ITEM 1. BUSINESS
GENERAL
Scientific Games Holdings Corp. (the "Company" or "Scientific Games") through its wholly owned subsidiaries, principally, Scientific Games Inc. ("SGI"), Scientific Games International, Limited ("SGIL") and Scientific Games Kommunikations - und Computersysteme A.G. ("SG Austria"), is the leading worldwide manufacturer of instant lottery tickets based upon the number of instant lottery tickets sold. Except as the context otherwise requires, references to "Scientific Games" or the "Company" refer to the consolidated business and operations. The Company's corporate headquarters and its primary manufacturing facility are located in Alpharetta, Georgia (suburban Atlanta) and the Company employs approximately 1,177 people. The Company also has production and operating facilities in California, the United Kingdom, South Africa and software development facilities in Georgia and Austria. Scientific Games' business consists primarily of manufacturing and selling instant lottery tickets to domestic and foreign governmental lottery authorities and licensees and providing lottery services to such customers. The Company also offers its customers a full range of instant lottery services under cooperative services contracts, including some or all of the following services: designing and installing game management software, ticket production, telemarketing, field sales, accounting, ticket distribution, training sales staff, estimating ticket needs, managing staff, advising with respect to security, ticket validation and fulfillment, provision of computer hardware, validation terminals, SciScan Technology(R) validators, maintenance, prize structure, communication network and sales agent hot-line service. Scientific Games' acquisition in April 1997 of Vienna, Austria based TeleControl Kommunications - und Computersysteme Gesellschaft m.b.h. ("TeleControl"), an on-line lottery and transaction processing company, enables the Company to expand the Company's systems offerings and make available on-line lottery technology. The Company announced in February 1998 that it had entered into a joint venture agreement with La Francaise des Jeux, the operator of the French National Lottery, to develop a new generation of on-line terminals incorporating the Company's SciScan Technology. The agreement also provides for the assumption by the joint venture of La Francaise des Jeux's terminal and software maintenance contracts with six German State Lottery customers. The joint venture is subject to the approval of the French Minister of Finance and the execution of definitive agreements for products and services.
INDUSTRY OVERVIEW
Lotteries are operated by domestic and foreign governmental authorities and their licensees in approximately 200 jurisdictions throughout the world. Currently, 39 jurisdictions in the United States sell instant lottery tickets. Of the approximately 8.8 billion tickets sold by the Company in 1997, approximately 30% were sold outside the United States. Governments typically authorize lotteries as a means of generating revenues without the imposition of additional taxes. Lottery revenues are frequently set aside for particular public purposes, such as education, aid to the elderly, conservation, transportation and economic development. As lottery ticket sales have become a significant source of funding for such programs, many jurisdictions have come to rely on the revenues generated by such sales.
Although there are many types of lotteries worldwide, government authorized lotteries may generally be categorized into three principal groups: instant lotteries, on-line lotteries and the traditional draw-type lotteries. An instant lottery is one which is typically played by removing a coating from a preprinted ticket to determine whether it is a winner. On-line lotteries are generally pari-mutuel in nature (although fixed prizes are also offered) and are conducted through a computerized lottery system in which lottery terminals are connected to a central computer, usually by dedicated telephone lines. Internationally, the older form of traditional draw-type lottery games, in which players purchase tickets which are manually processed for a future drawing for prizes of a fixed amount, is the prevalent form of play. In addition to the foregoing types of lotteries, there are video lotteries played on electronic machines featuring keno, "line-up" (cherries, bars, plums, etc.) and similar video games. Video lotteries are typically targeted to locations such as horse and dog racing tracks, athletic arenas, certain bars, clubs and similar establishments.
There are many promotional (i.e., commercial) game suppliers (including the Company) which produce instant tickets for both sales promotion companies and their end users. Management believes Scientific Games is the
only company which also offers the promotional market a full line of support and services similar to those which the Company offers to the government lottery market. While potential lottery customers in the United States currently are limited to the 39 jurisdictions where such games are legally permitted, promotional games are believed permitted in substantially all states. A significant difference between lottery games and promotional games is the lower level of security requirements associated with promotional games which typically offer less valuable prizes. The Company's promotional game business expanded significantly with the 1996 acquisition of its SGIL subsidiary see - "Products and Services" below.
BUSINESS STRATEGY
The Company is a leading provider of instant lottery tickets, integrated systems and support services worldwide. Scientific Games intends to expand this leadership position by (i) pursuing new instant ticket printing opportunities in both the domestic and foreign marketplaces, (ii) emphasizing and marketing Scientific Games' expertise in cooperative services capabilities, (iii) growing its on-line lottery business by utilizing its SGI-NET(TM) technology, the core of which was acquired through its 1997 acquisition of SG Austria, (iv) continuing the Company's emphasis on customer service and responsiveness to customer needs both before and after delivery of products and services, (v) investing in its facilities while aggressively pursuing practices and methods which reduce operating costs, (vi) funding research and development costs that continue to provide innovations for the Company's customers such as SGI-NET, a high performance, configurable hardware and software-redundant transaction processing system that can accommodate both instant an on-line lottery operations, (vii) partnering with respected local corporations to establish new lotteries in foreign countries and (viii) utilizing the joint venture with La Francaise des Jeux to develop a new generation of lottery terminals.
As state governments face budgetary pressures, they increasingly seek methods of reducing state spending. One method of reducing spending which is often considered by states is privatization or outsourcing of various operating tasks associated with lottery operations. The Company has cooperative services contracts with eight domestic lotteries which have elected to privatize certain operating functions related to the management of instant ticket games. It is expected that more state or foreign governments will decide to privatize or outsource various lottery operations. The Company has significant experience in this field and is well positioned to offer this privatization or outsourcing option to the industry. The Company intends to continue to emphasize and invest in the growing cooperative services segment of its business.
The increased application of computer-based and communications technologies (including proprietary technologies) to the manufacturing and servicing of instant tickets (See - "New Product Development") continues to separate the instant ticket from conventional forms of printing. The Company is generally recognized within the lottery industry as the leader in applying these technologies to the manufacturing and sale of instant tickets. In order to maintain its position as a leading innovator within the lottery industry, the Company intends to continue to explore and develop new technologies and their application to instant lottery tickets and systems.
In addition to the internal development of new products, the Company intends to leverage its management expertise, reputation, and contacts in the lottery industry by pursuing joint ventures and marketing agreements which will provide access to lottery customers to whom the Company does not currently provide products or services.
PRODUCTS AND SERVICES
In 1974, the Company introduced the first "secure" instant game ticket. Today, instant tickets manufactured by the Company are typically printed on recyclable ticket stock by a series of computer controlled presses and ink-jet imagers and are believed by management to incorporate the most advanced technology and security currently available in the industry. Instant tickets range in size from 2 inches by 3 inches to ticket sizes as large as some greeting cards; instant tickets are normally played by removing a coating to determine if they are winning tickets. The Company markets instant tickets to domestic lottery jurisdictions, foreign lottery jurisdictions and commercial customers. The Company currently has contracts with 25 of the 39 states/jurisdictions in the U.S. which currently sell instant lottery tickets. These domestic contracts are typically at a fixed price per thousand tickets and typically range from one to five years in duration, although they usually have one or more extension options. Customers of Scientific Games have exercised extension options in domestic lottery contracts with the Company a majority of the
time. See - "Markets" for additional information. In 1997, the Company sold approximately 8.8 billion tickets. Such instant ticket sales represented approximately 60% of all instant lottery tickets sold by all companies to domestic lotteries and approximately twice as many instant tickets as were sold by the Company's next largest domestic competitor.
The Company currently manufactures instant tickets for the promotional game market. Examples of promotional games produced by the Company include games for European newspapers, major food and beverage companies, telephone companies and games for various other commercial customers. The majority of the Company's promotional games are produced at its United Kingdom subsidiary SGIL. Approximately 50% of SGIL's sales are to promotional game customers. Sales of promotional game products and services accounted for less than 10% of the Company's consolidated revenues in 1997.
