GTech Is a Money Maker

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Multimillion-dollar jackpot. The very phrase elicits dreams of avarice and induces many of us to casually trade a few dollars in search of the winning ticket. Although Fools know that lotteries represent a losing proposition, investors looking to recoup some of that money may want to consider a company that profits from those eye-catching jackpots: GTech Holdings (NYSE: GTK). GTech is the world's largest lottery systems operator, and the stock is trading at all-time highs today on the strength of a sparkling fourth-quarter report card.

When last we looked at GTech, the company was in the process of digesting the recent acquisitions of credit/debit card processor Polcard, video lottery terminal maker Spielo, and instant ticket purveyor Interlott. Apparently, the integrations went smoothly, with GTech reporting a 29% jump in annual net income to $183 million on record full-year revenues of $1.05 billion. Management raised guidance for the current fiscal year as well, and is now expecting revenue growth of 20% to 21%, and earnings per share in the $3 to $3.10 range.

Globally, cash-strapped governments struggling to cope with budget deficits have increasingly turned to lotteries as a reliable revenue source. More often than not, GTech has been the recipient. The company now has a commanding 70% market share worldwide, including operations in 44 foreign markets and 26 of 39 U.S. state lotteries. Last year, GTech was awarded 11 new contracts, and negotiated 10 contract extensions. Lottery contracts are long-term, often lasting from five to 10 years.

With the purchase of International Gaming Technology's (NYSE: IGT) online lottery systems division by chief rival Scientific Games (Nasdaq: SGMS), only two real players remain in the domestic lottery game. Of the two, GTech seems the better buy. It has built a more dominant competitive position, has a cleaner balance sheet, is much more profitable, and is branching out into new arenas.

Scientific Games has gross and operating margins of 41% and 19%, respectively, a return on assets of 5.4%, and a return on equity of 21%. By comparison, GTech has margins of 43% and 26%, return on assets of 15%, and return on equity of 45.7%. GTech also generates far more free cash flow, consistently over $150 million each of the past three years. Furthermore, Scientific Games is more richly valued, with a current P/E of 35, versus 22 for GTech.

Aside from a handful of untapped markets such as India and China, new sources of revenue are slowly drying up. The ability to secure new contracts and protect expiring ones will become vital. GTech has a successful history of doing both. The aforementioned acquisitions will also contribute to profitability, in addition to the recent purchase of Caribbean-based Leeward Islands Lottery Holding, which is forecast to add up to $25 million in revenues this year. With a PEG ratio of 1.9, GTech is hardly a screaming bargain, but the long-term prospects for the stock are somewhat more attractive than the odds of hitting that multimillion-dollar jackpot.

Tom Gardner spends his time discovering underappreciated and undervalued small-cap companies. To join him in his search, take a free 30-day trial to Motley Fool Hidden Gems .

Fool contributor Nathan Slaughter prefers the numbers 5, 11, 14, 17, 20, and 34, though this particular combination has yet to produce. He owns none of the shares listed.