TIME TO FEED THE GORILLA

A steady diet of market share losses has IGT looking more like a chimp than the 500 pound Gorilla it once was. Have sentiment and market share both reach a trough?

 

 

We’re pretty sure IGT’s market share is close to bottoming.  With the latest downgrade, we think sentiment may be as well.  Sure there are still some buy ratings out there but no one seems to be pounding the table on the stock.  Why?  A perceived lack of catalysts, a perceived lack of earnings visibility, and a perceived 25% market share in perpetuity.  Well, in this case, perception is not reality.

 

The Elusive Replacement Market

The biggest catalyst out there is the normalization of replacement demand.  It will happen, only the timing is uncertain.  If we knew when, IGT would be a $25 stock.  We don’t but we’re not going to rely on the sell side consensus that replacements will stay under pressure for the next 18 months.  We think an analysis of the major potential drivers yields an acceleration sooner than that and potentially V-shaped in magnitude.  Here are the major drivers:

  1. Accelerated depreciation initiatives working through Congress.  President Obama proposed 100% expensing of capital equipment purchases.
  2. Floors are not old yet but they will be soon – end of TITO was 6 years ago
  3. IGT’s footprint is older than average
  4. Operator balance sheets are in much better shape
  5. More certainty in the casino business – revenues are stagnant but at least the world isn’t ending
  6. More competition from new markets

While accelerated replacement demand would benefit all suppliers, IGT’s stock could have the most upside to that catalyst.  Given the liquidity of the stock, name recognition, and its reliance on box sale, investors would likely flock to IGT.

 

Again, the problem is timing.  However, near term earnings visibility may be a little better than what the bears are chirping.  Despite the recent downturn in sentiment, we don’t believe anything has really changed since IGT last gave guidance in July.  Our $0.18 estimate looks safe and while we are a little below the Street for FY2011, we have not modeled significant replacement growth (yet), share buyback, or the convertible takeout. 

 

25% Ship Share Not Sustainable

IGT has rung up two consecutive quarters of mid 20s ship share.  The share deterioration is nothing short of stunning.  After all, IGT was at 50% as recent as Q3 2006 and at 40% in Q2 2008.  However, we think IGT’s recent share is unsustainably low.  The dearth of new casino openings has not helped since IGT usually garners a bigger share of slot orders from new and expanding casinos.  Second, IGT’s existing footprint is older than the average North American slot machine.  IGT’s content has undergone a significant upgrade as resources have moved from systems to development to game development.  Finally, server based gaming is finally gaining some traction.  Ship share in the 35% range is probably a good run rate and while we don’t see a lot of improvement occurring in the next few quarters, calendar 2011 should show gradual improvement throughout the year.  Ship share gains off the current bottom should be a catalyst.

 

Core Earnings

Given the trough level of replacement demand and the dearth of new markets, we believe earnings are also at a trough.  Starting at a baseline of $0.90, we get to $1.20 in core earnings just from normalizing industry wide replacement demand at 76,000 (adds $0.17), adding $0.08 from taking out the convertible, and $0.05 from using free cash flow to buy back stock.  Beyond the $1.20, IGT should be able to grow earnings 20%+ annually over the next 3-5 years with the addition of new markets (MD, OH, IL, Italy, etc.) and continued share repurchases. 

 

With cash earnings tracking very close to EPS, it seems reasonable to assume at least an 18x multiple for that kind of growth and cash flow generation.  So if IGT is worth at least $21-22 per the analysis, what will it take to get there?  It probably starts with making the FQ4 which we think IGT will do.  Market share stabilization and improvement will certainly help but the real catalyst will be replacement demand.  While we wait for the inevitable, downside appears limited, owing to awful sentiment.


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