Jeff Hwang's Favorite Gaming Stocks

Motley Fool gaming analyst Jeff Hwang knows casinos inside and out (he also plays a mean game of hold'em). I interviewed Jeff to get his thoughts on the past year and learn about his favorite gaming stocks for 2007.

Joey Khattab: There have been many surprises this year in gaming, including a bidding war for Aztar, Congress' legislation to curtail online gambling, and a private equity offer for Harrah's (NYSE: HET  ) . Jeff, what's been the biggest surprise for you?

Jeff Hwang: Clearly, the proposed buyout of Harrah's would be the biggest surprise, as that one came out of left field. As far as Aztar, it was a given that there would be several players -- namely Ameristar Casinos (Nasdaq: ASCA  ) and Pinnacle Entertainment (NYSE: PNK  ) -- interested in entering the Las Vegas Strip, and Aztar with its Tropicana property was a natural target. And as strange and ineffective as I think Congress' legislation regarding online gaming will be, at least we had warning that it was coming.

JK: Casino stocks saw some weakness in the summer but have since rebounded. What was the cause of this weakness?

JH: In a word, shortsightedness. High gas prices and a run of earnings misses probably contributed as well.

JK: If you had to pick one casino stock that's a good investment for 2007, what would it be?

JH: None. As we noted as second-quarter earnings were being released, casino stocks in general became dirt cheap. Since then, casino stocks as a group have been on a tear, fueled in a large part by the takeover bids for Harrah's and Station Casinos (Nasdaq: STN  ) . Ameristar Casinos (Nasdaq: ASCA  ) , for another, has nearly doubled off its lows. I would say that casino stocks as a group are pushing fair value. Value investors don't pay 100 cents for a dollar when we can buy one for 60.

Which isn't to say there aren't other opportunities in gaming out there. In fact, there are a couple of international plays that I've picked up within the past month that I'm quite excited about.

The first is U.K.-based e-wallet company Neteller (LSE: NLR.L  ) , which got hammered along with the other online gaming stocks when Congress passed the Unlawful Internet Gambling Enforcement Act in October, and is now dirt cheap. The company counts, I think, 80% of online gaming sites as its merchants and reminds me a lot of a company I bought a chunk of shares in almost five years ago called PayPal, which got acquired by eBay (Nasdaq: EBAY  ) not long after going public.

But right now, Neteller carries about a $350 million market cap. However, the company has $199 million in cash on its balance sheet and pulled in $80 million through three quarters this year. The company has the current quarter and the next two quarters until Congress will have enforcement rules in place, and I expect that these three quarters will be the best in the company's history. After that, consider that 33% of new customers in the third quarter came from outside of the United States, and 23% of the company's 619,550 active users in the third quarter came from outside of the U.S.

The point is this: Assuming even just zero-to-marginal growth and keeping G&A costs constant at about $40 million annually, we can subtract 77% of Neteller's $250 million-plus in annual revenue and reduce gross margins to 70% (from 71.8% for the first three quarters), and the company would still be operating at breakeven or better. Never mind that revenues climbed 48% in the third quarter and 9% sequentially. Neteller simply has a phenomenal business, and online gaming firms are counting on Neteller's ability to penetrate the Asian markets as the key to driving industry growth in that part of the world.

The company stands to lose a significant chunk of its business, but the stock price at this price is offering a nice head start.

The other play is a Japanese company that I can't really talk about at the moment, because my colleague Nate Parmelee -- who had spent some time working in Japan -- just made it the Wild Card for the January issue of Motley Fool Global Gains, our international newsletter. It's kind of a funny story, really. I was just in Japan in early November when I stumbled upon the company at what I think just happens to be an extremely good time to buy the stock, and I found out that Nate happened to be looking pretty hard at the company for the newsletter. Anyway, I had read through six years of annual reports, and I bought the stock within a week. We'll probably talk about it at some point, but for now you'll just have to get a free trial of Global Gains to read about it.

JK: 2007 looks like a big year for slot makers IGT (NYSE: IGT  ) and WMS (NYSE: WMS  ) as they replace older machines with new technologies. What's your outlook for the slot makers?

JH: The story for 2007 is really that the domestic slot market will see some expansion with the slot parlors and racinos in Pennsylvania coming online, along with the introduction of slot machines at the four pari-mutuels in Broward County, Florida -- two of which are already open. It's also possible that the Seminoles in Florida will replace their Class II machines to Class III machines this year, as technically the Seminoles should be entitled to Class III machines if it's legal elsewhere in Florida. We may also see server-based gaming come online later this year. I think both IGT and WMS are in great shape for the long haul, and I'm comfortable holding both of them. I wouldn't buy either of them at current prices, however.

For more gaming coverage:

Ameristar is aHidden Gemsrecommendation, and eBay is aStock Advisorrecommendation.

Fool contributor Jeff Hwang owns shares of Ameristar Casinos, eBay, Neteller, International Game Technology, and WMS Industries. Gaming editor Joey Khattab does not own any of the shares mentioned.


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