ISSUE Should the California State Lottery Commission (Commission) approve the proposed budget that presents a sales goal of $4.8 billion, the highest level of sales in California State Lottery (Lottery) history that is expected to provide $1.3 billion to public education for Fiscal Year 2012-13? RECOMMENDATION Staff recommends that the Commission approve the Lottery budget for Fiscal Year 2012-13 as presented in the attached documents. BACKGROUND The proposed Fiscal Year 2012-13 budget reflects the Lottery’s goal of $1.3 billion in profits to California public education. This budget includes funding to deliver the Fiscal Year 2012-13 Business Plan Initiatives approved by the Commission in May 2012. Those initiatives balance tactics to continue growing sales in the upcoming fiscal year as well as provide investments that set the foundation for continued growth in contributions to public education in future years.

Date: June 21, 2012

To: California State Lottery Commission

From: Robert T. O’Neill

Director

Prepared By: Michael Ota, Deputy Director Finance Division Subject: Item 9(a) – Fiscal Year 2012-2013 Budget

California State Lottery Commission June 21, 2012 Page 2 DISCUSSION Development of the Lottery’s Fiscal Year 2012-13 budget began by generating preliminary sales projections by product, determining prize funding levels for each product type, and calculating associated fixed costs. Using the preliminary sales projections, a base budget was developed to determine the availability of resources to fund Lottery Business Plan Initiatives and address operational improvements to drive increased sales and contributions to public education. The Business Plan Initiatives were developed by reviewing our business operations as well as trends in the Lottery industry. Our key partners participated in identifying strategic opportunities to further grow sales. Broad objectives and strategies were developed and prioritized. Tactics to implement these strategies were developed by staff and evaluated by senior management based on the availability of Lottery resources and the expected benefits those tactics would deliver. The results of this process are the Fiscal Year 2012-13 Business Plan Initiatives that were presented and approved at the May 2012 meeting. The Business Plan Initiatives are grouped under five major themes:

Product Development

Advertising and Promotions

Retail Initiatives

Focus on Efficiency and Effectiveness

Building Capacity Within the Lottery A summary of the Business Plan Initiatives with their associated costs are included in this issue memo as Attachment I. The expected increase in Fiscal Year 2012-13 sales from the Business Plan Initiatives is included in Attachment IV. Staff also developed proposals for operational improvements. These proposals were prepared as Budget Revision Proposals (referred to as BRPs). The BRPs include requests to fund items required to address growth and changes in Lottery operations and to address opportunities to achieve efficiencies in business operations. The BRPs were reviewed for consistency with Business Plan Initiatives and fiscal impact. A summary of the approved BRPs are included in this issue memo as Attachment II.

California State Lottery Commission June 21, 2012 Page 3 The result of this comprehensive assessment of sales goals and the funding needed to deliver those goals is the budget being proposed for the upcoming fiscal year. Attachment III to this memo presents the Lottery’s proposed Fiscal Year 2012-13 budget beginning with the base budget and displaying the fiscal impacts from the approved Business Plan Initiatives and the recommended BRPs. A summary of the elements of the proposed Fiscal Year 2012-13 budget is presented below: Sales Total sales for all Lottery products are projected to be $4.8 billion for Fiscal Year 2012-13. This represents a $455 million increase over estimated year-end sales levels for Fiscal Year 2011-12 (a 10.4 percent sales increase). The chart below contrasts estimated Fiscal Year 2011-12 year-end sales with proposed sales goals for the Fiscal Year 2012-13 budget. Following the chart is background information for the sales goals for each product type.

Comparison of Revenues FY 2011-12 Estimated Year-End Sales and Proposed FY 2012-12 Budget

(Dollars In Thousands)

Sales:

Year-End Estimate

FY 2011-2012 CHANGE

Proposed Budget

FY 2012-13

SuperLotto Plus® $ 426,000 $ -3,000 $ 423,000

Daily Games 341,000 4,000 345,000

Hot Spot® 131,000 29,000 160,000

MEGA Millions® 719,000 -127,000 592,000

Scratchers® 2,758,000 552,000 3,310,000

Total Sales $ 4,375,000 $ 455,000 $ 4,830,000

SuperLotto Plus Sales for SuperLotto Plus are projected to be $423 million. This reflects a $3 million decline from projected year-end sales levels of $426 million for Fiscal Year 2011-12. SuperLotto Plus sales have been on a downward trend since the introduction of MEGA Millions to the Lottery’s product portfolio in Fiscal Year 2005-06. Over the four years following the addition of MEGA Millions, sales for Super Lotto Plus averaged a year-over-year decline of nearly 11 percent. The rate of decline has slowed over the past two years to the point where without any initiatives, a 2 percent decline in sales (-$9.5 million) would be anticipated.

