The Long Case for International Gaming Technology: Get in at the Bottom

| About: International Game (IGT)

Looking at International Gaming Technology’s (NYSE:IGT) chart you’d wonder why I think IGT is at the bottom - this stock has had a nice run over the last two years and has pulled back slightly from recent highs of $48, but it is certainly not dirt cheap. The key to this story is to look at the gaming industry’s current upgrade cycle trends as well as a huge development coming to the gaming markets in the near future: server-based games.

To address the first point, the past few years the gaming industry has experienced a steady wave of slot machine upgrades which has been a pleasant surprise for company’s such as IGT. However the good times have come to an end and currently the cycle has turned downwards and seems to be reaching a trough at the bottom. Wall Street is forecasting slot makers’ earnings growth to suffer due to the limited opportunities for gaming companies to replace old machines as they have been over the last few years (although new machine sales should be strong internationally). The share price of IGT has taken a hit from it’s peak of $48 (and was down 4% yesterday) because of this and I think this stock looks like a good relative value.

To address the second point, the key to understanding the value proposition for IGT is server-based gaming technology. Server-based games (also known as downloadable slot machines) are slot machines which are connected to a central computer system which is able to dynamically adjust the denominations, awards, and game themes on the fly, instead of shutting down the game and having a technician re-engineer the details of the game manually, which is the current practice. Server-based games will make casinos more efficient (games have less down-time) as well as more appealing to consumers as casino operators can shift the denominations and game styles quickly while appealing to a wider audience of gamers (weekend vs. weekday visitors and day-time vs. late-night users). This idea of server-based games has caught fire with casino operators and they are eagerly awaiting manufacturers (such as IGT) to bring this technology to market.

IGT is head and shoulders above the competition in server-based gaming technology and is perfectly poised to take advantage of the potential for older, traditional slot machines to be replaced with this new technology in early 2008 through 2009. This, combined with the increasing demand from foreign casinos, particularly in Macau, should be an enormous catalyst for IGT over the next 2-3 years. Although this idea of server-based gaming growth is not new, I do not believe the full value of this future revenue stream is being fully priced into IGT and furthermore, think most analysts are forecasting this technology to hit the market later than it actually will - I think IGT could realistically start rolling these games out in large numbers in early 2008 while most analysts do not expect SBGs to affect earnings until mid-2008 and 2009. With IGT currently testing server-based technology in a few, select US casinos and with casino operators pulling for the technology to come to market due to it’s efficiency, profitability, and customer-appeal, I think this will be a bonus for IGT’s earnings as early as Q1/2008, two quarters before most analyst’s expectations.

Currently, IGT is trading at a forward P/E of ~ 21, not necessarily dirt-cheap but lower than most industry peers and at the low-end of IGT’s historical range. Furthermore, even the most pessimistic analyst that covers IGT has a target price of $45 (high target is $58) and, while I don’t usually put a lot of faith in sell-side analysts, all 13 analysts think this stock is worth more than $45, a premium of 17% over today’s closing price. I’ll give them the benefit of the doubt on this one and think that the market is knocking this stock too much because of the decelerating replacement cycle while not looking far enough out to realize the benefits of IGT’s position as the leader of server-based gaming technology which is poised to hit casinos in early 2008 and potentially re-shape slot machines floors across the world.

Now is the time to get long IGT before the market’s sights look past the current, decelerating growth in traditional games, and onto the future of server-based gaming technology. Once this technology catches investors’ attention, I think this stock is worth north of $50.

Disclosure: The author has a long position in IGT.

IGT 1-yr chart


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