IGT Placing a Bet Outside of Its Sweet Spot
Demand for slots is slowing, so gaming manufacturers are changing strategies--and it will be worth the gamble.
The gaming manufacturing industry has faced a poor demand environment during the last several years. Sluggish consumer discretionary spending and an overleveraged client base have combined to form a fierce headwind for the space. According to our estimates, the total number of North American slot machines increased a cumulative 33% from 1999 to 2006. This growth has fallen to 14% from 2006 to 2011, and we expect this rate to move even lower during the next few years. As a result, the three major North American gaming manufacturers-- International Game Technology (IGT), WMS Industries (WMS), and Bally Technologies (BYI)--have been forced to reevaluate their competitive positions and operational strategies.
At its 2011 investor conference in New York on Dec. 7, IGT announced three major tactical initiatives related to its long-term strategy: a heavy push into untapped international markets, a more robust build-out of its online gaming infrastructure, and a new casino floor management system.
While these new initiatives have the opportunity to contribute materially to the top and bottom lines, there are several obstacles that must be resolved before the full potential of these plans is realized. Therefore, it may be years before the firm sees any return from the investments it will make. Nevertheless, we believe there are several positive aspects to the long-term projects IGT announced. Combining these positive factors with our expectation of a steady ramp-up in gaming machine replacement rates positions IGT advantageously, in our opinion.
Turning the Tables on International Gambling Tastes
Markets outside of North America tend to follow closely what happens domestically, but IGT is making the bet that this correlation will dissipate over the near and medium term through secular trends and expansion into untapped geographies. The firm makes the case that international markets will provide a more fertile ground for growth given the expectations for higher GDP growth prospects and the expansion of gambling within many countries outside of the North American market. These countries also have an expanding middle class with a greater amount of discretionary income. The two main geographies IGT highlighted as key targets are Macau and Latin America. A solid economic growth outlook, growing tourism, and the cultural acceptance of gambling in both areas set the stage for robust gaming machine growth, according to the firm.
These variables are certainly positive. However, many casino patrons' gambling tastes are vastly different in areas outside of North America. Table games are far more popular than slot machines in many overseas markets, and this is especially true for the high-growth areas of Asia. In Macau, revenue from table games makes up 90% of total gambling revenue. This dynamic is double-sided, in our opinion. While it may take several years to grow the appeal of gaming machines among gamblers within the region, it also means there is opportunity as this market grows.
In order to create a strong foothold as a top provider of gaming machines to the plethora of international markets, IGT is implementing a local strategy: It will develop games (software) tailored to the tastes of the local gambler, but also will utilize its existing line of cabinets (hardware). We believe this strategy could be beneficial to IGT's international market share. Developing a unique lineup of gaming content for specific markets would lead to more demand for its products as the slot industry grows overseas. However, we believe this could also lead to lower profitability given the development costs for such uniquely tailored games.
All things considered, we believe international growth will be a main operational driver for IGT. In all likelihood, the top line should benefit the most from this strategy, but profits could be impaired somewhat on a percentage basis. The fight over content, cost of gaming development, regulatory expenses, and slow-to-change gambling preferences could provide pressure on the bottom line.
Domestic Online Gaming Will Be Worth the Wait
For the last several years, online gaming has been a significant topic within the gaming industry. According to the American Gaming Association, total revenue from worldwide online gaming was $30 billion in 2010. We estimate that the online gaming market in the United States alone could be approximately $13 billion annually. This is a massive opportunity for the three major gaming manufacturers.
Despite the massive potential tax revenues, influential congressional allies (such as Senate Majority Leader Harry Reid), and heavy lobbying by gaming industry stakeholders, the U.S. government has shown very little willingness to legalize online gaming. Given the immense political pushback attached to this subject, any robust regulatory approval for online gaming is most likely years away, in our opinion. Nevertheless, IGT has produced a well-structured operation in anticipation of U.S. regulatory approval. In addition, the firm has utilized this infrastructure to service other geographies where online gaming is legal, including the United Kingdom and Canada. IGT also has made a strong effort to make sure it can deliver its nontraditional services on all mobile platforms, including tablets and smartphones, and across all gaming categories, including poker and sports books.
Having a service this robust is a positive for any firm looking to become a major player within the nontraditional gaming space, in our opinion. We believe IGT's varied levels of services are very appealing for partners looking to move into the online gaming space. This is especially true for the major land-based casino operators who have yet to move into this market on a large scale. When they do (this will most likely happen once the U.S. federal government approves online gaming), IGT will be one of the best-positioned to reap the rewards. This business is highly scalable and would be a material contributor to both top- and bottom-line results. Again though, the question in our mind is not the viability of these services, but rather the timing of federal government approval. We believe this process won't be concluded at least until a few years after the next presidential election.
Taking Casinos Into the 'Cloud'
If we'd have heard the term "cloud" any more at IGT's investor day, we might have thought we were at a meteorology conference. Systems cloud services, or what we will call software-as-a-service, is clearly a distinctive variable that the firm wants to market to investors and customers. During the last several years, we have heard more from Bally regarding systems services, leading us to believe Bally is currently a much more entrenched player in the space. However, IGT's SaaS model could be a more efficient way of delivering casino floor management services. Instead of having to install, maintain, and manage a large operating system in-house, a customer could execute all floor management activities basically through one server. This would save valuable casino/hotel/resort floor space, staffing, and equipment costs--a great value proposition. IGT plans to test this service line during fiscal 2012 and roll out a full offering by the first quarter of fiscal 2013.
Despite the SaaS delivery model's appealing cost/benefit variable for casino operators, we believe some customers are reluctant to cede total control of their casino floors to an offsite technology center. IGT plans to house its systems SaaS operations in several centers worldwide, and some casino operators may view this as a risky proposition. Bally could be the beneficiary of such a dynamic, since its service still will be provided through traditional servers with back-office equipment installed and maintained at a customer's site.
Vishnu Lekraj does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.