Professional Documents
Culture Documents
2010 Selling Lotteries in America
2010 Selling Lotteries in America
2010 Selling Lotteries in America
FALL 2010
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378
379
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381
TABLE 1
CO
IL
IN
MI
TX
$52.3 $100.0 $117.7 $155.0 $336.6
Total Short-term
Operating Assets
% of Total Assets
36.2% 88.9% 98.4% 60.2% 30.6% 23.4%
Restricted Short-Term $340.1 $35.2 $0.1
$7.0 $85.1 $173.7
Investments
Restricted Long-Term $1,657.8 NA
$1.0 $65.9 $350.8 $1,101.6
Investments
% of Total Assets
61.5%
NA
1.0% 33.7% 69.3% 76.6%
Total Restricted
$1,997.9 $35.2 $1.1 $72.9 $435.9 $1,275.3
Investments
% of Total Assets
74.2% 59.8% 1.1% 37.3% 86.1% 88.6%
Capital Assets - net
$42.9
$0.7
$0.7
$2.8
$0.4
$7.7
% of Total Assets
1.6%
1.2% 0.7% 1.4% 0.1%
0.5%
Total Assets
$2,694.1 $58.8 $101.7 $195.4 $506.1 $1,438.9
Source: Balance Sheets abstracted from Comprehensive Annual Financial
Reports for each states lottery.
is that private companies are more efficient than public agencies and
might be able to enhance revenues by reducing costs (Lucas &
Chorneau, 2007). Available data, however, suggest that potential
savings from cost reductions are likely to be small. Table 2 shows
pure operating expenses for the six lotteries of interest. These
expenses averaged just over 4.8% of total revenues with a low of
2.9% for Illinois and a high of 6.48% for Colorado. At those levels,
there is little room for improvement. Further, time-series analysis of
lottery expense data between 1991 and 2006 shows downward
trends in operating expenses as a percent of lottery sales in California
(-.41% of total revenues per year) and Colorado (-.25% per year).
Operating expenses were flat as a percent of annual revenues in
Illinois, Indiana and Michigan. Only Texas showed upward pressure on
operating costs with expenses increasing by .13% of revenues per
year.6 It is important to note that, in most states, operating expenses
include advertising costs which are necessary for both the
maintenance and growth of ticket sales.
382
State
CA
$3,585.0
5.46%
7.04%
0.53%
4.48%
-0.41%
53.9%
0.31%
$1,236.8
34.5%
0.00%
5.59%
CO
IL
IN
MI
TX
383
384
state funds for other uses (c.f. Spindler, 1995; Miller & Pierce, 1997)
while more recent studies have found that lottery earmarks increase
total education spending significantly (c.f. Evans & Zhang, 2002;
Novarro, 2002).
These findings suggest that the division of lottery sale-proceeds
may be politically contentious. Conflict is particularly likely in states
with education earmarks, growing sales, and some evidence that
lottery revenue has expanded total education spending. In these
states, organized teachers and other education advocacy groups may
see themselves as being deprived of an important, and growing,
source of revenue and press demands that they be held harmless
against the loss of these funds into the future. Other actors, including
governors, may also be expected to lobby for alternative uses of these
funds. In California, Governor Schwarzenegger proposed diverting $8
billion in lottery privatization-proceeds to retire debt used to balance
the States budget. In similar fashion, Governor Perry of Texas
proposed dividing privatization proceeds among state education,
cancer research and expanded health-insurance coverage.
Under these conditions, political estimates of what it would cost
to replace previously earmarked lottery revenue are likely to vary
widely. Opponents of diverting funds may well argue, as proponents
of lottery privatization do today, that governments would not have
been able to maintain their historical growth rates and might even
have experienced declining proceeds over time. Rather, they might
argue, some significant portion of the observed post-privatization
growth was due to superior management skills brought to bear by the
for-profit operators. Even if politicians could agree on the size of the
growth-funding shortfall, they might still be reluctant to provide funds.
The money needed to plug any post-privatization gaps would have to
be drawn from the pool of limited discretionary funds that have
always been the main focus of budgetary debates.9 In such
situations, advocates for education and other earmarked causes
might be hard pressed to maintain what they perceive to be
equitable levels of funding.
Lottery privatizations also have the potential for generating
doubly-regressive outcomes. First, for-profit lottery operators focused
on maximizing cash flows will have an incentive to pressure
regulators to permit unbridled expansion of an ever-increasing variety
of games. To the extent they succeed and the demographic and
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387
relevant cash flow and operating data and the trends in those data.
