With their flashing lights, ringing bells, video displays, and multi-stage jackpots, slot machines are both the decor and the ambience of a casino. WMS Industries (NYSE: WMS), first known as a developer of video, pinball, and arcade games before deciding to focus exclusively on slots -- is one of the leading slot manufacturers around.

That said, though the Foolish 8 screen occasionally turns up companies in the gaming sector -- revealing leader Anchor Gaming (Nasdaq: SLOT) and others in the past -- WMS was only recently "discovered." Still, WMS -- whose Monopoly-themed games were among the first and biggest challengers to Anchor's powerhouse Wheel of Fortune slots -- is worth a look.

It's been some time since Fool gaming maven Paul Larson marked the company as a potential "future leader" in our Industry Focus 1999 research publication. Since then, the company has performed well on several fronts, with recent income statements providing several clues. Over the last two fiscal years (ended June 30), WMS has seen gross margins skyrocket as it has ridden Monopoly into lucrative new territory.

WMS counts on its ability to take a strong license and spin an engaging, popular game off of it, making its machines "must-plays" in casinos. When a game is successful, it pays off in spades because it can distribute more slots through so-called "participation and lease," or P&L, arrangements, rather than straight sales. What this means to WMS is hardly small change.

P&L deals provide an annuity of lease revenue to go along with a cut of the machines' take, and the margins are substantially better than sales margins: In fiscal 2000, gross margins from machine sales were 42%, compared with 88% from P&L. For the first nine months of the current year, the numbers were 44% and 86%, respectively. Now THOSE are some margins!

The challenge now is for the company to continue growing P&L as a percentage of total sales, in order to send more dollars toward the bottom line. P&L sales made up 32.4% of total revenues in the first three quarters of the current fiscal year, continuing a promising trend: P&L made up only 14% of sales in fiscal 1998. The more that balance shifts toward P&L, the better WMS' income statements stand to look.

It's worth noting, however, that increased P&L revenues can lessen one of the traditional strengths of the business: Slot makers have historically been somewhat protected from the effect of casino oversupply because once a machine is sold, it's sold. P&L arrangements, meanwhile, tie a company's performance more closely to a casino's.

On the other hand, since WMS has also reported rising average selling prices for slots in recent years, it may be a wash. And P&L arrangements also help protect the company when casino building slows. In the end, the company seems well positioned either way.

The opportunity for WMS to continue moving toward "future leader" status, as Paul mentioned, seems greater now than ever, especially with many casinos looking to update machinery purchased in the early and mid- 1990s. If there's a machine a casino wants, chances are good that WMS makes it:

  • It's well stocked in "video slots," which dominate casino floors today and are the evolved form of the traditional "spinning reel" machines that conjure up images of cherries and 7s;
  • It has continually rolled out multi-stage games, which allow players to use more coins, play "games within games," and proffer higher jackpots; and
  • It recently filled one of the supposed "holes" in its lineup, signing up to market games based on the Survivor TV series that will be distributed by International Gaming Technology's (NYSE: IGT) "wide-area, progressive-linked jackpot system" that allows jackpots to accrue over several machines and casinos -- the first such offering from WMS.

While Survivor might not have the same staying power as Monopoly or Wheel or Fortune -- though it might, in time, God help us -- that the company would acquire such a license highlights the premium WMS puts on acquiring well-known, high-profile media and other names around which it can develop games. In 2001 alone, the company has secured the rights to Hollywood Squares -- Whoopi Goldberg will star -- and Pac-Man. It's also still warming up the potential of its "Puzzle Pays" line, which already features games based on Scrabble and Jumble. More are on the way.

In sum, WMS looks like a company that's capable of rewarding long-term investors with steady profit growth over time. Its balance sheet looks solid, with nearly $90 million in cash and short-term investments as of March 31, and no debt to speak of.

Whether the company presents a bargain at today's prices is another story. Using a simple projection, it seems that it may be fairly valued today -- but if its new games continue to sell well and WMS can thus command higher valuation multiples, that story could change.

Using MarketGuide financial data for the past 12 months and recent full fiscal years, and assuming a five-year time horizon, we can illustrate that point using different assumptions. We'll start by assuming revenue growth of 20% and starting sales of $266 million, operating margins of 25%, a standard 37% tax rate, and share dilution of 5%. (That gives us year-five revenues of about $662 million.)

P/E           10x   20x   30x
Share Price*  $26    52    79
CAGR           -3%   12%   21%
*Starting share price: $30

In other words, given the above assumptions -- reasonable, if optimistic, given WMS' recent operating history -- we'd need to see significant multiple expansion if we hope to beat the S&P 500's historical return by a good margin.

If we tinker with those numbers, we can see both the potential and fallibility of models like these, as making only slight changes can really change the outlook: Something as simple as upping the revenue growth figure to 25% has the following effect:

P/E           10x   20x   30x

----------------------------- Share Price* $32 65 97 CAGR 2% 17% 26% *Starting share price: $30

Even understanding that, however, we're not quite ready to act. WMS' operating history just doesn't give us the luxury of being able to project stable, steady growth into the future with any certainty. Consider that it was unprofitable just a few years ago -- and has lately seen revenues skyrocket, from less than $60 million during the year ended June 1998 to nearly $200 million in the most recent nine-month period ALONE. Add to that the fact that WMS operates in a cyclical, competitive business industry and there's even more reason for caution.

This shouldn't scare you off WMS, nor should it leave you wary of trying to forecast growth when trying to decide how much you should pay for a particular stock. (There are plenty of other ways to value shares than the very simple one above.) Quite the contrary: By understanding the limitations of projections and valuation models -- and the importance of considering a number of different potential outcomes -- an investor should feel better equipped to make decisions.

Dave Marino-Nachison is doing fine on level nine. His stock holdings can be viewed online, as can The Motley Fool's disclosure policy