California State Lottery Commission June 21, 2012 Page 4 Business Plan initiatives for Fiscal Year 2012-13 includes the launch of a second chance draw feature for SuperLotto Plus. The cumulative effect of Business Plan initiatives are expected to provide $6.5 million in additional sales for SuperLotto Plus during the upcoming fiscal year. This game enhancement is expected to reduce the decline in SuperLotto Plus sales to only .7 percent ($3 million) for Fiscal Year 2012-13. Daily Games The proposed sales goal for Daily Games (Fantasy Five, Daily Derby®, Daily 3 and Daily 4) is $345 million. This forecast is $4 million above projected year-end sales levels of $341 million for Fiscal Year 2011-12. The goal of $345 million is primarily based on positive sales trends in Fantasy 5 and Daily 3 over the past couple of years. Hot Spot A sales goal of $160 million is proposed for Hot Spot for Fiscal Year 2012-13, a significant increase of $29 million (22.1 percent) over estimated year-end sales for Fiscal Year 2011-12. The projected increase in sales is primarily attributed to initiatives aimed at increasing the prize payout for this game from 56.7 percent to 63.0 percent. The increase to Hot Spot’s prize payouts is planned for implementation during the second quarter of Fiscal Year 2012-13. With the higher prize payouts being in effect for the last eight months of the fiscal year, the overall Hot Spot prize payout for Fiscal Year 2012-13 is estimated at 61.3 percent. The combination of an improved product plus recruitment efforts for additional Hot Spot specific retailers in social venues (i.e. bars, restaurants, and bowling centers) contribute to the forecasted increase in sales. MEGA Millions The sales goal for MEGA Millions is $592 million. This reflects a $127 million decline (17.7 percent) from estimated sales for Fiscal Year 2011-12. This decline is not reflective of any issues with the health of this game. Sales for MEGA Millions (and SuperLotto Plus) are heavily influenced by jackpot levels. Fiscal Year 2011-12 sales for MEGA Millions were greatly boosted due to a record breaking jackpot of $656 million in March 2012.

California State Lottery Commission June 21, 2012 Page 5 The $592 million sales goal for MEGA Millions is based on the following factors and assumptions:

The largest jackpot for Fiscal Year 2012-13 will get to the low $300 million level and one additional jackpot will reach the $250 million mark before being hit. This translates to five draws above $200 million in the upcoming fiscal year which is consistent with the average number of draws over $200 million during the past six years.

Draw sales for comparable jackpot levels have been rising over the past couple of years as a result of the advertising strategy to purchase media when the jackpot is above the $70 million mark. It is expected that sales for MEGA Millions will continue the year-over-year increases at comparable jackpot levels in Fiscal Year 2012-13.

The Business Plan initiatives are estimated to boost MEGA Millions sales by about $37 million.

Scratchers The largest increase in projected sales is in the Scratchers product line with sales expected to grow $552 million to a total of $3.31 billion. This sales goal represents a 20.0 percent increase over estimated sales for Fiscal Year 2011-12. Business Plan initiatives for Fiscal Year 2012-13 are expected to fuel $310 million of the sales growth. The Business Plan initiatives for the Scratchers product are focused on growing sales for $5 and $10 games. In addition, advertising campaigns will focus on increasing the number of consumers playing $5 games. Finally, the $10 game will have a full 12 months of sales in Fiscal Year 2012-13 (compared to 9 months of sales in Fiscal Year 2011-12) and for the first time there will be two $10 games being sold simultaneously. With the gains in $5 and $10 game sales, the aggregate prize payout for Scratchers will rise to 66.05 percent in Fiscal Year 2012-13. This compares with an estimated year-end payout of 65.30 percent in Fiscal Year 2011-12. Expenses Prize Expenses Section 8880.4 of the Lottery Act states: “The commission shall determine the percentage of total annual revenues that shall be returned to the public in the form of prizes as described in this chapter, however the percentage shall not be less than 50 percent of the total revenues.”

The Commission’s approval of the proposed budget satisfies this requirement.

California State Lottery Commission June 21, 2012 Page 6 The proposed sales goals in the Fiscal Year 2012-13 budget are supported by continuation of the Lottery’s strategy of utilizing higher prize payouts to increase sales in the upcoming fiscal year. The higher prize payouts are focused primarily on the Hot Spot game and in the Scratchers product line. The chart below shows the aggregate prize payout of 60.86 percent of total expected sales in Fiscal Year 2012-13.