For valuation purposes, we exclude investment returns, which were
volatile for some states, from net income and based valuations solely
on operating profits.
For valuation purposes, we created an optimal buyer-profile using
the lowest tax rate (28.8%) and cost of capital (6.5%) for any of the
potential buyers identified in the press.17 As we mentioned earlier, we
did not adjust the buyers cost of capital upward to reflect the impact
of the higher degree of leverage a lottery acquisition is likely to
require. To the extent specific buyers have less favorable financial
profiles or capital costs rise as a result of prevailing market
conditions or the financing structure employed, the valuations
presented here may be overstated. We allowed that upward bias
intentionally. If these best-case scenarios and the sensitivity tests
that we used to analyze them do not generate a positive case for
lottery privatization, less favorable profiles clearly will not.
The lease-valuation procedure we used involved two steps. First,
we estimated the after-tax proceeds to the buyers over the lease
term. That required a three-step process. We estimated compound
growth rates for lottery profits for each of the states using OLS logregressions of lottery profits against time. Then, we applied those
growth rates to each states reported 2006 profit level to produce a
forecast of pretax proceeds over lease terms of 30 to 50 years. We
then adjusted those proceeds by subtracting the tax shield generated
by amortizing the full purchase price over the term of the lease using
the most aggressive amortization method18 allowed under tax
regulations to generate an estimate of taxable income for each year
of the lease. Finally, we netted the tax payments from the gross
profits to calculate the cash flow the buyer would capture in each
year. The second step in the valuation process involved calculating
the purchase price that was equal to the present value of the after-tax
cash flows captured by the buyer discounted at the buyers 6.5% cost
of capital. The advantage of this approach is that it is consistent with
valuation theory and can easily be replicated by other researchers
and the finance staffs of state legislative and executive bodies. The
results of that analysis are shown in Table 3.
The six target states we studied proposed a range of privatization
alternatives and transaction structures. California Governor
Schwartzenegger proposed leasing the states lottery which
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389
TABLE 3
MI
TX
2.30%
0.00%
$688.1 $1,075.8
Lease term
30
35
40
45
50
$27,738
$31,283
$36,624
$37,784
$40,779
$1,777
$1,887
$1,973
$2,039
$2,091
$7,455
$7,709
$7,874
$7,978
$8,039
$3,130
$3,324
$3,475
$3,592
$3,682
$10,003
$10,637
$11,133
$11,521
$11,824
$11,963
$12,371
$12,637
$12,803
$12,901
390
391
US
Governments
Rate
1
5
10
12
15
17
20
5.26%
($22.7)
($34.2)
($50.1)
($56.9)
($67.8)
($75.4)
($87.5)
InvestmentGrade
Corporate
Bonds
6.19%
($4.37)
($15.9)
($31.7)
($38.6)
($49.4)
($57.1)
($69.1)
FNMA
MortgageBacked
Securities
6.50%
$1.8
($9.8)
($25.6)
($32.5)
($43.3)
($50.9)
($63.0)
High-Yield
Bonds
Assumed
Returns in
MI & TX
8.10%
$33.3
$21.8
$6.0
($0.9)
($11.7)
($19.4)
($31.5)
9.00%
$51.1
$39.6
$23.7
$16.9
$6.0
($1.6)
($13.7)
392
US Government Bonds
Investment-Grade Corporate Bonds
FNMA Mortgage-Backed Securities
High-Yield Bonds
Assumed Returns in MI & TX
Rate
CA
CO
5.26%
6.19%
6.50%
8.10%
9.00%
8
11
12
18
18
*
*
2
12
17
IN
Annuity
7
8
9
12
13
MI
*
*
*
12
16
Note: * Lottery proceeds always exceed investment returns over the 40-year
lease term.
Source: Bloomberg Data Systems and computations by the authors using the
methodology outlined above. Since the time these computations were
done, fixed-income market rates of return have declines substantially.