Scientific Games pioneered the idea of cooperative services as a means of reducing the operating costs of lotteries while increasing lottery revenues and is the only instant ticket manufacturer which has a separate lottery ticket cooperative support services business to supplement its manufacturing operations. Cooperative services consist of lottery ticket distribution and support services involving the performing of selected key sales, distribution, marketing and/or data processing services for lottery jurisdictions. While most lottery jurisdictions to date have chosen to control the distribution and sales of tickets, Scientific Games has been successful in demonstrating to a number of jurisdictions that the Company can perform these functions effectively and at a lower cost.
Domestically, the Company had cooperative services agreements with the states of Florida, Georgia, Maine, Nebraska, Pennsylvania and West Virginia during 1997, which accounted for approximately 22.8% of the Company's total revenues. Cooperative service agreements with the states of Delaware and Kentucky will commence in 1998, increasing the number of the Company's cooperative service customers to eight. Under cooperative services contracts, the Company typically provides selected management, distribution services and/or data processing for the jurisdiction's instant ticket lottery game business and is paid a percentage of the lottery's total instant ticket revenues. Customers select those services which they desire to privatize from a menu of services offered, including: designing and installing game management software, instant ticket production, telemarketing, field sales, accounting, instant ticket distribution, sales staff training, estimating ticket needs, managing staff, advising with respect to security, instant ticket validation, and provision of computer hardware, validation terminals, SciScan Technology validation units, maintenance, communication network and sales agent hot-line service. Replacement of cooperative services agreements can be associated with large conversion costs for the lottery, as the lottery would have to hire and/or retrain its staff and redesign and install a software system to control the instant ticket lottery business.
In addition to laminated scratch off instant tickets, the Company's business also includes the sale of pull-tab tickets to its lottery customers. In October 1997, Scientific Games sold substantially all of the assets of its pull-tab manufacturer subsidiary, GameTec Inc. to International Gamco, Inc. ("Gamco"). However, the Company will continue to sell pull-tab tickets to lotteries in the U.S. through a marketing agreement with Gamco.
Scientific Games and its partner TeleCom Productions, Inc. introduced The Daily Race Game(TM) in January 1997. The Daily Race Game is a player-selection game that combines on-line, virtual reality horse racing with a popular "pick your numbers" format. Players chose three horses from a field of 12 in a 55-second animated horse race that can be shown on either commercial or closed-circuit television.
Another innovation announced by Scientific Games during 1997 was its new probability-game ticket, Winner's Choice(TM). Winner's Choice is a scratch-off instant ticket lottery game in which every ticket is a potential winner (unlike existing tickets, where winning tickets are pre-determined before a player scratches). Winner's Choice combines some of the best features of instant and on-line games, and possesses three important player benefits - choice, instant-win opportunities and appealing play styles. Probability games have been discussed within the lottery industry for years, but have never been viable because secure validation could not be assured. The Company's new SciScan Technology provides secure validation to enable probability tickets to be sold. Winner's Choice games are currently undergoing field testing in Maine conducted by Scientific Games in cooperation with the Maine State Lottery.
As mentioned above, in April 1997, Scientific Games acquired TeleControl, now known as SG Austria, whose systems enable the Company to reenter the on-line lottery systems business. Scientific Games' predecessor company had previously developed and operated on-line lottery systems from 1985 until 1991. During that period, Scientific Games supplied and operated on-line lottery systems in Iowa, Maine, New Hampshire, Vermont, West Virginia and sold on-line systems to the Virginia Lottery.
NEW PRODUCT DEVELOPMENT
Since its inception, Scientific Games has provided many of the innovations in instant ticket technology in both manufacturing and game development which subsequently became the industry standard. Past examples of new products developed by Scientific Games include the ink-jet printed instant ticket, cooperative services (lottery privatization), bar coding on the front and back of tickets (which facilitates validation), the IL/MVS instant ticket accounting management, ticket validation software technology, Terra 2000(R) tickets, and SciScan Technology(R). The Terra 2000 ticket is a recyclable and biodegradable paper ticket which meets the rigorous security standards demanded by the lottery industry. SciScan Technology is a keyless validation system for retailers which significantly reduces the time requirements of ticket validation while at the same time improving security of the game. The Company's latest innovation, SGI-NET, is a high-performance, configurable hardware and software-redundant transaction processing system that can accommodate both instant and on-line lottery operations. SGI-NET's configurability and software-driven architecture enables it to operate with virtually any type or number of terminals and provides flexibility to adapt to unique characteristics of almost any lottery.
Certain technology associated with these innovations is the subject of issued patents and patent applications currently pending with the United States Patent Office and selected other countries outside the United States. The Company also holds a number of other patents and licenses with respect to certain technology used in its business. The loss of any such patent or license, however, would not in the opinion of management have a material adverse effect on the Company's overall business. Scientific Games is continually looking for ways to apply its expertise in specialty printing technologies and security/randomization techniques to develop commercially viable products for both the lottery industry as well as for other commercial applications.
CUSTOMER SERVICE
The Company has an active professional Customer Service Department which works closely with its account managers, the lotteries, and Scientific Games' Graphics and Game Programming Departments in the area of initial game design. Artwork concepts, game play style and prize structure are assembled, proposed, and refined. Important manufacturing information is also assembled and documented in the "working papers" by the Company's customer service representatives. This information, when approved by the lottery, becomes the technical manufacturing specifications for specific instant ticket orders.
MARKETING
Scientific Games has been instrumental in the development of marketing strategies for instant games for domestic and foreign lotteries, including some of the most successful lotteries in North America. The Company's involvement includes all phases of instant game marketing support, including marketing strategies, prize structures, game rules, delivery schedules, play styles, telemarketing, instant ticket ordering and billing, field sales support, research, game design, working papers, retailer manuals, instant game concepts, ticket quantities, delivery and promotions. Scientific Games or its predecessor has prepared market research analysis of gaming tendencies in most new state lotteries since 1982, and the Company can provide customers with a bank of lottery-specific consumer and market research data derived from these years of analyses.
Instant tickets are believed to have the broadest consumer appeal of any lottery product. Consumers are generally split equally between men and women, are distributed evenly between ages 25 and 65, and cover a broad range of socioeconomic groupings. This broad-based market is significantly affected by appropriate advertising and promotion. The most successful lotteries have found that instant lottery products are largely an impulse item which must be marketed like other consumer products.
Sales of instant lottery tickets are based on, among other factors, the quality of the lottery product, prize structure design and the existence of efficient retail distribution systems which allow maximum convenience to consumers. Scientific Games, with its large game library and extensive research into product design and consumer purchasing habits, has been an industry leader in producing new products, distribution methodologies and consumer promotions to enhance sales.
SECURITY
Scientific Games recognizes that security and integrity are the foundation of successful lottery organizations. As the incidence and severity of publicly reported cases of physical and computer crime continue, major lotteries periodically reassess key security questions concerning the vulnerability of lottery games. Attempts to penetrate security measures may come from various combinations of customers, retailers, vendors, lottery officials and others. Because the integrity of a lottery is believed essential to its successful operation, both the vendor and lottery must guard their systems against unauthorized actions. The Company is unaware of any practical, economically feasible way to breach the security of its instant lottery tickets which could result in a material loss to any of its customers, nor is it aware of any breach thereof which has resulted in any material loss to any of its lottery customers.
Scientific Games constantly assesses the adequacy of its security systems, incorporating various improvements, bar coding and additional layers of protection. There must be well-planned security measures in place at every stage of the lottery operation. Scientific Games has pioneered and effected security safeguards in areas of ticket specifications, production, packaging, delivery, distribution and accounting. Also, computer function safeguards, including secure ticket data, control number encryption, winner file data, and ticket stock control have been incorporated in the Company's data processing and the computer operations phase. The Company retains a major public accounting firm to perform agreed upon procedures for each game produced before it is sent to the customer.
MANUFACTURING PROCESS
Using a series of computer-controlled presses and ink-jet imagers, management believes Scientific Games' tickets incorporate the most advanced technology and security methodology available in the industry. Its facilities are designed for efficient, secure production of instant game tickets and support ink-jet image tape generation, printing, packaging and storage of instant game tickets.