Prize Expenses (Dollars in Thousands)

Category

Year-End Estimate

FY 2011-2012

FY 11-12 Prize

Payout % $

Change %

Change

Proposed Budget

FY 2012-2013

Prize Payout

%

Total Prize Expense $ 2,581,516 59.01% $358,147 13.87% $ 2,939,662 60.86%

A comparison of Fiscal Year 2011-12 estimated year-end prize payout percentages and proposed Fiscal Year 2012-13 prize payout percentages by Lottery product type is presented in Attachment IV. Administrative Expenses The Administrative Expense budget is comprised of three major elements: retailer compensation, game costs, and operating costs. Per the Lottery Act, Administrative Expenses are capped at 13 percent of total annual revenues. Total budgeted Administrative Expenses for Fiscal Year 2012-13 are $627.9 million, an increase of $59.2 million (10.4 percent) over expected Fiscal Year 2011-12 levels. It is important to note that $48.6 million of the increase is driven by the expected growth in sales in the upcoming fiscal year and the costs associated with that sales growth, i.e. 1) retailer compensation and 2) game costs. The chart on the next page shows a comparison of estimated Fiscal Year 2011-12 Administrative Expenses with the proposed budget for Administrative Expenses for Fiscal Year 2012-13. The narrative following the chart provides an overview of the three major elements of the Administrative Expense budget: retailer compensation, game costs, and operating costs.

California State Lottery Commission June 21, 2012 Page 7

Distribution of Administrative Expenses (Dollars in Thousands)

Category

Year-End Estimate

FY 2011-2012 $

Change %

Change

Proposed Budget

FY 2012-2013

Retailer Compensation $ 299,001 $ 33,144 11.08% $ 332,145

Game Costs 76,597 15,443 20.16% 92,040

Operating Costs:

Personal Services 54,752 5,080 9.28% 59,832

Marketing Plan 61,058 7,988 13.08% 69,046

Contractual Services 14,558 3,193 21.93% 17,751

Telephone Expense 2,350 -100 -4.26% 2,250

Building Lease 1,800 0 0% 1,800

Facilities Operations 1,111 -211 -19.01% 900

Pro Rata Expense 4,069 533 13.09% 4,601

Vehicle Operations 1,400 350 25.00% 1,750

Depreciation Cost 5,887 906 15.39% 6,793

Other Operating Expenses 5,810 3,832 65.95% 9,642

Administrative Reserve 40,357 -11,007 -27.28% 29,349

Subtotal, Operating Costs $ 193,152 $ 10,563 5.47% 203,715

Total Administrative Expenses $ 568,750 $ 59,150 10.40% $ 627,900

Retailer Compensation Retailer compensation costs of $332.1 million account for 52.9 percent of the Administrative Expense budget for Fiscal Year 2012-13. This amount represents an increase of $33.1 million (11.1 percent) over expected Fiscal Year 2011-12 retailer compensation costs and is directly attributable to the higher sales goals in the upcoming year. Game Costs Game costs are budgeted at $92.0 million. This budget category includes the cost of operating the gaming system, acquisition of gaming equipment, installation and maintenance of gaming equipment, and production and distribution of Scratchers tickets. The increase of $15.4 million over expected gaming costs for Fiscal Year 2011-12 is directly related to the projected sales growth as well as costs associated with the acquisition of new gaming equipment in the upcoming year.

California State Lottery Commission June 21, 2012 Page 8 Operating Costs The remaining elements of the Administrative Expense budget are grouped as operating costs. Operating costs include personnel costs, advertising/marketing costs and base operating costs. Operating costs also include the funding required to execute the Fiscal Year 2012-13 Business Plan initiatives as well as funding for the Budget Revision Proposals (BRPs) for operational improvements. Operating costs also include the Administrative Reserve. The Administrative Reserve is an element of the 13 percent of total annual revenues available for Administrative Expenses. The reserve is a safeguard against future uncertainties. The Administrative Reserve in the Commission adopted Fiscal Year 2011-12 budget was set at $13 million. During the year, as sales surpassed budgeted goals for the Scratchers product line and MEGA Millions sales were boosted by the world record-breaking $656 million jackpot, the Administrative Reserve grew from the budgeted level of $13 million to what is expected to be $40.4 million at the end of this fiscal year. The entire amount of the Administrative Reserve at the end of the fiscal year will be transferred to public education. The recommended Administrative Reserve in the proposed Fiscal Year 2012-13 budget is $29.3 million. This reserve will provide a safeguard against future uncertainties (e. g. lower than expected jackpot levels for MEGA Millions) and provide the Commission and the Lottery the flexibility to take advantage of sales growth opportunities that may emerge over the course of the upcoming year. Budget Summary The proposed Fiscal Year 2012-13 Budget contains sales goals of $4.8 billion, a 10.4 percent increase over expected sales for Fiscal Year 2011-12 and the highest sales level in the Lottery’s 27-year history. This will generate $1.3 billion in contributions to California public schools for Fiscal Year 2012-13. This will mark the 13th consecutive year the Lottery will surpass a billion dollars in contributions to public education. While the $4.8 billion sales goal for Fiscal Year 2012-13 is an unprecedented level, it is based on execution of a vast array of Business Plan initiatives designed to result in sustainable growth of future revenues. The proposed budget includes a balanced approach between actions that will increase sales above the record setting levels of Fiscal Year 2011-12 year as well as prudent investments that will provide greater sales and contributions to public education in years to come. Attachments