A potential short-term cross breeze (earnings reductions) but the long-term wind remains at the tail of the slot sector.
They’re cute (at least WMS is), safe (well, they should be), fun to own (when they go up), and the long-term story is as attractive as any in consumer land. Unfortunately, they’re not cheap and analysts keep overestimating slot demand. Ideally, we’d like to see estimates come down, particularly for the 1H CY2010, and the stocks come in. This is a space that needs to be on the radar screen.
Earnings
I feel like a broken record but unit sales to new casinos and expansions will be down considerably in 2010. We estimate almost a 50% decline. See our 11/25/09 post “ONE IN THE HAND IS WORTH TWO IN THE BUSH”. Replacement demand should accelerate, but will it grow more than the 50% necessary to make the Street’s slot projection? That’s a tall order. The first half of calendar 2010 is at risk with March being the most difficult comp of the year. We project new/expansion units to fall 80% in the March quarter. Yet, analysts are projecting significant revenue, EBITDA, and EPS growth in the first quarter as shown below.
Needless to say, we are below the Street for IGT and WMS, but in-line for BYI.
Valuation
They’re not cheap on a forward earnings basis. IGT and WMS both trade at 21x consensus 2010 earnings while BYI clocks in around 17x. Again, we think the IGT/WMS estimates are too high so the valuations may be even more inflated. However, we think there is approximately 50% upside to the numbers from normalized replacement demand alone. Combine “regression to the mean” replacements with a significant new market pipeline – domestically and internationally – and the gaming supply segment could generate 20%+ EPS growth over a 5+ year period. From that perspective, 20x EPS doesn’t seem so expensive although I’d prefer mid-teens. Maybe they’ll get there.
The Mexico Catalyst
This is one market that could surprise on the upside in 2H 2010. From what we are hearing, the transition from Class II games to Class III is showing promise. Operators like the performance. Class III games are also faster – 11 games per minute versus 8 for Class II. The Class II market is anywhere from 35k machines to 50k machines so there is a lot of potential for Class III replacements. Look for some color on the Mexico potential during the earnings conference calls. Stay tuned for more on Mexico from us as well.
The Perfect Storm
We could be at the trough of a huge 5-7 year cycle for slot demand. In a few years, we may look back on the 2008-2010 period as the perfect storm: slot customers on the verge of bankruptcy; a dearth of new markets, new casinos, and casino expansions; and the dud that is (was) server based gaming.
