By Vishnu Lekraj
Think about gaming, and glitz and glamour may come to mind. However, the industry has been anything but glitzy and glamorous, as overexpansion and poor consumer discretionary spending growth have plagued many gaming-related entities. This has been especially true for the gaming manufacturers--slot machine suppliers--which have been forced to retool their operational strategies in an effort to drive returns.
The robust growth that WMS Industries (WMS-OLD), International Game Technology (IGT), and Bally Technologies (BYI) experienced during most of the 2000s has diminished over the past few years. The toxic mix of customer overleverage, lackluster consumer discretionary spending growth, and poor operational execution has hampered these players. Nonetheless, we still believe the gaming manufacturing industry has an inherent narrow economic moat and the current poor disposition of the gaming market has created some solid opportunities for investors.
Despite the near-term challenges that face the major U.S.-based gaming manufacturers, we believe the narrow moats inherent to the industry will allow IGT, Bally, and WMS to produce returns on invested capital above their weighted average cost of capital over an extended period. In fact, we believe none of the three will earn below their cost of capital throughout the duration of our discounted cash flow model.
The ability of all the three major players to produce consistent top-tier gaming product, their entrenched positions with stodgy customers, their expertise with navigating the maze of regulations over hundreds of jurisdictions, and ownership of premium licensed content all provide a solid bedrock upon which the manufacturers are able to earn robust economic profits. Gaming content is especially key as consumers have a plethora of choices for entertainment, and having the ability to attract and keep gambling patrons at a slot machine is critical. Gaming operators will try to maximize the total yield of their casino floor, and only the most appealing games will be kept at any given time. With this dynamic at play, only the manufacturers that are able to develop the best game play and themes will be able to push product out on casino floors. Surround-sound systems, engaging bonus rounds, recognizable titles, community gaming capabilities, and optimal gaming volatility (the amount and frequency of wins) are only a few factors that will keep gamblers at a slot for an extended period.
With these factors in mind, the new machines that WMS, IGT, and Bally are currently developing are significantly more sophisticated than games developed 10-15 years ago. Most games in the past were reel-based, probability-driven machines, while games today are state-of-the-art computers.
The expertise needed to develop newer games is critical, and the fight to stay at the forefront of technological development is fierce. We were able to see WMS' next-generation gaming products, and their complexity, interactivity, and appeal are impressive. We expect to see similar products from IGT and Bally over the coming years. In our opinion, a new competitor will be hard-pressed to compete with these leading-edge gaming machines.
In addition to game development, the ability to efficiently navigate the U.S. regulatory environment is a critical asset to any gaming manufacturer. WMS recently faltered on this front, and the misstep cost the company significantly. It was unable to roll out its newest gaming content, and thus the number of machines sold, price per machine, and yield per machine were impaired over the past several quarters. If an established player like WMS can have regulatory hangups, then a less experienced player may have a very tough time with U.S. regulators.
Gaming operators are also reluctant to give up valuable casino floor space to an unproven supplier. As a result, the entrenched position of WMS, IGT, and Bally is most likely not going to deteriorate for some time. We estimate the three majors captured more than 60% ship share in 2011, and we believe this trend will not dissipate anytime soon.
Given the aforementioned competitive factors, we believe WMS, IGT, and Bally will also earn close to the same returns over time. Any outperformance by one gaming manufacturer over the others will be short-lived, in our opinion. The cost of content licensing, gaming development, regulatory expenses, technological partnership, and gambling patron demand will ultimately guide the returns of the three major players toward equilibrium. Coupling this fact with high barriers to entry for the industry should allow all three major gaming machine manufacturers to enjoy stable returns over the long term. Therefore, the strong competitive advantages these players enjoy outweigh any near-term headwinds facing the industry.
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