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Heavy Equipment

Slot-makers are in for a wild ride over the next several years

Heavy Equipment

The stocks of gaming equipment suppliers, especially the Big Three slot- makers, could be in for a ride over the next several years.

They have two things going for them right now:

  1.  they’re cheap compared to most casino operators and against overall fundamental
    measures; and  
  2. they have the chance to ride the waves of gaming expansion and the inevitable replacement cycle.

Let’s look at valuations first.

Three of our favorite measures appear below with figures from the time of this writing and might have changed some when you read this.

They are price to earnings, price to earnings growth and enterprise value to EBITDA.

Price to earnings, or PE ratios, of 14-16 times expecting earnings are in the middle of the ballpark, or even a bit conservative. The S&P 500 PE, for example, has been running around 22 times.

Of course, PE is valuable only if measured against growth. After all, a company with a 15 PE is overvalued if its earnings are only growing 3 percent, or not growing at all.

That is where price to earnings grow-PEG ratio-comes in. Any ratio under 1 means earnings are expected to grow faster than the stock is currently priced.

By the PEG measure, Bally, Shuffle Master and WMS are undervalued, and IGT is in a comfortable range for investors.

Finally, there is enterprise value to EBITDA. Put another way, this is the stock market value of the stock plus its net debt compared to cash flow. In this measure, Bally is inexpensive, IGT and Shuffle Master are OK, and Multimedia Games is dirt cheap.

But the point is clear: Bally, IGT and WMS have low PEs, and for Bally and WMS especially relative to their growth.

Put all together, and the Big Three slot makers-Bally, IGT and WMS-are attractively valued even in normal times. But they are especially so now, before consumer spending turns up and begins driving up their recurring-revenue games and before casinos begin their next round of slot purchases.

Then there is the absolute growth in orders that slot companies can expect. Consider the new markets coming on and their significant size:

Italy: Nearly 60,000 VLTs
Mexico: 50,000 Class III slots
Brazil: 100,000 slots initially and maybe  250,000 over time
Ohio: 20,000 slots; 37,000 if racetracks get slots, more if bowling alleys do
Illinois: 20,000 to 50,000 depending on the estimate
And those numbers do not count smaller but certain new markets such as Kansas and Maryland, or growing existing markets such as California, Oklahoma and Pennsylvania. Nor do they count other possible markets like Kentucky, Massachusetts and New Hampshire. Nor do they count all the individual casinos being built in Las Vegas, Macau and various Latin American countries.

Then there is that North American replacement cycle, whose absence has been so frustrating but by which every day’s delay means more pent-up demand on an ever-bigger base.

A lot of things will drive the replacement cycle. There is the need for casinos to remain competitive. Rapidly changing technology is profoundly changing the slot machine experience. It isn’t just graphics and sound effects or even bonus rounds. It’s now community gaming, mystery jackpots, application of player skill, sensory technology, 3-D-all that makes old-fashioned slots look like Tin Lizzies next to a Lamborghini.

And technology will help players spend more money in the casino, such as by allowing customized promotions right at the machine. And technology will help casinos spend less, such as in using less electricity.

But the sheer power of the replacement cycle comes in the size of the installed base of slot machines in North America.

There are more than 900,000 slot machines in North America, a number that is steadily growing. Yet replacement sales last year totaled only 40,000 units. That implies a life for each slot machine of more than 22 years. Slot machines simply aren’t built to last that long.

Even if they were replaced at the rate of one every 10 years, replacement sales would more than double.

So far, the cycle has not kicked in. It always seems to be six months off until that six months passes, then it’s said to be another six months.

And so it is this year, with a pickup now forecast to begin slowly in the second half of 2010.

But when the cycle does kick in, it could do so with a fury, given the pent-up demand.

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