393
Rate
5.26%
6.19%
6.50%
8.10%
9.00%
IL
($256.2)
($182.9)
($158.5)
($32.5)
$38.3
TX
($411.1)
($293.6)
($254.4)
($52.2)
$61.5
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395
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397
These findings suggest that, at least in the short run, lottery sales
or leases may be difficult for states to implement. The analysis
reported here clearly suggests that, even in normal market
conditions, lottery privatization makes at best short to medium term
financial sense for states. In addition, the recent OLC ruling, the
potential political controversy of lottery privatization, and the difficulty
potential purchasers are likely to experience raising the necessary
capital may make large-scale privatization unattractive in the current
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400
12. The importance of this point has been driven home by the most
recent relative performance statistics for lotteries and financialmarket instruments. For example, New York State reported that
fiscal year 2008 lottery proceeds were up 3% while potentially
high-yield investments like stocks and hedge funds were reporting
losses in excess of 35% and many high-yield fixed-income
securities could not be priced with any degree of certainty.
13. In cases where businesses have redundant, undervalued or
underutilized assets, cash flow may come not only from operating
profits but also from the sale of those assets and/or the taxshield they generate when marked to market. Based on the
proportion of real assets on lottery balance sheets (see Table 1),
asset sales are unlikely to be a significant source of value in
lottery privatizations. For a discussion of valuation models, see
Damodaran (2006).
14. The cost of capital is the weighted average of the rate of return
that investors demand to hold a companys stock, the cost of
equity, plus the companys marginal cost of debt. For example, if
a company were to use 30% equity and 70% debt with a cost of
equity of 8% and a marginal borrowing cost of 6%, its cost of
capital would be 30% * 8% + 70% * 6% = 6.6%. Although there is
still some debate about the use of discounting methods for
capital budgeting especially among smaller nonprofits and
governments, present value models are almost universally used
in corporate valuation analyses (c.f. Damodaran, 2006). Since the
valuations derived here are being done from the perspective of
large for-profit buyers, we feel confidant applying net present
value methodology.
15. In a lease, the full acquisition price can be amortized over the
lease term creating a tax shield that reduces the portion of net
lottery proceeds subject to state and local taxes, raises net cash
flows to the buyer and increases the value of the lottery. In
contrast, the lack of tangible assets in lotteries severely restricts
the size of the purchase tax-shield reducing net after-tax cash
flows and, with that, the value of the lottery.
16. The only exception to the time period analyzed was for Texas
which started lottery operations in 1992.
401
402
403
31. High-yield bonds are often referred to as junk bonds and are
one of the classes of fixed-income investments that have been
most heavily impacted by the sub-prime debt crisis.
32. In American Civil Liberties Union, et al., v. Department of Justice,
(Civil Action Nos. 06-00096 (HHK), 06-00214(HHK)), the opinion
states in reference to an OLC opinion "Memoranda issued by the
OLC, including this one, are binding on the Department of Justice
and other Executive Branch agencies and represent the official
position of those arms of government." Missing is the direct
statement that OLC opinions carry the same force outside the
federal executive branch. The Courts decision in United States
Court of Federal Claims, TENASKA WASHINGTON PARTNERS II,
L.P., Plaintiff,v. The UNITED STATES, Defendant. no. 95-420C
(Nov. 9, 1995) is more explicit; Because the OLC Memorandum
is binding on the Department of Justice and other Executive
Branch agencies, (a federal agency) is bound to assert the
position. Of course, the fact that the Department of Justice
asserts a legal theory does not bind the court to accept the
reasoning as legally correct;
33. Securitizations involve pledging future lottery receipts and
borrowing against them. Partial-securitization structures would
only borrow a portion of future projected lottery profits and could
be used to mirror the privatization proposals put forth in Indiana
and Texas without resorting to an outright sale or lease.
34. The states would have to be careful to structure their
securitizations and resultant investment vehicles to comply with
the restriction imposed by what are referred to as IRS Section148 arbitrage regulations that effectively prohibit borrowing on a
tax-exempt basis for the purpose of investing in higher-yielding
taxable instruments.
REFERENCES
Cain, C. & Hornbeck, M. (2007, January 26). State Bets Lottery Sale
Could Fix Deficit. DetroitNews.com. [On-Line]. Available at
www.DetroitNews.com.
Couch, M. P. (2007, April 22). Vets Pushing for Vote on State-Lottery
Sale. The Denver Post: C-04.
404
405
Counsel
in
Volume
32
[On-Line].
Available
at
www.usdoj.gov/olc/2008/state-conducted-lotteries101608.pdf.
Reynolds, N. (2007, February 23). Want Fair Lotteries? Let Bookies
Run Them. The Globe and Mail: B2.
