The gaming industry is changing and investors who play their cards right stand to reap the rewards. A much anticipated shift to online gaming moved closer to becoming reality with a ruling by the U.S. Justice Department late in 2011. The ruling clarified that the 1961 Wire Act applies to sports betting but not to internet poker and other forms of online betting that do not involve sports. This ruling removes an obstacle that states faced in their bids to legalize online gambling within their jurisdictions. Estimates of the online gaming market are about $13 billion in annual revenue or about 43% of the total worldwide gaming revenue in 2010.
International Gaming Technology is the biggest company in the space with a market capitalization of about $4.4 billion. Because of its size, the company is positioned very favorably to benefit from wide spread legalization of online gaming which will require gaming manufacturers to devote additional resources to address the online market. The company had a change in management and strategy with a new CEO installed in April 2009. In addition to its staple game machine business, the company is moving into casino floor management systems and has plans for online gaming once the market develops further. Although the casino floor management business has appealing characteristics for International Gaming, it faces resistance from some customers that are reluctant to trust its floor security to a third party. Like its rivals, International Gaming Technology must maintain its product portfolio to compete. Unlike its competitors, International Gaming Technology has a dividend which is yielding about 1.6%. Analysts are expecting earnings to grow at about 7.5% in 2012 and the price to earnings to growth ratio for International Gaming is about 2x. The consensus estimate of revenue growth is just above 5%. Both projected earnings and revenue growth are turnarounds from the annual declines of about 14% and 7%, respectively, that the company experienced from 2007 through 2011. I believe the company can meet these projections because the new management was able to stabilize the rates of loss in 2010 and 2011 and comparisons going forward will be less difficult to exceed. However, even with an optimistic forecast, the price currently being paid for shares at 2x PEG is too high for a company struggling for positive revenue and earnings growth and with the weakest gross margins in the industry. Fair value on a discounted free cash flow basis for International Gaming is about $14, a discount of about 7% from its recent price of 15. These shares need to back down before they become attractive and should be avoided now.
WMS Industries has a fair value on a discounted cash flow basis of about $21 which is about 9% below a recent price of about $23. The analysts consensus estimate for revenue growth for 2012 is about 5.8% and for earnings growth is about 15%. At the recent price of about $23, the forward price to earnings to growth ratio is about 0.9x. I agree with these estimates and believe this is a reasonable price to pay for WMS Industries' shares because with the industry's highest gross margins, the company should be able to increase the earnings growth rate slightly from a rate of about 13% annually since 2007. To realize this growth, the company will need to correct recent shipment delays caused by failure to gain regulatory approval for new products. These delays have adversely impacted average revenue per day per machine, a key metric for the company. The revenue growth rate is actually projected to slow from about 10% annually since 2007 which should support cash flow going forward. WMS Industries is a "pure play" gaming machine company because it does not offer ancillary services or products like casino management services and marketing software that are offered by its rivals. This could serve the company well by limiting distractions to its core operations which is particularly relevant considering the company's recent regulatory related shipmentdelays. However, shunning ancillary offerings may be destructive to WMS Industries value if competitors can leverage these other areas to achieve better cash flow and earnings growth. A trend which could strongly benefit WMS Industries in the future is networked gaming. Using networked gaming products made by WMS Industries, the casino operator can easily manage and acquire content that is uploaded to machines already on the casino floor. Investors interested in WMS Industries should track this trend and consider a buy when it gains traction with the company's customers. Also, any broad market weakness that causes shares to fall to a margin of safety below the $21 fair value is a favorable entry point.
Of the three leading gaming makers, Bally Technologies, has the highest estimated earnings growth rate and lowest price to earnings to growth ratio. Analysts see earnings growing by about 32% in 2012 and with the forward price to earnings ratio at about 18.3x, the PEG ratio is about 0.6x. I believe this earnings growth rate assumption is reasonable given the average earnings growth rate of about 45% annually since 2007, which was driven by significant improvements in gross and operating margins. However, the estimated revenue growth rate at about 14% for 2012 is a steep increase from the average 3% annual increase since 2007. I believe this higher growth rate will be realized because the company has recently taken market share from competitors, increased its gross margin above its 5 year average and enjoyed increased average selling prices, units sold, and units leased. Bally Technologies is the industry leader in cash flow generation and return on invested capital and is the only gaming manufacturer to post a positive share price appreciation since 2007 at about 58%. Bally Technology is currently fairly valued at about $44 based on discounted free cash flow and I believe is the best investment among the gaming makers and I would be a buyer at this level given the favorable growth profile and history of operational execution, cash flow generation, and return on capital.
It is common investing wisdom that it is better to buy a good company at a reasonable price than an ordinary company at a good price thus I recommend the shares of Bally Technologies for those investors seeking exposure to gaming. Toss in the possibility of huge upside from the emergence of the internet gaming phenomenon and vigilant investors could hit the jackpot.
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