Today's Short Opportunity: Bally Technologies

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You know that pair of rose-tinted glasses you own? That glass of water that always seems to look half-full? Chuck 'em. Roll up your sleeves and grab yourself a magnifying glass, because we're bringing you our first 11 o'clock short recommendation.

Finding the market's best short opportunities requires you to look at the world a bit differently. It doesn't mean you have to have a pessimistic or even a cynical perspective on things -- just a critical one. That's something I've learned so far working with John Del Vecchio, who's heading up our new Big Short service launching in September.

John is full of great lessons, and great short ideas -- which brings me to my pick today. There are plenty of reasons to short a stock, but seldom do you come across a business that operates in a struggling industry, is flashing some serious financial red flags, yet remains priced as if times were still golden. I see all these things right now in Bally Technologies (NYSE: BYI).

Bally Technologies fast facts

Source: Capital IQ, a division of Standard & Poor's.

An industry that's crapping out
Bally's builds and sells slot machines, video machines, lottery systems, and casino management systems, mostly to casinos in the United States. It has been in business for more than 40 years -- a good time to be in the gambling business, considering the tremendous expansion of state-run and Native American-owned casinos across the U.S. over that period.

But business couldn't be worse for the gambling industry right now. After hitting a peak of $34.1 billion in 2007, just before the onset of the financial crisis, gross gambling revenue for U.S. casinos -- the amount wagered minus winnings returned to customers -- has steadily declined.

Source: American Gaming Association.

No surprise, right? After all, we're in the middle of a terrible recession. The economy stinks. Unemployment is high. But it will bounce back. People love to gamble.

Ask yourself this: How much of the secular growth in the gaming business over the past several decades was fueled in part by the enormous expansion in consumer credit and housing prices? Las Vegas is sometimes referred to as the City of Lost Wages, but it wasn't just household income that kept the betting tables flush in recent years. Home equity loans and credit cards financed their fair share of trips to Vegas and other gambling hotspots.

A protracted period of tighter credit, lower home prices, and dare I say, higher consumer savings rates, could delay gambling's revival for years, if not decades.

That doesn't bode well for slot makers such as Bally. Hotel and casino developers will be hesitant to invest in new projects, and you can bet they'll try and squeeze every last nickel out of each gaming machine at their existing casinos before they have to junk them and replace them with newer models.

We're already seeing this trend play out for many of the industry's biggest casino operators:

Rolling snake eyes
If these secular headwinds weren't enough, Bally's latest results suggest that it's facing a potentially serious near-term slowdown in its revenue -- something that I don't think has been adequately reflected in the stock, or in the company's full-year earnings guidance.

Let's start with Bally's inventories.

Source: Capital IQ, a division of Standard & Poor's, and company filings. Revenue from the discontinued casino operations segment has been excluded. Numbers in millions.

Normally, this would appear to be a positive trend. Inventory is declining faster than revenue, suggesting a positive sell-through for Bally's products. That generates cash and helps avoid potentially expensive inventory write-downs.

But Bally uses a build-to-order model approach to most of its manufacturing, meaning that it waits for a confirmed order before it makes and delivers the product. Inventory in the build-to-order business can therefore be a useful proxy for new orders.

In the most recent quarter, Bally's inventories hit their lowest level since the fourth quarter of 2003. That low inventory number in 2003 foreshadowed a sharp slowdown in Bally's sales, beginning in 2004 and running through 2005.

Another sign of a potential revenue slowdown can be seen in Bally's deferred (or unearned) revenue -- cash that has been paid to Bally before it delivers the product. Like Bally's inventory line, deferred revenue is a good indicator of new orders.

Source: Capital IQ, a division of Standard & Poor's, and company filings. Revenue from the discontinued casino operations segment has been excluded. Numbers in millions.

Bally's deferred revenue has trended sharply lower in recent quarters, yet another sign that customers are slashing or delaying new orders.

Still, despite inventory down 19% and deferred revenue down a staggering 31%, Bally's revenue is virtually flat year over year. And most analysts are pegging Bally's revenue to actually climb 6% on average over the next 12 months, and nearly 12% for fiscal 2012.

I'm not much of a betting man, but given the trends I'm seeing in Bally's order volume, I'd wager some good coin on Bally's revenue falling short of those targets. It wouldn't surprise me at all to see Bally ratchet down its earnings guidance in the next quarter or so, especially if the economy remains sluggish and consumers keep spending more on food and diapers than they do on their gambling habit.

A pricey gamble
Still, Bally wouldn't make a great short candidate if I thought these problems were already sufficiently priced into its stock. Yet, as you are about to see, I don't think that's the case at all. In fact, Bally is actually more expensive than it was back during the economic go-go days of 2006 and early 2007.

Source: Capital IQ, a division of Standard & Poor's.

Now, you could argue that Bally's sales are depressed because of the recession, and that any measurable rebound (provided it doesn't also come with a higher stock price) would reduce that multiple. But Bally's stock price has more than doubled since hitting a low of around $13 in early 2009. I don't think that rise and today's price-to-sales multiple are justified, given the challenges still facing the gambling business, and the possibility of future revenue and earnings misses that Bally's order book suggests.

The bottom line
Investors betting on Bally Technologies today are gambling on a pricy stock with significant long-term and near-term challenges. In my opinion, the odds of a serious revenue miss over the next 12 months are higher than investors are currently anticipating in the stock price. That makes Bally a great short opportunity right now.

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