The Company's dedicated computer-controlled printing process is specifically designed for producing instant lottery game tickets for governmentally sanctioned lotteries and promotional games. The process is not a business forms press or a direct mail press temporarily diverted to lottery work. The Company's specialized equipment contributes to the underlying superior manufacturing and product quality. Instant ticket games are delivered finished and ready for distribution by the lottery, or by Scientific Games in the jurisdictions which are part of a cooperative services contract with Scientific Games.
Paper and ink are the principal raw materials consumed in the Company's manufacturing operations. The Company has a variety of sources for both paper and ink and should, therefore, not be dependent on any particular supplier.
PERSONNEL
As of December 31, 1997, the Company had approximately 1,177 full-time employees. Four of Scientific Games' employee groups are represented by a labor union. At the California Facility (See "Properties"), ticket packaging is performed by approximately 60 employees who are members of the Service Employees International Union Local 1877. SG Austria's employees are represented by a Worker's Council as is typical in many European companies. At the Leed's Facility in the United Kingdom, approximately 150 employees are members of the GPMU union. Approximately 14 employees who work at the Company's cooperative service facility in Harrisburg, Pennsylvania are members of the Chauffeurs, Teamsters and Helpers Local Union 776. The Company believes that its employee relations are good.
EXECUTIVE OFFICERS
The following table sets forth certain information regarding the executive officers of the Company who are considered executive officers by the Company for the purposes of Rule 36-7, as of March 1, 1998:
WILLIAM G. MALLOY has been President and Chief Executive Officer since 1990. Mr. Malloy was elected a Director and Chairman of the Board in October 1991 when Centre Partners L.P. and certain executive officers of the Company purchased substantially all of the assets of the instant lottery ticket sales business, the instant ticket cooperative sales business and the video lottery business of the predecessor to the Company in a leveraged buy-out transaction ("Acquisition"). Prior to becoming the Company's President and Chief Executive Officer, Mr. Malloy served as Vice President, Treasurer and Chief Financial Officer. Mr. Malloy joined the Company in 1987 when he transferred from the corporate staff of Bally Manufacturing Company. Mr. Malloy has over twenty years of experience in the coin-operated amusement and gaming industry.
WILLIAM F. BEHM joined the Company in 1978 and was promoted to Executive Vice President in 1988 and was elected a Director in 1992. Mr. Behm has overall management responsibility for Scientific Games' research and business development projects. In addition, he is also responsible for the Company's product security. Prior to joining Scientific Games, Mr. Behm was an aerospace engineer with McDonnell Douglas Corporation. Mr. Behm was instrumental in the development of the Company's former on-line lottery system, the invention of instant lottery bar codes, the development of the Company's environmental instant ticket and the development of the Company's recent SciScan and Winner's Choice product lines. He is co-named as the inventor of various issued patents and pending applications and is a regular speaker at trade shows and conferences on the subject of technology in the lottery industry.
THOMAS F. LITTLE joined the Company in 1975 and was promoted to Senior Vice President in 1991. Mr. Little has overall management responsibility for Scientific Games' Systems Division, which includes the Company's on-line lottery systems business. Prior to joining the Company, Mr. Little was Manager of Data Processing for First National Bank of Atlanta. Mr. Little's experience includes the introduction of the first video lottery test in Illinois, the development of the Company's former on-line lottery system and extensive contacts with the international lottery industry.
CLIFF O. BICKELL joined the Company as Vice President, Treasurer and Chief Financial Officer in January of 1995. Mr. Bickell has overall management responsibility for Scientific Games' corporate financial, accounting, and administrative affairs, including the Company's human resource function. Prior to joining Scientific Games, Mr. Bickell was Vice President, Chief Financial Officer and Treasurer of Paragon Trade Brands, a multi-national consumer products manufacturer where he had similar financial responsibilities. In addition, Mr. Bickell has held
the positions as Senior Vice President, Corporate Administration - Chief Financial Officer of the W. A. Krueger Co., a commercial printing company, and Treasurer of Dataproducts Corporation, a multinational electronics manufacturer.
C. GRAY BETHEA, JR. joined the Company in 1985 as Vice President, Secretary and General Counsel. Mr. Bethea has overall management responsibility for Scientific Games' legal compliance, statutory interpretation, corporate matters, and contract documents. Throughout his corporate and private practice of law, Mr. Bethea has had extensive experience in corporate and contract law. Prior to joining Scientific Games, Mr. Bethea was a partner with the law firm of Smith, Gambrell & Russell in Atlanta, Georgia.
BRUCE H. LONGHURST joined the Company in 1997 as Vice President, International Sales and Marketing. Mr. Longhurst has overall management responsibility for Scientific Games international marketing and sales efforts. Prior to joining Scientific Games, Mr. Longhurst was Vice President, International and Strategic Planning for Autotote Corporation and Managing Director of its subsidiary TeleControl, which was acquired in 1997 by Scientific Games. Mr. Longhurst held these and other positions with Autotote from 1993-1997. From 1988 - 1992, Mr. Longhurst held the position of Executive Vice President of the Worldwide Wagering Division of General Instrument Corporation. In addition, Mr. Longhurst was one of the founders and served as Executive Vice President and General Manager of Ticketron, including its AWI subsidiary.
HOWARD H. ROATH joined the Company in 1987 and was promoted to Vice President, U.S. Sales and Marketing in 1997. Mr. Roath has overall management responsibility for Scientific Games' U.S. marketing and sales efforts. Prior to joining Scientific Games, Mr. Roath served as Director of Marketing of the Pennsylvania Lottery, Director of Pharmaceutical Assistance Program for the Elderly for the Pennsylvania Department of Aging and the Director of the Division of State Employment for the Pennsylvania's Governor's Office of Administration.
TERRY D. MANGOLD joined the Company in 1975 and was promoted to Vice President-Instant Games Services in 1987. Mr. Mangold has overall management responsibility for Scientific Games' instant ticket game programming operations, i.e., the generation of games with the proper distribution of winning and non-winning tickets. Prior to joining Scientific Games, Mr. Mangold was responsible for computerized systems at First National Bank of Atlanta.
WILLIAM C. CHRISTIE joined the Company in 1996 as Managing Director for the Company's subsidiary SGIL in the United Kingdom. Mr. Christie has overall management responsibility for ticket production and printing for SGIL's production facilities. Prior to joining the Company, Mr. Christie was the Managing Director of Lottery Products for De La Rue in the United Kingdom. During his 26 years with De La Rue, Mr. Christie held various other management positions.
JAMES H. EDWARDS, JR. joined the Company in 1991 as Plant Manager and was promoted to Director of Manufacturing in 1998. Mr. Edwards has overall management responsibility for ticket production and printing for the Company's United States production facilities. Prior to joining the Company, Mr. Edwards held various management positions with Quebecor Printing, Inc. for over 20 years.
DI GERHARD HARWALIK joined the Company in 1997 as Executive Vice President. Mr. Harwalik has overall management responsibility for the Company's subsidiary SG Austria. Prior to joining the Company, Mr. Harwalik, as one of the original founders of TeleControl, (now known as SG Austria), served as their Managing Director from 1983 to 1995 and maintained a management role in the SG Austria until 1997. Mr. Harwalik also was the manager the computer center of the Technical University of Vienna and held positions with ETAG Group, Switzerland, which developed on-line systems for gaming wagering.
MARK L. HUTCHINSON joined the Company in 1997 as Managing Director. Mr. Hutchinson has overall management responsibility for the Company's branch office in Africa including operations in South Africa and Zimbabwe. Prior to joining Scientific Games, Mr. Hutchinson served as President from 1992 to 1997 of Gaming Solutions International. Mr. Hutchinson also held the position of Senior Vice President of an instant ticket printing company.
DONALD N. MACLEAN joined the Company in 1997 as Director of Human Resources. Mr. MacLean manages the personnel function for all of the Company's locations. Prior to joining the Company, Mr. MacLean held the position of Vice President of Human Resources for Burnham Service Corporation from 1989 to 1997. In addition, Mr. MacLean was the Corporate Director of Human Resources for Interlake Corporation and Division Director of Human Resources for Mueller Corporation.
