New WMS Industries

The New WMS Industries

By Jeff Hwang
December 14, 2005

Ordinarily, I don't spend too much time giving serious investment consideration to second-best players. But in slot maker WMS Industries (NYSE: WMS), we have a compelling picture: WMS is positioned to capture significant new market share with new wide-area and local-area progressive participation slots and new products that now address 100% of the slot floor (instead of 35%), while benefiting from both the coming wave of industry expansion and the next slot replacement cycle.

At the same time, the stock has been beaten down in recent months, the company has initiated a $20 million share buyback program, and -- at its recent price of around $25 -- the stock trades at a reasonable discount to my approximation of fair value.

The new WMS
WMS Industries' turnaround story is for real. The company -- which had pioneered the increasingly prominent multi-line video slot machine -- took itself out of the game in 2001, when a software glitch that allowed slot players to cheat compromised the integrity of its product. As a result, WMS' market share of new game sales dropped from 18% prior to 2001 to roughly zero by 2003.

In 2002, leader International Game Technology (NYSE: IGT) commanded more than 70% of new slot sales, while rivals Alliance Gaming (NYSE: AGI) and Australia's Aristocrat accounted for less than a 15% share each.

But in 2003, WMS returned with a new operating system and a next-generation slot cabinet code-named Bluebird that featured a high-resolution LCD monitor and Bose speakers, helping to spark replacement sales as well as regain lost market share. In addition to the new cabinets, a new premium-priced, dual-screen version of them has also contributed to rising average selling prices.

The average selling price of new slots has increased from $8,813 per machine in fiscal 2004 to $10,250 in fiscal 2005, and to $11,309 in the most recent quarter.

And in 2004, the company launched its first line of mechanical reel games (45% of the typical slot floor) and video poker machines (15% of the slot floor), as well as its first wide-area progressive (WAP) slots. As a result, the very fact that WMS Industries now addresses 100% of the slot floor -- and has an attractive game portfolio -- positions it to gain significant market share.

WMS snapshot

Fiscal year ended June 30
2003 2004 2005

Total revenues
$179M $230M $388M

Product revenues
$86M $146M $279M

Gaming revenues

$93M $84M $110M

Gross profit
$106M $128M $196M

Operating income
($18M) ($2M) $31M

Net income
($8M) ($1M) $21M

New slot units sold
6,867 12,661 22,784

Average selling price
$8,318 $8,813 $10,25

Participation slot base*

5,086 4,240 6,539

Win per day per machine
$39.19 $39.60 $47.31
*at year-end

Market position
The company's goal is to establish itself as the clear No. 2 player in the game behind International Game Technology, or IGT. In my opinion, WMS Industries will have no problem doing so.

The company's bread and butter remains the multi-line video slot. And as discussed with Motley Fool Hidden Gems selection Ameristar Casinos (Nasdaq: ASCA), ticket-in/ticket-out capability has helped drive demand and profitability of penny slots, making WMS' video slots increasingly relevant. Both Alliance Gaming and GTECH Holdings' (NYSE: GTK) Atronic are smaller players in this space. And while Aristocrat is a significant player, I really don't get the appeal of its games at all (just a personal take -- the games are apparently very popular).

Now let's take a look at some of the newer stuff.

Wide-area progressives and local-area progressives
The most significant of the company's new products are its higher-yielding wide-area (WAP) and local-area (LAP) progressive slots. These progressive slots put a portion of each wager into a jackpot that can grow very large over time. With a dual-screen version of the Bluebird cabinet, these include video games based on Monopoly and Hollywood Squares, as well as a Clint Eastwood game. The Jackpot Party is an LAP game based on a standard video slot game, but with a communal four-stage bonus round.

IGT, Aristocrat, and Atronic all have variations of the same communal multilevel bonus.

While participation slots make up a relatively small portion of the slot floor, the effect on the slot manufacturer's bottom line is relatively huge because the manufacturer gets revenue by taking a piece of the action.

WMS' installed base of participation slots had increased 54% to 6,539 machines by the end of fiscal 2005 (June 30), up from 4,240 machines at the end of fiscal 2004. Over the same period, gaming revenues jumped 43% to $110 million. Meanwhile, the win per day, per machine rose from $39.60 to $47.31, thanks largely to the WAP and LAP games.

The winper day, per machine rate increased to $50.62 in the first quarter, ended Sept. 30, as WAP and LAP games made up 19% of the company's installed base of participation slots, up from 14% at the end of the fourth quarter.

WMS expects the installed base of participation slots to rise to 8,100 to 8,300 by the end of June 2006, with the win per day, per machine coming in at $53 to $56 for the fiscal year. By comparison, at the end of the last quarter, IGT had an installed base of 38,800 recurring revenue machines yielding $87 per day, reflecting its massive WAP jackpots that routinely reach hundreds of millions of dollars.

That's something for WMS to shoot for.

Video poker
In July 2004, WMS introduced its first video poker product, entitled 3 Way Action Poker. Don't expect the game to make much of a dent in IGT's video poker crown.

But WMS' newest video poker product -- carrying Harrah's (NYSE: HET) World Series of Poker brand -- is certain to gain at least some share in this area by virtue of Harrah's owning and operating more than 40 casinos. That virtually everybody else is competing against Harrah's may also limit the upside; but then again, anything is upside from zero. Currently, IGT is the default video poker slot manufacturer, and incidentally, has licensed WPT Enterprises' (Nasdaq: WPTE) rival World Poker Tour brand.

On the flip side, I'd be willing to bet that IGT's WPT-branded game is one game that you probably won't find in a Harrah's casino.

Mechanical reels
Mechanical reel games represent another significant opportunity to gain share. However, I'm less enthusiastic about WMS' prospects here because IGT is far and away the leader in this category, and I believe Alliance Gaming to be the superior competitor. But again, any gain here is an increase from zero.

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.

	WMS	IGT
Market cap	$800M	$10B
TTM revenues	$417.7M	$2.38B
Operating margin	10.1%	28.3%
New units sold - North America (MRQ)	4,782	10,200
New units sold - International (MRQ)	473	29,700
Average selling price (MRQ)	$11,309	$7,500*
Participation slot base (MRQ)**	6,787	38,800
Win per day per machine (MRQ)	$51	$87