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An Investor's Lottery Ticket
04/23/2004 12:00 am EST
"Sales of lottery tickets around the world are estimated to top $160 billion in 2004; forty states currently sponsor lotteries and six more are edging closer to getting in the game," says Jon Markman, editor of the excellent StockTactics Advisor. Here's his top play.
"For investors, the curious thing about the lottery biz is that once
you peel back the glossy governmental layer it is virtually a duopoly, as
practically all games in this country are managed directly or indirectly by just
two companies: GTECH Holdings (GTK NYSE) and Scientific Games (SGMS NASDAQ). And it is even more curious that these
two mid-cap companies, while not wildly cheap at the moment, aren’t really
expensive, either. Each sports a forward price-to-earnings multiple of around
20. For GTECH, the larger of the two, that’s only about half again as big a
multiple as its estimated 12% to 15% growth rate, while for Scientific it’s
considerably less than its estimated 20% to 35% growth. It doesn’t take the
hyperactive imagination of a weekly Lotto punter to figure out that an
investment in either of these two companies is a lot smarter than playing the
"Scientific Games is interesting to us for a variety of reasons. First, it appears to be a good value despite its recent run-up from $2; second, it still seems misunderstood by the market; third, its growth prospects still appear bright; and fourth, it has significant moats around its business in the form of government contracts, intellectual property, and major market share. Here are several items I picked up after talking to chief executive Lorne Weill:
In 2003, the company bought a division of gaming devices giant International Gaming that doubled their revenue in the world of "online" games (like Powerball and Lotto.) IGT is mostly focused on branded slot machines, and picked up its lottery business as part of their Anchor Gaming acquisition. They weren’t running it with any passion, so there has been a lot of room for topline and bottomline growth simply by centralizing services.
SGMS recently won a contract to supply Italy with a national instant-ticket game. Italy previously had a $2 billion business in instant tickets, but it languished after a series of scandals. Weill is confident his company can get the numbers back to their prior level.
SGMS now has eight customers for 'cooperative' services. This means the company essentially takes over the business of running a state’s instant-ticket business. It develops new products, decides on price points, and handles all the retail sales.
New technology and equipment has allowed SGMS to push instant-ticket sales into vendors that were not previously able to handle them, and improve customer service at current vendors. This includes new ticket-dispensing machines that take all the guesswork and hand-work out of loading and unloading machines, counting inventory, etc.
In the United States, online lotteries generate $20 billion in sales and instant tickets generate $20 billion in sales. In Europe, the online business is $30 billion and instant tickets are just $4 billion. SGMS is now pushing its European initiatives and besides Italy has made headway in Spain and Germany. Weill says there are no cultural barriers to instant-ticket sales in Europe as France already has an instant business that is as developed as the US.
The US instant ticket business has been growing revenues 10% per year. In the lottery business, as your revenues grow your earnings grow faster because of the operating leverage (more sales spread out over same amount of infrastructure), so SGMS’ income is advancing about 20%.
The business is very recession resistant. Cash flow was steadily and increasingly positive throughout 2000-2003, including the recession, 9/11, and the Iraq war. Earnings have been up every quarter for eight years.
The company has significant opportunities in the growing new field of ‘racinos’, which are racetracks that have thousands of slot machines and video lottery terminals installed. They are generally run by state lottery systems, and have back-office systems very similar to the ones used by Scientific Games’ large pari-mutuel betting business. Weill says SGMS already has racino contracts in South Dakota, Quebec, and New Mexico, and notes it is high margin because it leverages existing expertise and equipment.
Debt on the books is easily covered by cash flow. About 90% of the company’s earnings come from medium- to long-term contracts, so there is a lot of predictability in its cash flow. It could probably even afford a higher level of debt if it found acquisition opportunities to pursue, but Weill says no major purchases are on the horizon for this year.
"In summary, we think that Scientific Games offers an unusually interesting combination of value and growth. It’s not affected by either recessions or, particularly, by economic growth, and is not over-owned in the institutional community."
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