Indiana Gaming Commission and Mitch Daniels and Arts & Entertainment, etc. and Hoosier Lottery and Government & Economic Development

Lottery privatization hinges on contractor's bolstering sales

December 25, 2006

To make the hefty payments to the state Gov. Mitch Daniels demands and still turn a profit, a private operator taking over the Hoosier Lottery would need to boost revenue by hundreds of millions of dollars a year.

That means an operator would have to reduce cash payouts, raise ticket prices, or market the lottery much more aggressively, perhaps even to out-of-state players, gambling and financial experts say.

Daniels said this month that he's seeking a contractor that would pay $200 million a year--which is more than the lottery has earned historically--plus another $1 billion upfront for a 30-year lottery lease. A bidding war could hike the price tag even higher.

Under public administration, the lottery already is a cash cow--29 cents of every average dollar of sales is profit. Just how much more valuable the Hoosier Lottery could be on the open market boils down to one variable: How much latitude would Daniels give the operator to maximize revenue?

"What your governor is doing is unlocking the potential of the lottery," said Michael Jones, director of the Chicago-based consultancy Independent Lottery Research. "Almost all of this has to do with increasing demand."

Experts say that means an expansion of gambling would be necessary--but not the obvious kind most detractors fear.

Daniels' plan, which requires the approval of the Indiana General Assembly, would not permit a private contractor to introduce new forms of gambling, such as electronic "cherrymasters." But fresh games aren't necessary, experts say. The lottery's existing product line has plenty of potential to produce more proceeds.

"You're setting up a structure where, very clearly, the operator has to move to a profit-maximizing mode," said Bill Eadington, a professor of economics and director of the University of Nevada Reno's Institute for the Study of Gambling and Commercial Gambling. "Under the existing structure, it's hard to say the government is doing that."

Given Daniels' asking price, an operator might push as far as its contractual boundaries allowed.

Experts say jackpots may be the biggest question mark. If an operator were allowed to keep a larger share of the lottery's ticket revenue, its path to profitability would be short--and certain.

"You could get your billion-dollar purchase price back pretty quickly by messing around with that payout percentage," said Mike Renninger, principal with the local consultancy Renninger & Associates LLC, who reviewed the lottery's financials for IBJ. "Those variables need to be ironed out."

Even if Daniels holds the line on the payout percentage, he can expect a private contactor to stretch every other variable possible, said Rachel Volberg, a problem-gambling expert who serves as president of Northhampton, Mass.-based Gemini Research.

"People who operate gambling [businesses] are very smart, entrepreneurial people," Volberg said. "If they can't get the machines, they might try to market lottery games on the Internet, or market to populations besides Indiana folks. They're endlessly ingenious."

And that worries Volberg, who fears more aggressive marketing will lead to more problem gamblers.

Volberg has reservations about all state-sponsored lotteries. Because they often attract low- to moderate-income players, some say they're the equivalent of a tax on people with the least ability to pay.

"It's simply boggling my mind that your governor seems to think this is a road his constituents would be interested in seeing him pursue," she said. "There would be a number of fairly major unintended consequences."

Asset valuation

Since its launch in 1990, the Hoosier Lottery has booked sales of $9.3 billion and profit of $2.7 billion. Indiana would be the first state to privatize its lottery, although others like Illinois and Wisconsin have considered it.

Bids will start with a $1 billion upfront payment, Daniels said at a Dec. 14 press conference. A private operator also would have to pay the state $200 million annually--a total of $6 billion over the 30-year contract.

Daniels came to that price tag after consulting with four investment banks, said State Budget Director Chuck Schalliol. He wouldn't reveal which ones.

Those terms would accomplish several things for the state. Daniels hopes to spend the $1 billion in upfront proceeds to stimulate higher education (see sidebar).

The additional $200 million annual payments would lock in a source of money that's historically been unpredictable.

The contract would guarantee future cash flow for cop, firefighter and teacher pensions, and ensure license plate fees remain low for drivers.