KENNETH W. TAYLOR joined the Company in 1987 and was promoted to Corporate Controller in 1990. Mr. Taylor has management responsibility for accounting and financial information as well as responsibility for customer pricing compliance. Prior to joining the Company, Mr. Taylor held auditor positions with Bally Manufacturing Corporation, Duchossois Industries and Amsted Industries, Inc.
JOHN J. WALSH joined the Company in 1986 and was promoted to Director of Cooperative Services in 1994. Mr. Walsh has overall management responsibility for coordinating lottery operations support through the Cooperative Services Program. Prior to joining the Company, Mr. Walsh held positions with Control Data Corporation and Ticketron's sports and entertainment division.
THE FOLLOWING DISCUSSION OF ASPECTS OF THE COMPANY'S BUSINESS ALSO CONSTITUTES A CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.
The Company wishes to caution readers that the following important factors, among others, in some cases have affected, and in the future could affect, the Company's actual results and could cause the Company's actual quarterly and annual consolidated results for 1998, and beyond, to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company:
GOVERNMENTAL REGULATION
Lotteries are not permitted in the various states/jurisdictions of the United States unless expressly authorized by law. The ongoing operations of authorized lotteries in the United States typically are extensively regulated. Applicable legislation varies from jurisdiction to jurisdiction but, in addition to authorizing the lottery and creating the applicable regulatory authority, the lottery statues generally dictate certain broad parameters of lottery operation, including the percentage of lottery revenues which must be paid out in prizes. Lottery authorities typically exercise significant control as to the selection of vendors (such as the Company) and award of lottery contracts, ticket prices, types of games played and marketing strategy, all of which can affect the Company's operating results.
Prior to and after granting a lottery contract, governmental authorities generally conduct an investigation of the Company and its employees and such authorities may require removal of an employee deemed to be unsuitable. The Company has not been disqualified from a lottery contract as a result of any such investigation. Certain states also require extensive personal and financial disclosure (including, among other things, submission of fingerprints, personal financial statements and federal and state income tax returns) and background checks of control persons and entities beneficially owning a specified percentage (typically 5% or more) of the Company's securities. The failure of such beneficial owners to submit to such background checks and provide such disclosure could jeopardize the award of a lottery contract to the Company or provide the basis for cancellation of existing lottery contracts.
Scientific Games generally retains governmental affair representatives in various states of the United States to advise legislators and the public concerning its views on lottery legislation, to monitor any such legislation and to advise the Company on contract proposals to lottery authorities. Scientific Games also makes campaign contributions to various state political parties and political candidates. The Company believes it has complied with applicable laws and regulations concerning campaign contributions and lobbying disclosures.
The award of lottery contracts and ongoing operations of lotteries in international jurisdictions also are extensively regulated, although this regulation usually varies from that prevailing in the United States. Restrictions are frequently imposed on foreign corporations seeking to do business in such jurisdictions and, as a consequence, the Company has, in a number of instances, allied itself with a local company when seeking foreign lottery contracts. Laws and regulations applicable to lotteries in the United States and foreign jurisdictions are subject to
change and the effect of such changes on the Company's ongoing and potential operations cannot be predicted with certainty.
MARKETS
The Company's operations are international in scope. With 39 states and the District of Columbia currently operating lotteries in the United States, the Company's growth in the domestic market depends primarily on expanded activities of existing lotteries as well as winning new contract awards, re-bids and contract extensions. Contrasted with the domestic market, the international market is far from mature, with various countries viewing lotteries as a source of revenue for a variety of governmental programs. For a discussion of the Company net revenues, operating income and identifiable assets attributable to U.S. production operations, see Note 11 of the Notes to the Financial Statements set forth elsewhere in this report, which is incorporated herein by reference thereto. For a discussion of revenues from lottery agencies and other customers domiciled in foreign countries, also see Note 11 which is incorporated herein by reference thereto.
In 1997, no state accounted for more than 10% of the revenues of the Company. The Company had twelve domestic contracts that were scheduled to expire in 1997. Six of these contracts were extended, and the Company was awarded new contracts for five states through a competitive procurement process. The Company was the unsuccessful bidder on the New Hampshire Lottery contract. With regard to contracts previously held by its competitors, the Company was the successful bidder in 1997 for the Pennsylvania Lottery, which now has a cooperative services contract with the Company.
The Company has seven domestic contracts which are subject to extensions or scheduled to expire in 1998. Of these seven contracts, five have extensions available. Management believes new contracts for those states without extensions will be awarded through a competitive procurement process in which the Company will participate. The Company estimates, based in part upon industry and lottery furnished information, that 1997 domestic instant ticket retail sales by lotteries ("1997 Lottery Sales") were in excess of $14.1 billion. In comparison, 1997 international instant ticket retail sales are estimated to be $13.0 billion. Based in part on such information, management estimates the Company's domestic customers with contracts subject to extensions or scheduled to expire in 1998 represent, in the aggregate, retail sales of approximately 22.1% of 1997 Lottery Sales. In contrast, management believes that lottery contracts with seven states currently serviced by its competitors are subject to extensions or are scheduled to expire in 1998. The Company expects that new contracts for such states not exercising extensions will be awarded through the competitive procurement process in which the Company expects to participate. The Company estimates, based in part upon industry and lottery furnished information, that instant ticket contracts for the Company's competitors scheduled to expire in 1998 represent, in the aggregate, retail sales of approximately 24.2% of 1997 Lottery Sales.
The Company's domestic lottery contracts typically have an initial term of from one to five years and usually provide the customer with options to extend the contract one or more times under the same or mutually agreeable terms and conditions for additional periods generally ranging from one to five years. The Company's customers have exercised extension options in the Company's domestic instant lottery contracts a majority of the time.
The table included herein lists the domestic instant lottery contracts with which the Company had executed agreements as of March 23, 1998 and certain information with respect thereto. The Company is the primary instant ticket supplier unless otherwise noted. The table also includes 1997 instant ticket retail sales for each state or district. Information obtained from industry sources lists 1997 domestic instant ticket retail sales of $14.1 billion and international instant ticket retail sales of $19.6 billion.
DOMESTIC LOTTERY CONTRACTS
Based on industry information, it is estimated that 1997 domestic on-line lottery retail sales were $19.6 billion compared with 1997 international on-line lottery retail sales of $48.7 billion. The Company's re-entry into the on-line lottery business in 1997 will allow the Company to compete for a share of both the domestic and international sales in the future. The Company believes on-line lottery contracts with four states currently serviced by its competitors are subject to extensions or will expire during 1998. It is estimated that domestic on-line lottery contracts for the Company's competitors scheduled to expire or subject to extensions during 1998 represent, in aggregate, on-line lottery retail sales of approximately 8.8% of 1997 on-line lottery retail sales. The Company expects to bid on these domestic contracts, while pursuing international on-line opportunities during 1998.
Sales outside the United States may consist of sales of goods and services exported to customers located overseas, sales of goods and services to customers in countries in which the Company's foreign subsidiaries have manufacturing facilities or sales of goods and services by the Company's foreign subsidiaries located outside the
country of production. Although the Company does business worldwide, a majority of the Company's current foreign operations are conducted in, and U.S. export sales are made to customers located in Europe.
The Company's international lottery contracts are less likely to have firm contract periods and, historically, international lottery ticket customers have sought competitive bids for such contracts more frequently than domestic U.S. customers. The volume and timing of the international contracts fluctuate from country to country and it is difficult to predict the volume or timing of sales to these customers from period to period.
LOTTERY CONTRACTS: PROCUREMENT PROCESS AND REQUIREMENTS
Lotteries in the United States typically select an instant ticket supplier by issuing a Request for Proposals ("RFP") which outlines contractual obligations as well as products and services to be delivered. An evaluation committee frequently comprised of key lottery staff evaluates responses based on various criteria. These criteria usually include quality of product, security plan and features, experience in the industry, quality of personnel and services to be delivered and price. The Company believes that the quality of its personnel, technical expertise and manufacturing efficiency give it many advantages relative to the competition when responding to state lottery RFPs. However, many lotteries still award the contract to the qualified vendor with the lowest price, regardless of factors other than price. Contract awards by lottery authorities in the United States are sometimes challenged by unsuccessful competitors which can result in protracted legal proceedings.
