Scientific Games makes gambling machines, among other things. Photo: Aaron, Flickr
You know about socially responsible investing (SRI), where investors steer clear of certain industries – for example, guns, alcohol, tobacco, gambling, military equipment, and prisons -- on principle, objecting to their role in society. But have you thought of investing in these industries on purpose, and adding a sin stock or two to your portfolio? If so, you might want to consider Scientific Games Corp (LNW -0.10%), a technology company providing products and services to the lottery and gambling industries.
It's not such a crazy idea, as long as your values permit it. The USA Mutuals Barrier Investor (VICEX) mutual fund, for example, focuses its assets solely on "sin" stocks, and has outperformed the S&P 500 over the past five and 10 years (though it lags it a bit over the past three).
Why might you buy Scientific Games Corp?
What, exactly, does Scientific Games provide to its customers? In its own words: "instant and draw-based lottery games; electronic gaming machines and game content; server-based lottery and gaming systems; sports betting technology; loyalty and rewards programs; and social, mobile and interactive content and services." Got that? It's not a huge company, with its market capitalization recently approaching $800 million.
You might consider investing in it because of that relatively small size, since smaller companies are able to grow more briskly than big companies, if they execute well. Indeed, revenue has generally been growing steadily over the past decade, peaking over the past 12 months at $1.4 billion. Meanwhile, gross margins have been growing, though net margins remain negative. The company's share count has been falling, which is generally a good thing, boosting the value of remaining shares for shareholders -- but remember that a falling share count can also make earnings per share look better, too.
Scientific Games acquired WMS Industries last year, and expected the purchase to deliver annual savings of $100 million by 2015. The progress of the integration of WMS is worth watching, as that kind of savings can make a huge difference to Scientific Games's bottom line. Meanwhile, the company has racked up some valuable contracts, such as a three-year one with La Francaise des Jeux, the operator of the French Lottery and the world's second-largest instant lottery. It has a licensing arrangement with toy and game specialist Hasbro, too, and contracts with various states, such as a six-year contract to supply instant games for the state of Washington and a three-year contract extension with Delaware.
The stock's valuation is also intriguing, as it recently sported a price-to-sales ratio of 0.6, below its five-year average of 1.1, and a price-to-cash-flow ratio of 3.9, vs. its five-year average of 6.2. A seemingly low valuation isn't sufficient for an investment decision, though. Great bargains aren't the only stocks that sport low valuation ratios, a company going out of business can look appealing on a valuation basis, too, for a while.
Why might you steer clear of Scientific Games Corp?
You might be interested in Scientific Games for its growth potential as a smallish company, but longtime shareholders would point to a dearth of growth in their shares' value. The company's stock has averaged annual losses of 3% over the past 20 years (but average annual gains of 9% over the past 15), and has been sliced roughly in half over the past year. If you're uncomfortable with volatility, this may not be the stock for you.
In its last quarter, reported on October 30, Scientific Games posted a 77% jump in revenue, thanks to contributions from WMS, along with a quintupling of operating income and sizable increases in cash and free cash flow. The bottom line was still in the red, though, with a net loss of $70 million, in part due to increased interest expense.
Dividend-lovers might want to look elsewhere, too, as the stock offers no payout. That's not unusual for small companies and those that aim to grow rapidly, as they need to funnel all excess cash into furthering their growth. Scientific Games does sport a growing top line, but its net income has been in the red for about five years. It does have positive free cash flow, but that cash flow has been shrinking in recent years.
And here's a definite red flag: lots of debt. Long-term debt has ballooned from $1.5 billion in 2012 to $3.2 billion in mid-2014. Considering that the company has relatively little cash and equivalents and is not generating much free cash flow, a heavy debt burden is a big concern. The situation may get more pronounced, too, as Scientific Games is angling to buy Bally Technologies for about $5 billion.
Overall, this gambling stock looks like too much of a gamble for most investors. Ideally, we should seek out companies with both top and bottom lines growing, and with healthy balance sheets. This sin stock might do well in the long run, but as of right now it looks quite risky.
