Online Gambling is Coming--Where’s a Good Bet?

The proliferation of online gaming has already begun. New Jersey has already passed a bill allowing internet betting to begin by 2014. Nevada did likewise, and it's easy to assume other states will follow. Gamblers can't seem to wait--a recent report by British-based research firm H2 Gambling Capital found that Americans spent $2.6 billion gambling online in 2012, despite its questionable legal status.

Casino companies are an obvious choice when looking to play this trend. They will likely be the known face of mobile gaming, given their reputation and marketing savvy. But, while casinos will have the highest profiles, gambling equipment vendors might be equally attractive investments. These firms could gain significantly from online gaming, and they are already well positioned in the industry. Most already have some experience with interactive gambling and own stables of popular and familiar games of chance. They also have the technological aptitude and, since many hold online licenses, the legal authority to quickly make these games live over the internet.

Checking out the equipment makers
With so much to offer, the gaming equipment companies seem to be worth a look. For instance, International Game Technology (NYSE: IGT  ) , a leader in the industry with over $2 billion in 2012 revenues, is positioned nicely thanks to its experience with DoubleDown Casino. DoubleDown, a $700 million corporate acquisition made in 2012, is the company's popular online social gaming venue.

International Game's social gambling business is booming. Sales more than doubled in its latest quarter versus the prior year. The growth driven by an increased average take from a growing Daily Average User, or DAU, base. DAUs were a substantial 1.7 million, an increase of 25% over 2012 volumes.

The company also has other attractive attributes, which were well explained by CEO Patti Hart in this recent interview with CNBC celebrity analyst Jim Cramer.

International Game shares look reasonably priced. Using a cash earnings times a capitalization multiplier valuation method, the company's fair business value looks to be around $22 a share (assuming revenues of $2.3 billion and $368 million in cash earnings at a 16% profit margin and an industry average 16 times multiple).

Bally Technologies (NYSE: BYI  ) is another well-respected casino equipment maker. The company already has online capability with its server product, which allows access to an entire library of games and currently operates on eight portals and 16 sites in Europe. Bally is looking for additional advantages from its $1.3 billion acquisition of SHFL entertainment, a well-known provider of automatic card shufflers.

SHFL's lesser-known electronic table systems business could provide Bally with interesting opportunities. The most innovative might be an electronic betting interface that lets gamblers interact with a live dealer and live cards or a live wheel. This provides a "real" casino feel with the convenience of Internet access. For markets where live table games are not permitted, SHFL also offers products that feature a virtual dealer.

The stock market seems to be pricing Bally a bit optimistically given its reasonable fair value of roughly $70 per share. The figure is based on a standard multiple of 16 times earnings of around $176 million, on sales of $997 million and a 17.7% profit margin. One might also want to be somewhat cautious given that the company seemed to pay a hefty price for SHFL--nearly 28 times estimated cash earnings of $46 million delivered at a 15.5% margin.

Scientific Games (NASDAQ: SGMS  ) might be the most interesting equipment vendor. Known mostly as a leading supplier of lottery equipment and systems, the company has been expanding into video gaming. Growing as a supplier of gambling content and systems to operators in the U.K. and continental Europe, it acquired Parspro.com for about $12 million in mid-2012. Parspro gives Scientific Games access to sports betting systems delivered through the internet.

The company's biggest play seems to be its acquisition of longtime casino equipment vendor WMS Industries. This $1.5 billion purchase provides access into the heart of the gaming industry. One of the deal's benefits is an interactive product called Play4Fun Network that seamlessly links players online to a casino's land-based games. A more lucrative prize might be WMS' Jackpot Party Social Casino, a social gaming site available through mobile devices. WMS' growth in social gaming has been impressive, with Jackpot Party Social Casino's DAUs increasing over 35% sequentially thus far in the September quarter.

Scientific Games' buyout of WMS looks like it could pay off for shareholders. Based on a combined pro forma estimate, including higher debt interest expenses and some synergistic savings, Scientific Games' reasonable business value looks to be around $30 a share. This assumes the standard 16 times multiple, with expected revenues of $1.63 billion and $160 million in cash earnings at a 9.8% profit margin.

One needs to tread cautiously, however. The potential upside is tempered by a significant risk from the $1.5 billion WMS deal price placed atop an already high debt load. In most cases, it would be prudent to pass on this kind of leverage. But the participation of Ronald Perelman gives some comfort. Though not as well known as some of his 1980's raider peers, Mr. Perelman has shown an adroit ability to manage high debt situations successfully. His 38% stake in Scientific Games and Board of Directors seat diminishes my debt-level anxiety somewhat.

Online gaming will likely become very popular. As the industry is getting ready to take advantage of the new trend, investors may also want to position themselves in companies that could offer a good chance to profit from this new market. Casinos seem an obvious choice but other ancillary players, like equipment vendors, might be an equally worthy consideration.

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