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Stock Strategist

Viva Las Vegas with This 5-Star Pick

The long-term odds look good for this slot-maker.

Mentioned:

Following is a sampling of stocks that recently jumped to 5 stars. By way of background, we award a stock 5 stars when it trades at a suitably large discount--i.e., a margin of safety--to our fair value estimate. Thus, when a stock hits 5-star territory, we consider it an especially compelling value.

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International Game Technology
Moat: Wide | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.74 | Three-Year Expected Annual Return*: 21.9%

What It Does: International Game Technology (IGT) designs and manufactures computerized gaming equipment (primarily slot machines), network systems, and licensing and services for the casino gaming industry. North American operations contributed 77% of consolidated revenue in fiscal 2007.

What Gives It an Edge: Morningstar analyst Bradley Meeks believes International Game Technology benefits from a wide economic moat, as evidenced by its 70% share of the slot machine industry. IGT derives its advantages from its product-development capabilities (spending nearly 4 times more than its next competitor), and significant barriers to entry in the industry, including time-consuming and costly local and federal gaming regulatory requirements, a wealth of patents, and significant economies of scale. Further making Meeks' case for a wide economic moat, IGT is extremely profitable with operating margins in the mid-30% range, and the firm converts an average of 18% of revenues into free cash flow.

What the Risks Are: Fickle casino operators' demand for replacement units and casino patrons' gaming preferences make predicting IGT's cash flows difficult on a year-to-year basis. A weak economy could also deter people from gambling, affecting profitability. Additionally, a delay of the server-based initiative and a protracted lull in the replacement cycle (see below) would aggravate IGT's long-term growth prospects. If IGT is unable to obtain the necessary gaming licenses or continue to comply with regulations in gaming jurisdictions in which it operates, growth and profitability could be hindered substantially.

What the Market Is Missing: Meeks thinks investors have shunned IGT stock lately as it is becoming clear that the next replacement cycle for gaming equipment probably won't happen until the second half of 2009, meaning lower profits for the firm in the meantime. However, although IGT's short-term results will stay bumpy, Meeks sees significant growth opportunities for the firm once the replacement cycle takes hold. For starters, IGT was chosen to install a server-based network in CityCenter,  MGM Mirage's (MGM) new $8 billion megacasino on the Las Vegas Strip. Once installed, Meeks believes this technology has the potential to revolutionize the gaming environment, causing other new casino properties to install similar systems. As this happens, an industrywide replacement cycle could kick off, as existing casinos also turn to IGT to stay competitive with newer properties, spurring a period of strong growth for the firm. Aside from the inevitable replacement cycle, Meeks also points out that IGT should capture more of the international marketplace as areas such as Macau (that are typically composed of table games), upgrade their technology and start playing more "high tech" slot games. While IGT should continue to suffer from a general slowdown in slot purchases until the next replacement cycle begins, Meeks points to the firm's leading market share, new product lineup, and international expansion opportunities as reasons to buy the stock today.

* Price/fair value ratio and expected return calculated using fair value estimate, closing price, and cost of equity estimates as of Friday, May 23, 2008.

Jeff Viksjo does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.