That's an important point, because the Hoosier Lottery has produced profits over $200 million just once in its history. It reaped $204 million in 1999. On average, profit has been $169 million--more than $30 million less than the proposed deal would guarantee.

What's more, they tend to seesaw. In the Hoosier Lottery's history, profit has risen as high as 26 percent in a single year, and fallen as much as 23 percent. In 1992, its worst year, the lottery produced profit of just $116 million.

"Give him credit; he's creative," said Matt Will, associate dean at the University of Indianapolis School of Business who also reviewed the lottery's financials for IBJ.

"Even if someone pays the state zero dollars [upfront], we still come out ahead. And if someone pays [another] billion dollars for this, it's a home run for the state," Will said.

Daniels said he assumes that if the lottery remains under state management, it will increase revenue about 5 percent a year, in line with historical performance.

To justify meeting Daniels' terms, a private operator would have to achieve much faster sales gains. Through more aggressive management, he said, it almost certainly could do so.

In fact, experts say, competition for the contract could bump the final price much higher than what Daniels proposed.

"I think the governor is hoping to create a bidding war with this," Will said. "The big unknown is how much upfront money this is worth to somebody."

Independent Lottery Research's Jones, who ran the Illinois Lottery from 1981 to 1985, says an even bigger payoff might not be wishful thinking.

"Perhaps with some fresh minds and ideas, private companies will think this is worth a lot more money than it seems to be right now and maximize return," Jones said. "If nothing else, it's smart and tremendous to have the discussion of what is the potential here."

On the chance a private operator unleashes a windfall, Daniels wants to include a contract requirement to pay the state 5 percent of any sales over $700 million. The Hoosier Lottery has topped that figure twice, in 2004 and 2005.

Unlocking value

A private operator would have lots of opportunities to wring more profit from the Hoosier Lottery, Jones said, but the biggest would be to attract more players.

In Indiana and most states that offer lotteries, he said, the majority of sales come from a relatively small, core group of frequent players, about 12 percent to 18 percent of the adult population.

But as much as 70 percent of adults play the lottery occasionally when jackpots soar. Creative marketing could make those folks regulars.

"They're not religiously or morally opposed," he said. "They're just sort of blind to lottery products, until the prize gets big enough."

A private operator also could reduce the number of small payouts. While state lotteries typically pay out as much as two-thirds of their revenue, much of it is in tiny jackpots of $1 or $2.

Lotteries offer those small rewards to boost low-end "churn." When they're having fun, players use proceeds to buy more lottery tickets. But after a player has spent 10 minutes scratching tickets, the lottery's profit is the same as if it had sold just one.

Other options include hiking the price of lottery tickets or aggressively advertising bigger jackpots that would be awarded less frequently. Any combination would boost the bottom line, said University of Nevada Reno's Eadington.

Regulatory risks

Volberg, the lottery critic, points out that state governments took over lotteries in the first place because of widespread corruption in the late 19th century among private businesses that ran them.

Louisiana might have had the most infamous example. The private lottery industry ultimately collapsed because practitioners seldom paid players, and bribed public officials to look the other way.

Volberg warns the regulator of a privately managed Hoosier Lottery would have to be strong, independent and heavily funded to avoid such problems again. If legislators approve the plan, they'll have to decide how to regulate the winning bidder.

"At this point, most state lotteries spend an enormous amount of money on advertising, but they're held to a relatively restrictive code of ethics. I wouldn't expect a private contractor to necessarily abide by that," Volberg said. "It would have to be a strong agency indeed to stand up to the kind of pressures that would be brought to bear."

But Mike Smith, executive director of the Casino Association of Indiana, said it wouldn't be difficult to establish a regulator with teeth.

After all, he said, Indiana already has done so for casinos.

"We are the one industry that operates under a regulatory microscope," Smith said. "There's nobody that goes through more scrutiny than we do, or has more regulation than we do. I think those principles could be applied to any business the state deemed necessary."

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