The Company's domestic lottery contracts typically contain provisions for payment of liquidated damages for late delivery of tickets or delivery of defective tickets, which in the aggregate could result in several million dollars or more per day in penalties to the Company. Although the incurrence of liquidated damages with respect to on-line lotteries may not be uncommon, the Company believes it is uncommon for instant lotteries. Scientific Games has not typically paid any material liquidated damages under an instant lottery contract, although it has on occasion negotiated customer allowances which management does not consider material.
Lottery contracts to which the Company is party frequently contain exacting implementation schedules and performance requirements. Failure to meet these schedules and requirements can result in substantial monetary liquidated damages, as well as possible contract termination. The Company maintains a bonding program for its bid bonds, litigation bonds and performance bonds through various insurance companies. As of December 31, 1997, $64.7 million was outstanding in aggregate face amount of surety bonds issued. One or more of these bonds is generally required by a lottery customer in order to participate in a lottery procurement or to enter into a contract with the lottery following successful bid. Failure to provide such bonds would materially and adversely affect the Company's ability to do business. The Company's bonding program is backed by a blanket indemnity of the surety.
Lottery contracts of the Company periodically expire and/or reach optional extension dates. Upon the expiration of a contract (including any extensions thereof), lottery authorities may award new contracts through a competitive procurement process. There can be no assurance that the Company's contracts will be extended or that the Company will be awarded new contracts as a result of competitive procurement processes in the future. The Company's lottery contracts typically permit a lottery authority to terminate the contract at any time for failure to perform and other specified reasons, and many of such contracts permit the lottery authority to terminate the contract at will without penalty. Depending upon, among other factors, the amount of new revenue derived by the Company thereunder, the termination, expiration or failure to renew one or more instant lottery contracts could have a material adverse effect on the Company's business or prospects.
COMPETITION
The instant lottery business is highly competitive, and the Company business faces competition from a number of domestic and foreign instant ticket manufacturers, on-line lottery system providers and other competitors.
In particular, Scientific Games currently has two primary instant lottery ticket competitors in the U.S.: Pollard Banknote Limited ("Pollard") and BABN Technologies ("BABN",a subsidiary of Group Francois-Charles Oberthur of France), which purchased the lottery ticket business of a former competitor, Dittler Brothers, Inc. ("Dittler") in 1997. The Company estimates that the retail sales value of its domestic customer base was in excess of 60% of total domestic instant ticket retail sales in 1997 - approximately twice as many as its next largest competitor.
Except as permitted by the applicable provisions of the North American Free Trade Act with respect to Canada and Mexico, it is currently illegal to import lottery tickets into the United States from a foreign country. The Company's business could be adversely affected should additional foreign competitors in Canada or Mexico export their lottery products to the U.S. or should other foreign competitors establish printing facilities in the U.S., Canada or Mexico to supply the U.S. market.
Internationally, there are many lottery instant ticket vendors which provide competition to the Company, including, among others, BABN, Pollard, Creative Games International, Inc. in the United States, government owned printers in Scandinavia, GPS Honsel in Germany and various other vendors.
Both in the domestic market and internationally, factors which influence the award of lottery contracts in addition to price, are believed to include, among others, the ability to optimize lottery revenues through game design and technical capability, quality of the product, dependability, production capacity, marketing experience, financial condition and reputation of the bidder, the security and integrity of the bidder's production operations, products and services and the satisfaction of various other requirements and qualifications imposed by specific jurisdictions.
Scientific Games' position as a leading worldwide producer of instant lottery tickets and its reputation as a developer of state-of-the-art technology and marketing concepts, as well as its experience in the industry, are believed to enhance significantly the Company's competitive position. The large capital investment necessary to purchase, customize and install an instant ticket printing operation, the high level of security required in the lottery industry and the fact that all states in the U.S. which have lotteries have typically required potential suppliers to have prior lottery experience are all factors which tend to limit the number of firms which are willing to, or are in the position to, enter the instant lottery ticket production business. The Company's business could be adversely affected should its competitor's research and development activities result in reduced technological differentiation between the products of the Company and its competitors. Similarly, in the event technological developments materially reduce the capital investment required to finance secure lottery ticket printing operations, the Company's business could be adversely affected by increased competition. Management does not anticipate any material reduction in the level of capital financing required for entry into the lottery ticket product business in the foreseeable future.
In the cooperative services business, the Company believes it has no current competitor in the U.S. market which produces instant lottery tickets, provides on-line systems and offers a full range of cooperative services to state lotteries. Competitors have typically either manufactured only instant tickets or provided only certain services which comprise cooperative services, such as software for the management systems, marketing assistance or other specific duties. However, an on-line vendor in cooperation with an instant ticket supplier may be considered a competitor or potential competitor in cooperative services. In addition, an on-line vendor not in cooperation with an instant ticket supplier may nonetheless provide various cooperative services, including data processing services. Scientific Games has two primary domestic and international competitors in this regard: Powerhouse Technologies, Inc., which changed its name from Video Lottery Technologies, Inc in 1997 and GTech Corporation.
In 1997, the Company discontinued its charity pull-tab ticket business, which was produced and distributed by its subsidiary GameTec Inc. ("GameTec"). In connection with the disposition, the Company sold substantially all of the assets of GameTec to International Gamco, Inc. ("Gamco"). The Company entered into a three-year extendible marketing agreement with Gamco to provide marketing and related services to state lotteries for pull-tab tickets. Currently, the Company has 3 contracts with state lotteries for pull-tab tickets. The Company believes it is desirable to offer pull-tab tickets to its lottery customers to maintain a full range of products and services and the Company will continue to provide pull-tab tickets to its lottery customers through the marketing agreement. The Company does not consider the provision of pull-tab tickets to its lottery customers to be a separate operating segment, and sales of pull-tab tickets to lottery customers accounted for less than 10% of the Company's consolidated gross revenues in 1997.
POTENTIAL FLUCTUATIONS IN OPERATING RESULTS
The Company's operating results may vary significantly from period to period. Revenues and capital expenditures may be difficult to forecast because the Company's sales cycle may vary and depend upon facts such
as the size and timing of awarded contracts, changes in customer budgets, delays in customer orders, changes in lottery marketing strategies and ticket ordering patterns and general economic conditions. Contracts with governmental entities operating newly authorized instant lotteries tend to generate higher levels of ticket sales in the initial months.
Operating results also may be affected by the working capital requirements associated with preparing facilities and equipment, establishing the distribution system and printing tickets for a recently awarded contract, and by the amount of time elapsing before the receipt and/or recognition of revenues from the sale of instant lottery tickets and the provision of cooperative services. New cooperative service customers may require additional resources and infrastructures that may be required to be put in place before revenues are realized. In addition, operating results may be affected by utilization of overtime labor and the Company's ability to smoothly integrate new and/or upgraded production equipment with its existing production operations. Revenues from the sale of instant tickets, cooperative services, software and hardware development may be recognized based upon ticket shipments, a percentage of the lottery's instant ticket sales to the public, a contracted price, a license agreement, an equipment lease agreement or any combination of the foregoing. Current on-line revenues are generated from the sale of hardware and software to lotteries, as well as support and maintenance contracts on the on-line systems.
Additionally, circumstances encountered in international markets, including the substantial amount of time involved in bidding on any international contract, the evaluation of such bid and the resultant contract award or rejection can vary significantly from that originally anticipated when the bid is prepared. All of these factors may make it difficult to forecast revenues and expenditures related to the Company's operations over extended periods and may result in fluctuations in the Company's quarterly financial results. Accordingly, quarter to quarter fluctuations in revenues may be expected.
RELIANCE ON SENIOR MANAGEMENT
The Company believes it has benefited and continues to benefit substantially from the skills, experience and efforts of its senior management (See "Executive Officers"). The loss of the services of members of the Company's senior management could have a material adverse effect on the Company's business and prospects.
