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Near-Term Spotlight -- Leisure Gaming Industry

By Paul Tracy
Editor, StreetAuthority Market Advisor
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Published:  January 20, 2004

Year-to-date through January 15th, the Leisure Gaming/Equipment Index has gained +5.4% compared with a gain of just +2.5% for the S&P 500. Last year, the gaming index soared +50.7%, trouncing the S&P's +26.4% gain.

Gaming Industry Fundamentals
The gaming industry is estimated to be a $60-billion-dollar a year business. It includes casino operations, state lotteries, pari-mutuel wagering, charitable gaming and gaming-equipment manufacturing. Half of all gaming revenues come from casino winnings. The other half comes from entertainment, hotel rooms and restaurants. About 65% of gaming revenues come from slot machines, which are preprogrammed to pay out certain amounts. According to industry experts, gaming generates more revenue than spectator sports, recorded music, theme parks, and cruises combined.

What's Fueling Growth in the $60-Billion Industry?
Gaming companies continue to aggressively expand in both new and existing markets. Whereas only Nevada and New Jersey allowed gambling 14 years ago, casino gambling is now legal in more than 20 states. The geographic expansion of casinos and lotteries has been fueled by a desire on the part of state governments to create jobs, boost tourism and generate more tax dollars. Also assisting the expansion is the federal government's passage of legislation that allows Native Americans to own or operate casinos in various states.

According to a recent study, there are an estimated 51 million-plus casino gamblers in the U.S. As a group, these gamblers make about 300 million trips to casinos each year. About a quarter of the adult population has gambled at a casino at least once in the past 12 months. State lotteries have also helped boost interest in gambling. Lotteries are now conducted in more than 30 states.

The aging and growing Baby Boomer generation continues to spend money on leisure activities such as gambling. This demographic alone could provide a solid long-term foundation for revenue growth, as the number of people over the age of 55 is projected to double over the next 25 years. This older generation tends to have more free time and more disposable income to gamble with.

Another trend that seems to be picking up in the gaming industry is the development of "racinos." Racinos involve a combination of racetracks with slot machines. Many states -- including Massachusetts, Maryland, and Maine -- are now considering allowing racetracks to develop gaming rooms with slot machines on the premises. Gambling equipment makers could see a surge in business in the coming years thanks to new demand for slot machines from racinos.

In addition to adding new jobs to the local economy, casino gambling is recognized as a means of stimulating state economies through the addition of new tax revenues. It's that recognition that has spurred the expansion of gambling throughout the country. Meanwhile, international markets could also provide a huge catalyst for future industry growth. For example, the U.K. is considering deregulating the use of slot machines. Only a few thousand slots are in use there now, but with less regulation, the long-term potential in that market could be enormous. And finally, gaming equipment makers are constantly working to create new slot machines and other games. The introduction of popular new slot machines, as well as cashless machines (more on these below), should also fuel industry growth in the coming years.

Industry Risks
Two negatives stand in the way of gaming industry growth. First, gaming requires legislative approval, which is often slow in coming. Secondly, governments often look to gaming as a source of tax increases -- the old sin tax -- which cuts into casino profits. For example, when Illinois recently raised its top tax rate to 50% on gaming profits, the whole industry took it on the chin.

Another vulnerability of the industry was brought to light after the September 11th terrorist attacks. Prior to the attacks, the industry had posted solid revenue growth for more than 30 consecutive years amidst all types of economies. However, the terrorist attacks back in 2001 limited consumer travel and put a damper on casino revenues the following year. On the positive side of things though, the attacks also demonstrated the resiliency and strength of the industry, as most companies managed to bounce back fairly quickly.


Favored Sector Pick:  International Game Technology (IGT, $35.64)
International Game Technology (IGT, $35.64) is our favored pick in the leisure-gaming industry. IGT develops, manufactures and distributes video-based cash and cashless gaming machines, including slot and video poker machines. With the rapid expansion of gaming across the country, IGT will continue to benefit from sales of gaming equipment to new and existing casinos. In addition, the company stands to benefit even more from the trend to convert existing coin-operated slots to "cashless," or EZPay, machines. Both developments signal the likelihood of many more years of ample growth for the slot machine maker.