Schnitzler, P. (2006). Lottery Privatization Hinges on Contractor
Bolstering Sales. Indianapolis Business Journal, 27: 1
Selby, W. (2007, April 29). Lottery Sale Looks to be a Scratch.
Austin
American
Statesman.
[On-Line].
Available
at
www.AustinAmericanStatesman.com.
Shields, Y. (2007). Goldman to Advise Illinois on Lottery
Privatization. The Bond Buyer, 35: 32.
Spindler, C. J. (1995).The Lottery and Education: Robbing Peter to
Pay Paul. Public Budgeting and Finance, 3: 54-62.
Texas Lottery Audited Comprehensive Annual Financial Reports
(1990
to
2007).
[On-Line].
Available
at
http://www.txlottery.org/export/sites/default/About_Us/Publicati
ons/Financial_Information.html.
Walker, K. (2008, October 30). Lottery Lease Proposals Prompt
Warnings.
Baptist
Press.
[On-Line].
Available
at
www.baptiststandard.com.
Williamson, O. (1979). Transaction-Cost Economics: The Governance
of Contractual Relations. The Journal of Law and Economics, 22:
233-261.
Young, J. (2007, March). Public Asset Sales: Does the Public Benefit
from State Lottery Sales? PA Times: 4-5.
APPENDIX I
AR
CA
CO
CT
2006
Gross
Revenue
($ in
Millions)
$469
$3,585
$469
$970
Prize
2006 Net
Operating
Gross
Net
Revenue Revenue Per Expenses & Payouts as Revenue
($ in
Commissions % of Gross as % of
Capita
Millions)
as % of Gross Revenues
Gross
Revenues
Revenues
$141
$76
15%
55%
30%
$1,259
$98
11%
54%
35%
$126
$99
13%
60%
27%
$285
$277
10%
61%
29%
406
APPENDIX I (Continued)
Sate
DC
DE
FL
GA
ID
IL
IN
IO
KA
KY
LA
MA
MD
ME
MI
MN
MO
MT
NC
ND
NE
NH
NJ
NM
NY
OH
OK
OR
PA
RI
SC
SD
TN
TX
VT
WA
WI
WV
2006
Gross
Revenue
($ in
Millions)
$266
$728
$3,929
$2,995
$131
$1,964
$816
$340
$236
$742
$332
$4,501
$1,561
$230
$2,212
$450
$914
$40
$866
$22.3
$113
$263
$2,407
$155
$6,803
$2,221
$205
$1,101
$3,070
$1,731
$1,145
$688
$928
$3,775
$105
$478
$509
$1,523
Prize
2006 Net
Operating
Gross
Net
Revenue Revenue Per Expenses & Payouts as Revenue
($ in
Commissions % of Gross as % of
Capita
Millions)
as % of Gross Revenues
Gross
Revenues
Revenues
$74
$458
17%
55%
28%
$316
$146
NA
NA
43%
$1,225
$217
9%
60%
31%
$822
$316
11%
61%
28%
$33
$90
17%
58%
23%
$646
$153
8%
59%
33%
$216
$129
13%
60%
27%
$81
$114
40%
36%
24%
$67
$85
17%
55%
28%
$204
$176
12%
60%
28%
$119
$77
13%
51%
36%
$951
$699
7%
72%
21%
$501
$278
10%
58%
32%
$52
$174
16%
62%
22%
$688
$219
12%
57%
31%
$119
$87
13%
60%
27%
$261
$156
8%
63%
29%
$9
$42
25%
52%
23%
$314
$100
13%
52%
35%
$6.5
$35
22%
49%
29%
$28
$64
20%
56%
24%
$80
$200
11%
58%
31%
$844
$276
8%
57%
35%
$37
$79
21%
55%
24%
$2,203
$336
11%
57%
32%
$646
$193
12%
59%
29%
$69
$57
12%
54%
34%
$571
$98
NA
NA
51.9%
$992
$247
9%
59%
32%
$324
$244
11%
70%
19%
$321
$265
11%
61%
28%
$119
$50
NA
NA
17.3%
$285
$154
11%
58%
31%
$1,090
$161
10%
61%
29%
$23
$168
15%
63%
22%
$125
$75
13%
61%
26%
$133
$92
16%
58%
26%
$610
$120
NA
NA
40%
Source: Lotteries Profit But Do Students, New York Times, Online Feature,
October 5, 2007.