ADDITIONAL RISK FACTORS AND INVESTMENT CONSIDERATIONS
Additional or related factors which could affect the Company's actual results and could cause the Company's actual consolidated results for the first quarter of 1998, and beyond, to differ materially from those expressed in any forward-looking statement made by, or on behalf of, the Company include:
Continued or increased pressure to change the selling prices for the Company's products, and the resulting effects on margins, the Company's actions in connection with continued competition in many product areas, including, but not limited to, price competition and fluctuating demand for certain lottery ticket products by one or more lottery customers;
Difficulties or delays in the development, production, testing and marketing of products, including, but not limited to, a failure to ship new products utilizing SGI-NET, SciScan Technology and/or other technologies when anticipated, the failure of customers to accept these products or technologies when planned, any defects in products and a failure of manufacturing economies to develop when planned;
Occurrences affecting the Company's ability to reduce product and other costs, and to increase productivity;
Inability to offset pricing competition with production efficiencies and economies of sales; underutilization of the Company's plants and factories resulting in production inefficiencies and higher costs; start-up expenses and inefficiencies and delays and increased depreciation costs in connection with the start of production in new plants and expansions;
The amount, and rate of growth in, the Company's selling, general and administrative expenses, and the impact of unusual items resulting from the Company's ongoing evaluation of its business strategies, asset valuations and organizational structures;
The compromise or breach or perceived compromise or breach of the Company's production security and integrity or the security and integrity of its products or services;
Difficulties in obtaining raw materials, supplies, power and natural resources and any other items needed for production of lottery tickets and other products;
The acquisition of fixed assets and other assets, including inventories and receivables, and the making or incurring of any expenditures and expenses, including, but not limited to, depreciation and research and development expenses, any revaluation of assets or related expenses and the amount of, and any changes to, tax rates;
The effects of, and changes in, trade, monetary and fiscal policies, laws and regulations, other activities of governments, agencies and similar organizations, and social and economic conditions, such as trade restrictions or prohibitions, inflation and monetary fluctuations, import and other changes or taxes, the ability or inability of the Company to obtain, or hedge against, foreign currency, foreign exchange rates and fluctuations in those rates, loss of international contracts or lower international revenue resulting from increased expenses associated with overseas operations, the impact of foreign labor laws and disputes, adverse effects arising out of political unrest, terrorist activity, nationalizations and unstable governments and legal systems, and intergovernmental disputes, as well as actions affecting frequency, use and availability of lottery products and licensing of lotteries for business;
The costs and other effects of legal or administrative cases and proceedings (whether civil, such as environmental and product-related, or criminal), settlements and investigations, claims, and changes in those items; developments or assertions by or against the Company relating to intellectual property rights and intellectual property licenses; adoptions of new, or changes in, accounting policies and practices and the application of such policies and practices;
The rejection or a delay in implementing terms of the joint venture agreement with La Francaise des Jeux by the French Minister of Finance or the inability to execute definitive agreements for products and services related to the joint venture agreement;
The effects of changes within the Company's organization or in compensation and benefit plans; any activities of parties with which the Company has an agreement or understanding, including any issues affecting any investment or joint venture in which the Company has an interest; the amount, type and cost of the financing which the Company has, and any changes to that financing; and
The ability to integrate acquisitions into the Company's existing operations and unexpected difficulties or problems with such acquired entities including inadequate production equipment, inadequate production capacity or quality, outdated or incompatible technologies or an inability to realize anticipated synergies and efficiencies, whether within anticipated time frames or at all.
For a more detailed discussion of certain of these risks see Item 3 "Legal Proceedings" and Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations".
ITEM 2.
ITEM 2. PROPERTIES
The Company currently has four instant ticket manufacturing sites: a 71,000 square foot leased facility in Gilroy, California (the "California Facility"), a 185,000 square foot owned headquarters and manufacturing facility in Alpharetta, Georgia (the "Georgia Facility"), a 112,000 square foot leased facility in Leeds, United Kingdom (the "Leeds Facility"), and a 30,000 square foot leased facility in Bradford, United Kingdom (the "Bradford Facility"). Scientific Games has a 8,000 square foot leased facility in Vienna, Austria (the "Austria Facility"), where the main
software development activities for its on-line business are located. Sales support, research, product development, U.S. software development and graphics are located in the Company's corporate headquarters at the Georgia Facility. The four manufacturing facilities have a combined maximum production capacity of approximately 14 billion "standard sized" (2 by 4 inch) tickets per year. However, at maximum production capacity, the Company incurs substantial overtime expense and can encounter reduced efficiencies. The California Facility consists of office and production space equipped with a modern gravure press with multiple ink-jet imagers. The California Facility lease expires April 30, 2005. Currently, annual rents for the California Facility are approximately $680,000. In addition, the Company separately leases in California an approximately 14,000 square foot ink production facility under a lease expiring April 30, 1999 with annual rents of approximately $90,000. The Leeds Facility consists of office and production space equipped with five sheet-fed offset presses. The administrative and game development departments for both the Leeds and Bradford Facilities are in this location. The Leeds Facility lease expires October 31, 2001 with annual rents of approximately $368,000. The Bradford Facility includes office and production space and is equipped with three separate printing processes: offset, inkjet and rotary screen. The Bradford Facility lease expires June 30, 2016 with annual rents of approximately $212,000. The Austria Facility consists of office and software development space equipped with state of the art software development tools. The Austria Facility lease expires on December 31, 2007 with annual rents of approximately $465,000.
Scientific Games' headquarters and printing facility in Georgia began operation in February 1992. The Georgia Facility operates two presses, including a modern 15 station gravure press. The Georgia Facility's gravure press is equipped with a state-of-the-art register control system, designed to reduce overall waste while achieving high quality. The press has four reversible stations providing color flexibility including potential four-color back printing in selected situations and is designed to accommodate alternative printing technology on a station-by-station basis. The press is designed to dry both water-based and solvent-based inks at full press speed. Currently, the use of water-based inks is increasing as the printing industry moves to reduce its output of volatile organic compounds (VOC's) created as the result of drying solvent based inks.
In 1994-95, after an analysis of projected future manufacturing requirements, the Company installed new imagers, data stations and related equipment incorporating significantly advanced technology for its existing presses in its California and Georgia facilities at a total cost of approximately $5 million. Such imagers materially increased the efficiency and flexibility (and thus capacity) of the Company's existing presses.
In 1995, the Company also installed an additional custom-designed printing press, including new imagers, data stations and related equipment, in its Georgia Facility. The total cost of the equipment and building expansion was approximately $15.5 million. The new press is designed to employ both offset and flexographic printing technologies and allows Scientific Games to more economically produce smaller print runs than the existing two gravure presses, by, among other things, reducing press set-up costs versus the existing two gravure presses. The savings in operation of the third press are attributable to, among other factors, the flexographic and offset technologies which use photopolymer and aluminum plates rather than the engraved chrome plated cylinders used in the gravure process.
The Company has presses at the Leeds and Bradford Facilities located in the United Kingdom. The Leeds Facility has five sheet-fed offset presses as well as imaging and silk screen equipment. The Bradford Facility utilizes three separate printing processes, which are an offset, inkjet and rotary screen. In 1997, the Company, after an analysis of projected future manufacturing requirements, began installation of new imagers, data stations and related equipment incorporating significantly advanced technology for its existing presses at the Bradford Facility at a total retail cost of approximately $3.0 million. Such imagers were fully operational in March 1998 and are expected to materially increase the efficiency and flexibility (and thus capacity) of the Company's existing presses at the Bradford Facility.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company's SGI subsidiary owns a minority interest in Wintech de Colombia S.A. ("Wintech"), which has operated the Colombian national lottery under contract with Empresa Colombian de Recuros para la Salud, S.A. ("Ecosalud"), an agency of the Colombian government. The contract projected that certain levels of lottery ticket sales would be attained, and provided a penalty against Wintech, SGI and the other shareholders of up to
$5,000,000 if such levels were not achieved. In addition, with respect to the further guarantee of performance under the contract with Ecosalud, SGI delivered to Ecosalud a $4,000,000 bond issued by a Colombian surety. Wintech started the instant lottery in Colombia but, due to difficulties beyond its control, the projected sales level was not met for the year ending 1993. On July 1, 1993, Ecosalud adopted resolutions declaring, among other things, that the contract was in default and asserted various claims for compensation and penalties against Wintech, SGI and shareholders of Wintech. As the Company has previously disclosed in its filings with the Commission, litigation is pending in Colombia concerning various claims among Ecosalud, Wintech and the Company relating to the termination of the contracts with Ecosalud (the "Colombian Litigation"). Ecosalud's claims in the Colombian Litigation are for, among other things, realization on the full amount of the penalty plus interest and costs of the bond.
