A Slots Jackpot?

In Part 1, we took a look at the new WMSIndustries (NYSE:WMS). Since its two-year hiatus from the game that ended in 2003, the slot maker and multi-line video-slot pioneer is coming back and is poised to gain significant market share with new products for every area of the slot floor, rather than 35%. In addition, the company will benefit from industry expansion -- both domestic and international -- as well as the next slot replacement cycle.

Expansion and replacement
Last month, we discussed slot king International Game Technology (NYSE:IGT) and its prospects of benefiting from expansion in the industry past fiscal 2006, as well as a new slot replacement cycle featuring server-based gaming about two years later.

Both of these trends also apply to WMS Industries.

Last week, Florida legislators passed a bill that will allow four parimutuel betting facilities in Broward County -- one will be owned by Isle of Capri (NASDAQ:ISLE) and one by Magna Entertainment (NASDAQ:MECA) -- to house 1,500 Class III (Las Vegas-style) slots each by next summer. That by itself is 6,000 new machines for WMS to compete for. But in addition, that bill means that the Indian-owned casinos already active in Florida will be allowed Class III machines, as opposed to the Class II "bingo" or "virtual lottery terminal (VLT)" machines in play.

It could be that another 4,300 machines will be replaced at the two Hard Rock casinos in Florida alone, plus a couple of thousand machines at the other much smaller facilities in the state.

Slots in Pennsylvania -- where casino operators such as Harrah's Entertainment (NYSE:HET), Penn National (NASDAQ:PENN), and Boyd Gaming (NYSE:BYD) are either in or are trying to get in -- are expected to come online by 2007. That means another 37,000 new slots over the next couple of years at seven racetracks, five slot parlors, and two resorts, with the possibility of another 24,000 slots soon after (though I don't see that as likely).

Add in a pair of large racinos in New York and the rebuilding of the casinos along the Mississippi Gulf Coast, plus opportunities in Maine and maybe Maryland and California over the next few years, and you can see that the recent lull in domestic expansion is temporary.

International growth also represents a tremendous opportunity for WMS Industries, primarily in Russia, Macau, and the United Kingdom. Of its new slot sales in fiscal 2005 ended June 30, 32% were to countries outside North America, and the company expects that to be the case going forward. WMS also sees sales to the red-hot Russian market picking up after the new year.

And in 2008, the industry expects server-based gaming to spark the next replacement cycle; WMS stands to be a leader on this front as well.

A beaten-down stock
In all, WMS Industries' efforts are reflected in the results thus far. After two years of showing losses, WMS returned to a profit in a big way in fiscal 2005. Revenues climbed 69% to $288 million, helping the company post a $31 million operating profit and a $21 million net profit. While a big part of that year-over-year increase in revenues is due to pent-up replacement demand of the company's old legacy machines, I think investors can expect rapid profit growth to continue.

The stock has been hit hard because of the hurricanes that slammed the Mississippi Gulf Coast and New Orleans; it has fallen from the mid-$30s in July to the low $20s after WMS's first-quarter report at the beginning of November. Not only did WMS lose both slot sales and gaming business, but it also lost participation revenue, which is 40% higher in Louisiana and Mississippi than the company's overall average.

As a result, WMS ratcheted down its expectations for the year, reducing revenue guidance by 3%. Still, the company expects fiscal 2006 revenues to rise to $460 million to $480 million from $388 million last year, for a gain of 18.6% to 23.7%. It also expects new unit shipments of 23,500 to 25,000, up slightly from 22,784 last year, with the average selling price rising to more than $11,000 from $10,250. Meanwhile, the installed base of participation slots is expected to rise 23.9% to 27% to between 8,100 and 8,300 units, with revenue per day per machine coming in at $53 to $56, up from $47.31 last year.

A reasonable price
The analyst estimate calls for earnings of $0.99 per share for fiscal 2006, growing to $1.33 in fiscal 2007 and showing five-year compound annual growth of 20%. That puts the stock at around 25 times this year's earnings and 19 times next year's earnings, which I think is moderate for a company in this position.

WMS Industries has a solid balance sheet with $37 million in cash, no long-term debt, and $115 million in convertible debt.

My fair value estimate is about $28 to $30 per share with some upside, which mostly depends on how much new market share WMS takes and how fast and wide margins grow. From the table below, you can see that International Game Technology's operating margin over the past 12 months was a healthy 28.3%, compared with WMS's 10.1% margin. And because WMS is still early in its new growth phase, it is natural to expect margins to expand rapidly as the company scales. While I don't expect WMS to approach 28.3% any time soon -- if at all -- that figure is a good proxy as to how scalable a business this can be.

Overall, I still believe IGT is the surer bet as the industry's best player, but WMS has more room to grow. And at around $25, I think WMS is reasonably priced for a buy.

MRQ: most recent quarter.

*The average selling price in North America was $15,800, while internationally it was $4,700.

**At period end.

For more commentary on slots by Jeff Hwang, check out:

• IGT: Time to Buy?
• The Magnitude of Pennsylvania's Slots
• Those Pennies Add Up

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Fool contributor Jeff Hwang owns shares of WMS Industries and International Game Technology. The Motley Fool has a disclosure policy.