Description

Thesis Summary: IGT was once the dominant player in slots with over 75% market share at its peak in the early 2000’s.  However, IGT fell from grace as competitive dynamics drastically increased with its market share eroding to ~25% in video gaming in addition to losing focus on its core product offering. Then, in 2015, IGT was acquired by GTECH. This combination of the largest lottery company in the world with one of the top 3 gaming suppliers created a steady and strong FCF yielding company.  Yet, since the merger, analyst coverage of IGT fell from ~20 analysts covering it to just 6 and has also fallen on deaf ears in the buyside community.  The casino space has been one of the best performers in consumer, with the average stock up double digits. Moreover, its two closest peers SGMS and ALL AU are each up 165% and 37% respectively, yet IGT is the lone gaming stock down 19% YTD.

With a rich near term catalyst path, we believe IGT is an undiscovered idea, with a positive sector backdrop that is nearing an inflection point in the story that could drive material EBITDA upside, along with a multiple re-rate higher. Base case price target of $31, or 35% upside, with potential line-of-sight to $40 or 95% upside.  

Company Overview:

IGT operates and provides products and services across all gaming markets, including: lottery management services, online and instants lotteries, instant ticket printing, electronic gaming machines (slot machines/VLT’s), sports betting, and interactive gaming. IGT was acquired by GTECH in April 2015.

Investment Thesis:

• Positive Backdrop -  2 Key Points:

o   Casino Deleverage Should Drive a Pick-Up in Replacement Demand.  Since 2009, gaming operators have been dealing with excessively high net debt levels.  Over the past 8 years, leverage levels have finally come down to a point that casino operators are using FCF to initiate dividends and stock buybacks.  Over this period, casinos have put very little capex into their slot machine floors, evidenced by 55K annual replacement units on a total installed base of ~1m slots in North America. This compares to over 100K annual replacements in the past.  With CZR emerging from bankruptcy, we believe they may look to refresh the slots on their casino floors, which will cascade into other competitors injecting capital into their floors to remain relevant.   In CZR’s S-4, they plan to spend $425m in capex/year for the next 3 years and we believe much of this will be earmarked for refreshing slot floors.  CZR has historically been an IGT advoacate, so we expect IGT to get their fair share.

o   Regional Gaming Gross Revenue Trends Have Been Trending Up.  After a few years of declining GGR, positive LSD regional gaming revenue will benefit IGT’s WAP game installed base.  It will also likely drive casinos to more likely look to inject capital into casino floors.

• Change in Management Culture Not Well Known (Variant View #1).  IGT once held ~75% share of the total slot market.  However, that has fallen significantly as the competition improved and IGT lost focus on its core in the early mid-2000’s, as they focused on downloadable game technology and less on game content and cabinet design. This led to IGT losing some of its key talent, which went to other competitors.  While IGT still dominates Video Poker and Mechanical Reel spinners, their share of Video has dropped to the mid 20%’s.  We believe this has bottomed and is poised to improve.  The street has not appreciated that since GTECH acquired IGT there has been a material culture change that has occurred, which should translate in better results in the coming years.

o   In the past: When IGT lost its game development talent, they moved to outsource its game content development to 3rd parties.  These 3rd parties were compensated on the amount of games developed, not on the games ultimate performance.

o   What Has Changed: IGT has now brought a lot of game development back in-house.  Importantly, they brought back past studio talent that left for other competition within the last 12 months (Kurt Anderson, Dallas Orchard (from ALL), Anthony Barklow (SGMS), Jason Cramer).  Now 3rd party game content is focused on quality not quantity, and compensation is linked to game performance. There is much more collaboration with sales and marketing and customer focus groups.  These are all things that were not done in the past and has reinvigorated the internal culture.

• Near-Term Inflection is Coming Which Should Disprove the Bear Thesis.   There is a bear thesis circulating predicated on buy-side analysts calling the same few casino slot managers through expert networks with some negative feedback on IGT’s WAP games and highlighting that IGT’s games are trailing behind Aristocrat, SGMS, and AGS. However, this is backward looking and well known that “Betty White” did not play well.  We think investors are missing the follow key inflection points:

o   (1) IGT has a strong slate of new game content coming out in 4Q that will likely change the narrative of these calls in coming months: Fort Knox, Wheel of Fortune Mega Tower, The Voice, Sphinx 3D, Wild Fury, Star Rise.

o   (2) IGT’s new cabinet, Crystal Curve, will be a for sale game, not a leased game.

• Expect much of this to be unveiled at the upcoming G2E trade show, which should drive incremental interest in the name.

• Importantly – these initiatives can drive (a) ASP as Crystal Curve will sell for $19-$21K per box vs. the average ASP of ~$13.7K, and (b) can help drive gaming win per day from the current $56.80. Every $1 ~$7m in annual EBITDA.