SGI has consulted with Colombian counsel and been advised that SGI has various legal defenses to Ecosalud's claims. SGI also has certain cross indemnities and undertakings from the two other private shareholders of Wintech for their respective shares of any liability to Ecosalud. That obligation is secured in part by a $1,500,000 confirmed letter of credit in favor of SGI. The Colombian surety which issued a $4,000,000 bond to Ecosalud under the contract has reportedly paid $2,400,000 to Ecosalud under the bond, and made demand upon SGI for that amount under the indemnity agreement entered into by the surety and SGI. SGI declined to make or authorize any such payment and notified the surety that any payment in response to Ecosalud's demand on the bond is at the surety's risk. No suit by the Colombian surety has been filed to date. No assurance can be given that the other shareholders of Wintech will, or have sufficient assets to, honor their indemnity undertakings to SGI when the claims by Ecosalud against SGI and Wintech are resolved in the even such claims result in any liability.
In June 1996, Ecosalud filed a complaint against the Company in the Unites States District Court for the Northern District of Georgia, Atlanta Division (the "Georgia Litigation"). Total damages claimed in the original Complaint were "not less than $84,423,267." The Complaint also sought reasonable attorneys' fees and costs allegedly pursuant to the contract. In response to the complaint, SGI filed a motion to dismiss the action on multiple grounds, including the mandatory arbitration clause contained within the contract. Ecosalud then filed an "Amended Complaint" in which it withdrew its claim for in excess of $84,000,000 and, instead, sought $5,000,000 under an "Executive Title," a purported joint and several guarantee by the Company, Wintech and other shareholders in Wintech that projected levels of lottery sales would be attained. In addition, Ecosalud also sought attorneys' fees and interest on the claim. SGI filed a motion to dismiss the Amended Complaint on the ground, inter alia, that litigation involving the same subject matter is pending in Colombia, the dispute is subject to an arbitration clause and forum non conveniens. On March 19, 1997 judgment was entered on behalf of the Company. The Court dismissed the action on the grounds that it was governed by the arbitration and forum selecting clauses in the contract which require that all disputes be settled either by arbitration in Colombia or in the administrative courts of Colombia. The Court also dismissed the action on the grounds of lis alibi pendens. On April 16, 1997, the Plaintiff filed a Notice of Appeal. The United States Court of Appeals for the Eleventh Circuit heard oral argument on the appeal of the dismissal of the complaint of Ecosalud on January 16, 1998 and thereafter affirmed the holding of the trial Court. Ecosalud did not seek reconsideration by the Eleventh Circuit; accordingly, the Georgia Litigation has been concluded.
SGI intends to vigorously defend the Colombian Litigation and has been advised by counsel that the Company has numerous defenses on the merits, as well as procedural defenses to the litigation. Although it is not possible to determine the outcome of the litigation in Colombia, or the other related surety and indemnity claims, management believes, based upon, among other things, the advice of counsel, the advice of counsel that SGI has various defenses (which it has asserted in response to such proceedings and claims), that adequate provision has been made for such claims and the disposition thereof should not have a material adverse effect on the Company's consolidated financial condition or consolidated results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders at any time during the fourth quarter of the year ended December 31, 1997.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
In July 1997, the Company adopted a shareholders rights plan which provided for the issuance to each holder of the Company's Common Stock, certain rights (the "Rights") to purchase shares of the Company's redeemable Series A Participating Cumulative Preferred Stock pursuant to the terms of a Rights Agreement. Such rights are exercisable after distribution by holders other than "Acquiring Persons" as defined in the Rights Agreement in the event of certain ownership changes and in connection with certain business combinations. The Rights may have certain anti-takeover effects. The Rights may cause substantial dilution to a person that attempts to acquire the Company without a condition to such an offer being that a substantial number of the Rights be acquired or that the Rights be redeemed or declared invalid. The Rights should not interfere with any merger or other business combination approved by the Board of Directors (under some circumstances, with the concurrence of the Continuing Directors) since the Rights may be redeemed by the Company. A copy of the Rights Agreement and a more expansive summary of the provisions thereof is set forth in the Company's Form 8-A/A with respect thereto, filed with the Commission on August 6, 1997.
The information presented under the caption "Corporate Information" on page 37 of the Company's 1997 Annual Report to Shareholders is incorporated herein by reference.
ITEM 6
ITEM 6 SELECTED FINANCIAL DATA
The information presented under the caption "Five-Year Selected Financial Data" on page 14 of the Company's 1997 Annual Report to Shareholders is incorporated herein by reference.
ITEM 7
ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information presented under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 15 through 22 of the Company's 1997 Annual Report to Shareholders is incorporated herein by reference.
ITEM 8
ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information presented under the caption's "Consolidated Statements of Income", "Consolidated Balance Sheets", "Consolidated Statements of Cash Flows", "Consolidated Statements of Shareholders' Equity", and "Notes to Consolidated Financial Statements", on pages 23 - 35 of the Company's 1997 Annual Report to Shareholders is incorporated herein by reference.
ITEM 9
ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not Applicable
PART III
ITEM 10
ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
This information required by Item 10 is incorporated by reference from the information in Registrant's proxy statement (filed or to be filed pursuant to Regulation 14A) for its Annual Meeting of Stockholders to be held May 22, 1998, except as to biographical information on Executive Officers which is contained in Item 1 of this Annual Report on Form 10-K.
ITEM 11
ITEM 11 EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated by reference from the information in Registrant's proxy statement (filed or to be filed pursuant to Regulation 14A) for its Annual Meeting of Stockholders to be held May 22, 1998.
ITEM 12
ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 is incorporated by reference from the information in Registrant's proxy statement (filed or to be filed pursuant to Regulation 14A) for its Annual Meeting of Stockholders to be held May 22, 1998.
ITEM 13
ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated by reference from the information in Registrant's proxy statement (filed or to be filed pursuant to Regulation 14A) for its Annual Meeting of Stockholders to be held May 22, 1998.
PART IV
ITEM 14
ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) Consolidated Financial Statements
The following financial statements and notes thereto of Scientific Games Holdings Corp. are incorporated in Item 8 by reference from the Company's 1997 Annual Report to Shareholders:
(a)(2) Financial Statement Schedules
Schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted.
(a)(3) Reports on Form 8-K
No reports on Form 8-K were filed during the fourth quarter of 1997.
(a)(4) Listing of Exhibits
The exhibits listed below are filed with or incorporated by reference into this annual report on Form 10-K.
