant to which it purchased $140.6 million in aggregate principal amount of the 2019 Notes for total consideration of $1,051.25 for each $1,000 principle amount of the 2019 Notes tendered, plus accrued and unpaid interest to the applicable payment date. On June 4, 2014, SGI delivered a notice of redemption with respect to all $209.4 million of the remaining outstanding principal amount of the 2019 Notes, and satisfied and discharged the indenture governing the 2019 Notes by depositing funds with the trustee sufficient to pay the redemption price of 104.625% of the principal amount of the 2019 Notes, plus accrued and unpaid interest to the redemption date. In accordance with the notice of redemption, the 2019 Notes were redeemed on July 4, 2014 and the redemption payment was made on July 7, 2014. The purchase and redemption of the 2019 Notes were funded, in part, with the net proceeds from the issuance of the 2021 Notes. In connection with the purchase and redemption of the 2019 Notes, we recorded a loss on early extinguishment of debt of $25.9 million comprised primarily of the tender and redemption premiums and the write-off of previously deferred financing costs. For additional information regarding our 2021 Notes and the repurchase and redemption of our 2019 Notes, see our Current Report on Form 8-K filed with the SEC on June 6, 2014. For additional information regarding our 2018 Notes, 2019 Notes and 2020 Notes, see Note 15 (Long-Term and Other Debt) in our 2013 Annual Report on Form 10-K. We were in compliance with the covenants under our debt agreements as of September 30, 2014. Other Debt 71-------------------------------------------------------------------------------- In September 2014, we repaid in full a $5.0 million China Loan with cash on hand. Contemplated Financing for Bally Acquisition In connection with the pending acquisition of Bally, we entered into a commitment letter with Bank of America, N.A., Merrill Lynch, Pierce, Fenner & Smith Incorporated, JPMorgan Chase Bank, N.A., Deutsche Bank AG New York Branch and certain of their respective affiliates, which was subsequently joined by Fifth Third Bank, HSBC Securities (USA) Inc., HSBC Bank USA, N.A., PNC Capital Markets LLC and PNC Bank, National Association as additional commitment parties. Pursuant to the commitment letter, the commitment parties have agreed to provide the financing necessary to fund the consideration to be paid pursuant to the terms of the merger agreement (the "Debt Financing"). The commitment letter contemplates that the Debt Financing will consist of, among other things, (1) a senior secured incremental term loan facility (in an originally contemplated principal amount of $1,735.0 million), (2) a senior secured increase in the revolving credit facility (in an originally contemplated principal amount of $350.0 million), (3) if applicable, amendments to, or the refinancing of, Scientific Games' existing credit facilities, consisting of (a) a senior secured term loan facility in a total principal amount of $2,294.0 million and (b) a senior secured revolving credit facility in a total principal amount of $650 million, and (4) senior secured notes and senior unsecured notes yielding $3,450.0 million in aggregate gross cash proceeds and/or to the extent that the issuance of such notes yields less than $3,450.0 million in aggregate gross cash proceeds or such cash proceeds are otherwise unavailable, a senior secured bridge loan facility and a senior unsecured bridge loan facility up to an aggregate principal amount of $3,450 million (less the cash proceeds received from the notes and available for use, if any). The funding of the Debt Financing is contingent on the satisfaction of certain conditions set forth in the commitment letter. The merger is not conditioned on our obtaining the proceeds of any financing, including the Debt Financing. In connection with the pending Bally acquisition, on October 1, 2014, the Company entered into an amendment to its existing credit agreement to, among other things, (1) effective as of October 1, 2014, permit the Bally acquisition and the transactions related thereto, including the incurrence of term loans by SGMS Escrow Corp., and (2) effective as of the consummation of the Bally acquisition (and the satisfaction of the other conditions contemplated by the amendment), (A) increase the Company's existing revolving credit facility by $267.6 million, (B) permit SGI to assume the term loans under the Escrow Credit Agreement (as defined below) as incremental term loans under the existing credit agreement and (C) modify the financial covenant applicable to the revolving credit facility under the existing credit agreement such that it will be tested each quarter, irrespective of usage of that revolving credit facility. As a result of the amendment, the applicable margin for the existing term loans under the credit agreement (1) prior to the consummation of the Bally acquisition, will remain at 3.25% per annum for eurodollar (LIBOR) loans and 2.25% per annum for base rate loans and (2) from and after the consummation of the Bally acquisition, will be 5.00% per annum for eurodollar (LIBOR) loans and 4.00% per annum for base rate loans. There will be no change to the borrowing rate applicable to loans borrowed or to letters of credit issued under the revolving credit facility after the consummation of the Bally acquisition. In addition, on October 1, 2014, SGMS Escrow