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    MARKET EDGES

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Investors may have trouble seeing the sun through the cloud of a weak FQ1 replacement quarter and a looming market share reversal.

And we’re not just talking about the weather which was cloudy and rainy all day for IGT’s investor day in New York.  Aside from talking about “Cloud,” which is a way to recoup some of their investment on a bad bet on sbX, there wasn’t a whole lot of new stuff at IGT’s investor day.  Much of the discussion was a recap of IGT’s recent achievement of “right-sizing the ship”.  The rest focused on new growth initiatives – two of which have been a mainstay at investor presentations for at least a year.

Our near-term issue with IGT is two-fold:  we think the company takes a large sequential ship share loss in F1Q12 since IGT pulled forward some sales into its fiscal year end quarter - especially in regards to replacements.  We expect that replacements will have a 3 handle vs. a 4 or 5 handle.  New opening share should also drop since IGT recognized both Kansas shipments while BYI and Konami did not.  We would caution that new opening and expansion ship share can shift if Revel and Cleveland units end up shipping at the end of this month instead of early calendar 1Q.  

We actually think calendar 2012 will be a great year for the suppliers, IGT included.  While we like the sector over the long-term, IGT will have to improve the economics of its gaming operations business to keep pace with the competition in terms of ROIC and free cash flow growth.  We estimate IGT spends about 15% of gaming operations revenue on maintenance capex, just to keep revenues stable.  By way of comparison, the average casino spends around 5%.  Unless IGT can spark growth, this is not an attractive business for them long term.

INVESTOR DAY TAKEWAYS


The big financial discussion centered on a revenue growth target of $500 million on top of the current $2 billion.  The company expects to generate an incremental $250MM from new business initiatives over the next 3-5 years on top of $250MM of growth from a recovery in replacement demand and the new domestic market openings.  Here are the three buckets of new business growth that IGT identified:  increased international penetration, Interactive, and Cloud.

  • While incremental revenue growth from new businesses will likely come in at lower margin channels, as long as IGT can leverage fixed costs or their “scale”, gross margins should increase.  This shouldn’t be a stretch:
    •  IGT continues to prudently deploy R&D dollars
    • SG&A has a variable component tied to sales and staff/infrastructure for new initiatives which don’t currently generate sales or profits are already in place
    • Product sale margins should improve as the number of units produced/sold increases as IGT will be able to leverage fixed costs over a larger base. The reduction in the number of platforms should also help margins.
  • Increasing international penetration
    • Bulls will point to Australia as an example.  IGT’s international strategy is twofold:
      • Global best practices and leverage scale by consolidating a lot of functionality across regions
      • Localize existing content by adopting a WMS-like strategy of more market research/customer focus sessions.  Importantly, IGT’s strategy is NOT to develop new content for local markets but rather to simply tweak their existing game library and math models to local tastes (this is part and parcel of Patti’s vision of increasing distribution of existing content and lengthening the “tail”).
  • Interactive growth
    • IGT’s strategy is to continue to grow the interactive division as more markets in Europe legalize gaming and leverage their recent Entraction acquisition by expanding their product portfolio into poker, bingo and sports betting.
    • Our take is that the growth in online gaming is very real, but it’s hard to evaluate the opportunity for IGT without any financial disclosure on their part. 
  • Systems
    • They’re doing their best to squeeze the most juice out of what was a bad investment.  Generally, IGT’s strategy for systems is one of a loss leader to gain floor share and potentially create a distribution channel for the content on some sort of recurring revenue basis.  This is especially true to sbX, which utilizes cloud technology to remove some of the largest feedback hurdles that casino operators face when presented with the sbX proposition – namely:
      • They don’t want to make that upfront investment
      • They don’t have the time, expertise, and in many instances space to run the servers necessary to deploy SB
    • Since IGT has already invested a lot of money into SB, Cloud allows them to deploy their technology at a minimal incremental cost to them and gives operators “easy access” to their content – whether that be game content or yield management analytics.  The hope is that this easy access will create a sticky “pay as you go” revenue stream for IGT. 
      • It’s really too early to tell whether this strategy will be successful or not since Cloud isn’t on schedule to become commercial for another year.  Our two cents is that as long as the cost to IGT is truly “minimal,” this could be a cheap option for the company to take a shot at recouping some of their investment.