IGT Shares Have Low Expectations Priced In

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Jul 01, 2015

After an incredible run of over 100% in less than two years, shares of International Game Technology (IGT) recently hit a three-year low.

On a variety of valuation metrics, IGT has never looked cheaper in comparison to historical levels. On a P/E, P/B, P/FCF and EV/EBIT basis, IGT’s valuation is hitting all-time lows.

Does the recent massive pullback (down 50% in 18 months) signal a buying opportunity? Or are there reasons to believe shares have further to fall?

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The business

As its name implies, International Game Technology is a leading manufacturer of casino gaming and lottery systems. It sells to commercial casinos and both government-sponsored and privatized lotteries. The company aims to offer a full suite of gaming products, including both the systems themselves, as well as the software that provides the gaming experience.

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Recent merger has shifted exposures

In March of 2015, G-TECH (GTK) formally bought out the old International Game Technology in a $6.4 billion merger. This combined the world's leading slot machine producer (IGT, Financial) and the world’s leading lottery servicer (GTK, Financial).

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The merger gave the company an unprecedented level of scale in the gaming industry. The combined size, over twice that of its nearest competitor, has given the company unmatched R&D capabilities, resulting in industry-leading margins.

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With GTK’s heavy exposure to the Italian market, the combined company has now diversified away from the North American market, with more than half of all revenues stemming from outside the U.S.

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The new company is also more service oriented. Service revenues typically are more predictable as they run off multi-year contracts. For example, the firm’s lottery contracts have a remaining weighted-average life of 4.6 years, providing a long runway of free cash flow visibility.

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Growth opportunities

The global gaming market tracks total consumer spending on gaming (wagers minus payout). Growth over the next five years is expected to be slower than the previous, as spending growth in the world’s largest betting market (Macau) grinds to a halt. Still, expectations are for a steady 3% growth for the next few years.

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Breaking this down into the company’s main exposures (Casino B2B and Lottery), we can see that IGT is expected to operate in some rough conditions. While the respective markets are still growing, industry revenue growth is expected to be weak moving forward due to slow product sales (in Casino B2B) and tepid emerging markets (in lottery).

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Competition risks

Aside from lower total market growth, competition has risen over the last few years for most of IGT’s exposures.

Lotteries: Margins have fallen due to higher competition in both the U.S. and internationally. This is expected to result in lower margins against weaker top-line growth.

Gaming Machines: IGT faces increasing competition from smaller companies with innovative platforms. While the replacement market is stable, new product sales are incredibly weak.

Social Gaming: In 2012, IGT bought DoubleDown for $250 million. DoubleDown operates the world's largest virtual casino, bringing Vegas-style, social casino games to more than six million players every month. While the combined company has done very well (inducted to Facebook’s [FB] “Hall of Fame” for social games and ranked the #1 social casino by Apple [AAPL] in 2013), it is still a free-to-play service relying on users to purchase optional paid chips. While user growth may be impressive, profits may never materialize in a way to support the $250 million price tag.

Guru ownership

While shares are still owned by the likes of Mario Gabelli (Trades, Portfolio) and Jim Simons (Trades, Portfolio), gurus such as Jeremy Grantham (Trades, Portfolio), John Rogers (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), and Joel Greenblatt (Trades, Portfolio) have all sold out.

On March 31, 2015 (the last filing period), three gurus reported adding to their positions while two sold their stakes completely.

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Valuation

Next year should see the fully consolidated sales and earnings power of the combined company. For 2016, analysts are expecting EPS of $1.78 off revenues of $4.71 billion.

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Based on these expectations, we can use GuruFocus’ Reverse DCF Tool to estimate that investors are currently pricing in only ~2% annual EPS growth over the long-term. With IGT’s markets growing at an expected average of 3% annually through 2018, the current share price implies that the company’s profitability should continue to fall. With intensifying competition, that prediction will probably prove to be correct.

For now, the future share price looks to be contingent on managements ability to maintain its industry-leading margins against the onslaught of new global competitors.

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For more ideas like this one, check out GuruFocus’ 52-Week Low Screener or the rest of R. Vanzo’s Articles.