Corp. entered into an escrow credit agreement (the "Escrow Credit Agreement") by and among SGMS Escrow Corp., as borrower, the lenders and other agents from time to time party thereto, and Bank of America, N.A., as administrative agent. The Escrow Credit Agreement provides for $2.0 billion of new term loans, the net proceeds of which are expected to provide a portion of the funds to be used to finance the Bally acquisition. Upon and in connection with the consummation of the Bally acquisition, the term loans under the Escrow Credit Agreement will be assumed by SGI and become incremental term loans under the existing credit agreement. The term loans under the Escrow Credit Agreement (including after they are assumed by SGI and become incremental term loans under the existing credit agreement) are scheduled to mature on October 1, 2021 (subject to accelerated maturity under certain circumstances) and amortize in equal quarterly installments beginning on the last day of the first of March, June, September or December to occur after completion of the Bally acquisition, in an amount equal to 1.00% per annum of the stated principal amount thereof, with the remaining balance due at final maturity. Interest on the new term loans is payable at a rate equal to the eurodollar (LIBOR) rate or the base rate, plus an applicable margin, in each case, subject to a eurodollar (LIBOR) rate floor of 1.00% or a base rate floor of 2.00%, as applicable. The applicable margin for the incremental term loans (under the Escrow Credit Agreement and, if and when assumed by SGI, the existing credit agreement) is 5.00% per annum for eurodollar (LIBOR) loans and 4.00% per annum for base rate loans. Borrowings under the Escrow Credit Agreement are solely the obligation of SGMS Escrow Corp., are not guaranteed by the Company or any of its subsidiaries, and are secured by a pledge of amounts deposited into a secured escrow account of SGMS Escrow Corp. In the event that the Bally acquisition is not consummated, SGMS Escrow Corp. will repay amounts borrowed under the Escrow Credit Agreement, plus accrued interest thereon, with amounts deposited into a secured escrow 72 -------------------------------------------------------------------------------- account of SGMS Escrow Corp. and other amounts that may be contributed by the Company and its other subsidiaries to SGMS Escrow Corp. and deposited into that escrow account from time to time. The term loans under the Escrow Credit Agreement were funded into escrow, less original issue discount, by the lenders on October 17, 2014 and began accruing interest, initially at the LIBOR rate plus the applicable margin referred to above, beginning on October 18, 2014. Interest for the prospective month was funded into escrow by the Company on October 16, 2014. Upon closing of the Bally acquisition, we expect to incur approximately $170 million of financing fees in connection with the term loans and revolving credit facility under the Escrow Credit Agreement and with respect to the remaining financing commitments under the commitment letter for the Bally acquisition. We also anticipate incurring fees related to our additional financing activities during the balance of the quarter ending December 31, 2014. For further information regarding the Debt Financing, please see the full text of the commitment letter, our credit agreement, the amendment to our credit agreement and the Escrow Credit Agreement, copies of which are filed as Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on August 4, 2014, Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on October 18, 2013, and Exhibit 10.1 and Exhibit 10.2 to our Current Report on Form 8-K filed with SEC on October 7, 2014, respectively. The foregoing summaries of the terms of the existing credit agreement, the commitment letter, the amendment to the existing credit agreement and the Escrow Credit Agreement are qualified in their entirety by reference to the respective exhibit. Capital Leases On March 31, 2014, we entered into a new leasing arrangement with ITL for the lease of gaming machines in connection with a long-term contract with a U.K. customer. We completed the placement of the new gaming machines under this contract as of June 30, 2014 and recorded a capital lease asset and minimum lease liability of $42.8 million. Contractual Obligations Other than the issuance of the 2021 Notes as described above, there have been no material changes to our contractual obligations disclosed in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity, Capital Resources and Working Capital - Contractual Obligations" included in our 2013 Annual Report on Form 10-K. Item 3. Quantitative and Qualitative Disclosures about Market Risk There have been no material changes to the disclosure under "Item 7A. Quantitative and Qualitative Disclosures about Market Risk" included in our 2013 Annual Report on Form 10-K. Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures We have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this Quarterly Report on Form 10-Q. The evaluation was conducted under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective. Changes in Internal Control over Financial Reporting There were no changes in our internal control over financial reporting during the three months ended September 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 73-------------------------------------------------------------------------------- |