EXHIBIT NO. DESCRIPTION OF EXHIBIT
3.1 -- Second Amended and Restated Certificate of Incorporation of Scientific Games Holdings Corp. with Certificate of Designation 3.2 -- Second Amended and Restated By-Laws of Scientific Games Holdings Corp.(4) 10.2 -- Agreement by and between the Massachusetts State Lottery Commission and Scientific Games, Inc. dated December 18, 1987 and extensions thereto(1) 10.6 -- Employment Agreement ("Malloy Employment Agreement") dated as of October 1, 1991 between Scientific Games Operating Corp.(now known as Scientific Games Inc.) and William G. Malloy(1) 10.7 -- Employment Agreement ("Behm Employment Agreement") dated as of October 1, 1991 between Scientific Games Operating Corp.(now known as Scientific Games Inc.) and William F. Behm(1) 10.8 -- Employment Agreement ("Little Employment Agreement") dated as of October 1, 1991 between Scientific Games Operating Corp.(now known as Scientific Games Inc.) and Thomas F. Little(1) 10.10 -- Form of Promissory Note evidencing loans to Management Stockholders(1)
10.16 -- Second Amendment to Asset Purchase Agreement dated as of October 1, 1991 between Bally Manufacturing Corporation and Scientific Games Operating Corp. (now known as Scientific Games Inc.)(re: Earnout)(1) 10.17 -- Stockholders' Agreement dated as of July 1, 1993, as amended(1) 10.18 -- Amended First 1991 Management Stock Option Plan(1) 10.19 -- Amended Second 1991 Management Stock Option Plan(1) 10.20 -- 1993 Management Stock Option Plan(1) 10.21 -- Industrial Real Estate Lease dated December 4, 1984 between Arroyo One as Landlord and Scientific Games Inc. as Tenant (Gilroy Lease), as amended(1) 10.22 -- Lease dated April 27, 1987 between Kishimura Bros. and Scientific Games of California, Inc. (Scientific Games of California, Inc. assigned its leasehold interest to Scientific Games Operating Corp., now known as Scientific Games, Inc.), as amended(1) 10.23 -- Form of Amendment to Malloy Employment Agreement(1) 10.24 -- Form of Amendment to Behm Employment Agreement(1) 10.25 -- Form of Amendment to Little Employment Agreement(1) 10.26 -- Instant Ticket and Associated Products and Services Agreement dated May 4, 1993 by and between Georgia Lottery Corporation and Scientific Games, Inc.(4) 10.31 -- Form of revised Severance Benefits Agreement(4) 10.32 -- Amendment to Amended First 1991 Management Stock Option Plan(4) 10.33 -- Amendment to Amended Second 1991 Management Stock Option Plan(4) 10.34 -- Amendment to 1993 Management Stock Option Plan(4) 10.35 -- First Amended and Restated 1993 Directors' Stock Option Plan(4) 10.37 -- 1994 Management Stock Option Plan(6) 10.38 -- 1995/1996 Management Stock Option Plan(6) 10.39 -- Key Employee Restricted Stock Option Plan(6) 10.40 -- Severance Benefits Agreement dated as of May 5, 1995, between Scientific Games Holdings Corp. and Cliff O. Bickell(7) 10.42 -- Key Employee Restricted Stock Plan(6) 10.43 -- Form of Key Employee Restricted Stock Plan Restricted Stock Award Agreement(7) 10.45 -- Instant Lottery Tickets Supply Agreement between Thomas De La Rue Limited, Scientific Games Inc. and Camelot Group plc, dated June 15, 1995.(3)(8) 10.46 -- Credit Agreement for Line of Credit From First Union National Bank of Georgia to Scientific Games Holdings Corp. and Scientific Games Inc. Dated: December 20, 1996(9) 10.47 -- Rights Agreement dated as of July 10, 1997 between Scientific Games Holdings Corp. and First Union National Bank as Rights Agent(11) 10.48 -- Amended Bank Credit Agreement 10.49 -- 1998 Employee Stock Purchase Plan, as amended and restated 10.50 -- Stock Purchase Agreement dated as of April 15, 1997, by and between Scientific Games Holdings Corp. and Autotote Corporation with Respect to All Outstanding Capital Stock of Tele Control Kommunications - und Computersysteme Gesellschaft m.b.h. 10.51 -- Form of Amendment to Behm Employment Agreement 10.52 -- Form of Amendment to Little Employment Agreement 11.0 -- Statement re: computation of per share earnings(loss) 13.1 -- 1997 Annual Report to Shareholders pages 14, 15-35 and 37 only 21.0 -- List of Subsidiaries of Registrant 23.0 -- Consent of Independent Auditors 27.0 -- Financial Data Schedule (for SEC use only)
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(1) Previously filed with Registration Statement No. 33-65582, filed on July 2, 1993 or as subsequently amended on July 28, 1993, August 9, 1993 or August 20, 1993.
(2) Previously filed with the Company's Quarterly Report on Form 10-Q for the Quarter Ended September 30, 1993. (3) Portions of Exhibits 10.28 and 10.43 deemed confidential by the Company have been omitted, were filed separately with the Commission and confidential treatment has been granted for portions of these exhibits. (4) Previously filed with the Company's Registration Statement No. 33-75168, filed on February 11, 1994 or as subsequently amended on March 4, 1994. (5) Previously filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1993. (6) Previously filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1994. (7) Previously filed with the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1995. (8) Previously filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1995. (9) Previously filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1996. (10) Previously filed with the Company's Current Report on Form 8-K dated April 15, 1997 and filed with the Commission on June 30, 1997. (11) Previously filed with the Company's Current Report of Form 8-K 8A/A dated August 6, 1997 and filed with the Commission on such date.
(b) Reports on Form 8-K: none.
(c) Executive Compensation Plans and Arrangements.
(i) Employment Agreement ("Malloy Employment Agreement") dated as of October 1, 1991 between Scientific Games Operating Corp. (now known as Scientific Games Inc.) and William G. Malloy, Exhibit 10.6(1) (ii) Employment Agreement ("Behm Employment Agreement") dated as of October 1, 1991 between Scientific Games Operating Corp. (now known as Scientific Games Inc.) and William F. Behm, Exhibit 10.7(1) (iii) Employment Agreement ("Little Employment Agreement") dated as of October 1, 1991 between Scientific Games Operating Corp. (now known as Scientific Games Inc.) and Thomas F. Little, Exhibit 10.8(1) (iv) Amended First 1991 Management Stock Option Plan, Exhibit 10.18(1) (v) Amended Second 1991 Management Stock Option Plan, Exhibit 10.19(1) (vi) 1993 Management Stock Option Plan, Exhibit 10.20(1) (vii) Form of Amendment to Malloy Employment Agreement, Exhibit 10.23(1) (viii) Form of Amendment to Behm Employment Agreement, Exhibit 10.24(1) (ix) Form of Amendment to Little Employment Agreement, Exhibit 10.25(1) (x) Form of revised Severance Benefits Agreement, Exhibit 10.31(2) (xi) Amendment to Amended First 1991 Management Stock Option Plan, Exhibit 10.32(2) (xii) Amendment to Amended Second 1991 Management Stock Option Plan, Exhibit 10.33(2) (xiii) Amendment to 1993 Management Stock Option Plan, Exhibit 10.34(2) (xiv) 1994 Management Stock Option Plan, Exhibit 10.37(3) (xv) 1995/1996 Management Stock Option Plan, Exhibit 10.38(3) (xvi) Severance Benefits Agreement dated as of May 5, 1995, between Scientific Games Holdings Corp and Cliff O. Bickell, Exhibit 10.40(4) (xvii) Key Employee Restricted Stock Plan, Exhibit 10.42(3) (xviii) Form of Key Employee Restricted Stock Plan Restricted Stock Award Agreement, Exhibit 10.43(4) (xix) Form of Amendment to Behm Employment Agreement, Exhibit 10.51 (xx) Form of Amendment to Little Employment Agreement, Exhibit 10.52
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(1) Previously filed with Registration Statement No. 33-65582, filed on July 2, 1993 or as subsequently amended on July 28, 1993, August 9, 1993 or August 20, 1993. (2) Previously filed with Registration Statement No. 33-75168, filed on February 11, 1994 or as subsequently amended on March 4, 1994. (3) Previously filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1994. (4) Previously filed with the Company's Annual Report on Form 10-Q for the quarter ended June 30, 1995.
SIGNATURE PAGE
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant, Scientific Games Holdings Corp. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized in the City of Alpharetta, and State of Georgia on this 31st day of March, 1998.
Scientific Games Holdings Corp.
By: /s/ William G. Malloy ------------------------------- William G. Malloy, Chairman of the Board, President, and Chief Executive Officer
Pursuant to the requirements of the Securities Act of 1934, this report has been signed by the following persons on behalf of the Registrant, Scientific Games Holdings Corp. in the capacities and on the dates indicated.