• Bloated R&D - Opportunity to Cut (Variant View #2).  The street has not focused on IGT’s bloated R&D budget and are mis-modeling this.  When GTECH bought IGT in 2015, the company simply added the two R&D budgets together and never right-sized the base.  Now that IGT has readjusted its NA gaming business, there is a signicant opportunity to reduce this by $50-$100m.  In 2016 IGT had an R&D expense of $343m, versus SGMS of $240m. When you look at this against total revenue this looks reasonable at 6.6% versus SGMS of 8.3%. However, digging deeper, only 15% of the R&D budget is typically spent on Lottery, with the rest for Gaming/Interactive.  As such, when we adjust for this, IGT’s R&D adjusted for lottery is well above its closest peer SGMS at 21.0% versus 9.7% or ~$85m.  The street is modeling IGT’s R&D increasing each year, when it will likely be declining.

• Lottery Business is More Stable than People Realize.  The North American lottery business is a much more stable and steady business than people recognize.  It is a stable 2-4% organic grower.  There can be volatility around bigger jackpots, but that tends to by just 10-15% of the business.  The Italian Lottery business is more mature business with flat growth, but it is a cash cow.  Lottery is a series of 5-10 year contracts, with a 90%+ renewal rate.  Upon renewal, there is often a 1x upfront payment that is required.

o   Under the radar catalyst coming up in NA Lottery.  In October, Mega Millions will increase its price per ticket to $2 from $1.  This has been just 10-12% of total US lottery, well behind Powerball.  Last year Mega Millions did $31b in revenue versus Powerball of $88b.  This has the potential to add an incremental $10-$15m in EBITDA. Possibly more if this drives higher Mega Millions Jackpots.  

• Wildcards – Brazil could privatize its lottery business in 2017, which would be a material positive.  Japan is also a possibility to privative is lottery.

Valuation: Please see supporting valuation materials at the end of the document.

• Massive Underperformance and Strong Valuation Support Relative to SGMS/ALL AU.

*ALL AU based on Bloomberg estimates

SOTP’s Implies that Investors are Getting the Gaming Business for Free.

• We would argue that given the stability of the Lottery business, IGT deserves to operate at a materially higher multiple.  The Lottery business is misunderstood and we think the NA Lottery business should trade at 12x and Italy at 9x (given its maturity).  Under that scenario, you are getting the NA and International Gaming for 1x EBITDA.  As investors get more comfort with lottery, we think the re-rate could be material.

o   Basis For Lottery Target Multiple – There are 3 public pure play lottery companies that trade between 9.7x-14.9x EBITDA. Tatts (14.9x), Tabcorp (9.7x), and Pollard Banknote (10.8x).  Thus, applying 12x for NA Lotto that grows organic topline at 2-5%, with 5-10 year contracts and a 90%+ renewal rate is fair to us.  Italy, which is a stable cash flow business and flat growth warrants a 9x EBITDA.  We note that Italians have some of the highest spend per cap in the world.  We believe IGT is likely to host an analyst day to get investors more comfortable with the stability of Lottery cash flow, which could result in a re-rate.

o   Basis For Gaming Target Multiple – Based on SGMS at 9x and ALL at 12.5x, we think IGT’s gaming business at 8-9x is fair if not conservative.  We would argue that IGT gaming’s gaming business is in the early innings of a turnaround (described above), and share losses have likely bottomed.  As such, EBITDA is likely at trough levels with potential for upside if they are successful in better video content.

Base Price Target: $31.50 (36% upside)

• Based on 2018 EBITDA of $1.695b vs. street at $1.68b (no guidance yet, assumes 4% y/y growth).

• 2018 EV/EBITDA multiple of 8.0x  

Downside Case Price Target: $17.70 (14% downside)

• Based on 2018 EBITDA of $1.66b (assumes 2% y/y growth).

• 2018 EV/EBITDA multiple of 6.5x.

Upside Case Price Target: $40 (95% upside)

• Based on 2018 EBITDA of $1.8b (assumes 10.5% y/y growth- see EBITDA bridge below).

• 2018 EV/EBITDA multiple of 8.5x (in line with current SGMS multiple).

**1x in EV/EBITDA multiple = $8 in equity value.

2018 EBITDA Bridge Scenario

Next Catalysts/Event Path:

Historic Valuation:

EV/EBITDA

P/E Ratio

IGT Stock Chart – It’s worth nothing that IGT did see material appreciating when a turnaround was starting to be evident. However, 2 quarterly misses drove the shares lower, as investor confidence was shaken.

Catalyst

Please see above for detailed catalyst schedule. 

G2E Conference (10/2/17) - will highlight new talent hired and gaming announcements

Mega Million (Mid-October) 

Potential announcement for a share buyback

Analyst initiations

Q3'17 Earnings (End of October)