Casino operators like cashless slots because the machines improve company margins by reducing operating expenses. As anyone who regularly plays the one-armed bandits well knows, slot players ordinarily need a steady supply of coins to keep gambling. To meet this need, workers have to keep supplying change and stocking the machines with coins. However, cashless machines can save as much as 30% on labor costs, according to industry experts.

Currently, about 30% of the industry's installed base of slot machines have been converted to the new cashless format. That leaves plenty of room for IGT to benefit from future conversions. North America is currently home to about 700,000 slot machines, and IGT estimates that roughly 400,000 of those are prime candidates for replacement with cashless machines. Along those lines, IGT has already signed contracts with Caesars Entertainment (CZR, $12.00), MGM Mirage (MGG, $40.00) and Harrah's Entertainment (HET, $52.37) to retrofit or replace thousands of machines over the next several years. Last year, Station Casinos (STN, $32.93) agreed to buy 8,000 EZ pay or cashless gaming machines over a three-year period.

According to the American Game Association, IGT manufactures and sells roughly 70% of all slot machines sold in the United States, giving the firm a commanding lead in the slot machine market. Company growth has also been impressive, as sales have climbed from $930 million in 1999 to over $2.1 billion last year. In addition, sales of slot machines aren't IGT's only source of revenue. The firm has also had some success leasing its machines to casinos in exchange for a percentage of the daily win. The company also derives about 25% of its sales from international markets, and as we mentioned before, growth opportunities in overseas are enormous.

Acquisition Strategy
In October, IGT bought Acres Gaming, a maker of sophisticated gaming software that tracks which games customers play and how they play them. The software has greatly enhanced IGT's marketing efforts. The company uses the information it gathers to keep the casino's customers loyal in much the same way that airlines use frequent-flier miles. Casino players accumulate points at IGT's machines and get bonuses for sticking with the establishment.

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IGT also bought Anchor in December 2001 to gain control over the firm's blockbuster "Wheel of Fortune" game, as well as other popular titles such as "The Price Is Right" and "Jeopardy." The acquisition also gave IGT inroads into the lottery business. The firm now makes the machines for games like PowerBall and Mega Millions, which provide IGT with about 6% of its revenue.

Growth Prospects and Valuation
IGT is currently trading at 28 times this year's consensus earnings estimate of $1.28 per share. On average, analysts expect the company's profits to grow at a 15% annual clip over the next five years. We don't consider that to be much of a gamble for growth investors, so we've decided to add IGT to our "Watch List" for our new short-term portfolio (we'll bring you a table and analysis of all of our watch list holdings in our next issue).

International Game Technology (IGT, $35.64)
Market Capitalization:  $12.3 billion
Shares Outstanding:  346.2 million
Average Daily Volume:  2 million shares
2003 Revenue:  $2.1 billion
2001 EPS:  $0.70
2002 EPS:  $0.84
2003 EPS:  $1.07
2004 EPS:  $1.28 (estimate)
2005 EPS:  $1.48 (estimate)
Five-year average expected earnings growth rate:  +15%
P/E on 2004 EPS estimate:  28
Institutions own 81% of the outstanding shares
52-week range:  $18.26 to $37.00

Other Major Players in the Leisure-Gaming Industry:

GTECH Holdings (GTK, $54.60)
GTECH is the world's largest supplier of computerized online lottery products and services. The company has contracts with 25 of the 39 lotteries in the United States and 59 of 105 international lotteries.

GTECH Holdings (GTK, $54.60)
Market Capitalization:  $3.2 billion
Shares Outstanding:  59 million
Average Daily Volume:  527,000 shares
2002 Revenue:  $979 million
2001 EPS:  $1.40
2002 EPS:  $1.41
2003 EPS:  $2.43
2004 EPS:  $2.75 (estimate)
2005 EPS:  $3.02 (estimate)
Five-year average expected earnings growth rate:  +10%
P/E on 2004 EPS estimate:  20
Institutions own 95% of the outstanding shares
52-week range:  $25.62 to $54.82

Harrah's Entertainment (HET, $52.37)
Harrah's owns and operates casino/resorts and riverboats under the Harrah's, Showboat and Rio brand names. One of the most geographically diverse casino operators, the firm's locations are spread throughout Nevada, New Jersey and ten other states.

Harrah's Entertainment (HET, $52.37)
Market Capitalization:  $5.8 billion
Shares Outstanding: 110.5 million
Average Daily Volume:  519,000 shares
2002 Revenue:  $4.1 billion
2001 EPS:  $2.04
2002 EPS:  $2.99
2003 EPS:  $2.94 (estimate)
2004 EPS:  $3.08 (estimate)
2005 EPS:  $3.32 (estimate)
Five-year average expected earnings growth rate:  +13%
P/E on 2004 EPS estimate:  17
Institutions own 95% of the outstanding shares
52-week range:  $30.30 to $52.59

Mandalay Resort Group (MBG, $46.93)
Mandalay owns a variety of casino/resorts located primarily in Nevada. The firm's casinos include Mandalay Bay, Excalibur, Luxor and Circus Circus in Las Vegas. It also owns the dockside casino in Tunica, Mississippi and a casino in Detroit. Mandalay also jointly owns Monte Carlo in Las Vegas, the Silver Legacy in Reno and the Grand Victoria riverboat in Illinois.

Mandalay Resort Group (MBG, $46.93)
Market Capitalization:  $3.0 billion
Shares Outstanding:  64.9 million
Average Daily Volume:  866,000 shares
2003 Revenue:  $2.4 billion
2001 EPS:  $1.47
2002 EPS:  $1.24
2003 EPS:  $1.87
2004 EPS:  $2.37 (estimate)
2005 EPS:  $2.67 (estimate)
Five-year average expected earnings growth rate:  +15%
P/E on 2004 Earnings:  20
Institutions own 98% of the outstanding shares
52-week range:  $23.40 to $48.04

MGM Mirage (MGG, $40.00)
MGM owns the MGM Grand Hotel/Casino in Las Vegas, a 5,000-room hotel and a movie-related theme park. It also owns the MGM Grand Diamond Beach Hotel/Casino in Australia. MGM also owns the New York-New York Casino in Las Vegas.

MGM Mirage (MGG, $40.00)
Market Capitalization:  $5.8 billion
Shares Outstanding:  144.9 million
Average Daily Volume:  513,000 shares
2002 Revenue:  $4.0 billion
2001 EPS:  $1.37
2002 EPS:  $1.87
2003 EPS:  $1.49 (estimate)
2004 EPS:  $1.78 (estimate)
2005 EPS:  $2.00 (estimate)
Five-year average expected earnings growth rate:  +15%
P/E on 2004 Earnings:  23
Institutions own 44% of the outstanding shares
52-week range:  $24.09 to $40.72

WMS Industries (WMS, $27.97)
WMS designs and makes video and reel spinning gaming machines, as well as video lottery terminals.

WMS Industries (WMS, $27.97)
Market Capitalization:  $822 million
Shares Outstanding:  29.4 million
Average Daily Volume:  180,000 shares
2003 Revenue : $179 million
2001 EPS:  $1.47
2002 EPS:  $0.33
2003 EPS:  -$0.03
2004 EPS:  $0.12 (estimate)
2005 EPS:  $0.93 (estimate)
Five-year average expected earnings growth rate:  +17.5%
P/E on 2004 Earnings:  233
Institutions own 82% of the outstanding shares
52-week range:  $10.50 to $28.18

Please Note: The above article was merely a small excerpt from an issue of our premium, long-term-oriented investing newsletter -- the Market Advisor. To receive your copy of our most recent Market Advisor newsletter, as well as other guidance similar to this every other week, you'll need to subscribe to this publication. To learn more, please visit the following link:  https://www.StreetAuthority.com/subscribe-ma.asp

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