The Best Way to Invest in the Global Gambling Surge

Back in January, I highlighted that state and local governments were starting to turn to legalizing gambling to shore up their tax bases. Since then, the activity has only increased. Massachusetts recently held a forum to hear arguments on why it should develop casinos, and Maryland set up a commission to investigate whether it should expand its gaming operations.

Gaming activity continues to heat up in the United States, but is already red hot overseas. The Chinese province of Macao has grown much larger than Las Vegas as the world’s largest gambling destination. Last year, Macao reported an estimated $33.5 billion in revenue, or five times that on the Las Vegas Strip. Las Vegas-based operators are leading the charge into these markets. MGM Resorts (NYSE: MGM), one of the largest casino operators in the world, has turned to Macao and just reported 17% sales growth to HK$ 5.5 billion, or about $708 million.

In the article, I also pointed out that the leading gaming suppliers are a great way to gain exposure to the global gaming build-out. Casinos must spend billions of dollars building casinos and also take the risk that goes with running slot machines and table games. The suppliers simply sell the games to the casinos, though in some cases they also get a percentage of the winnings.

One of my picks was WMS Industries (NYSE: WMS). I am happy to report its stock has rallied modestly so far in 2012. The stock should have plenty room to run further.

WMS designs and distributes some of the most popular games in the industry. These include slot machine names such as “Monopoly,” “The Wizard of Oz,” “The Lord of the Rings” and “Battleship.” WMS considers itself one of the pioneers in helping casinos roll out video game machines that offer a dizzying array of winning combinations. The technologies are also very advanced and allow a casino to track usage in real time and make changes to keep the gambling dollars coming in.

Last year, WMS generated total revenue of $783.3 million. This represents a 45% jump from $539.8 million five years ago. Prior to the credit crisis, gambling was thought to be recession-resistant, but total industry revenue plummeted along with rising unemployment. However, WMS experienced steady sales growth, which speaks to a benefit of the gaming suppliers. Regardless of total industry spend, casinos must maintain their games and strive to offer the most popular names out there.

Earnings growth has been more erratic at WMS. During the past couple of years, it has experienced a number of missteps in delivering games to customers in a timely manner. But it’s working through these operational issues and should start delivering steadier earnings growth going forward.

The potential for WMS to report steady sales and profit growth is there. Just a few years ago, growth was rapid. Sales rose steadily between 2005 and 2010, doubling from $388 million to $765 million, but the earnings growth was much more robust. During that time, profits more than quadrupled from $0.41 to $1.88 per share. Clearly, WMS is capable of boosting profitability while innovating and delivering games to casinos. It has also held up better than rivals in the current tough environment.
In the next few years, WMS sees a much stronger gaming replacement cycle coming from casinos operating in the United States and Canada. It also explicitly stated that new opportunities will stem from new domestic opportunities from state and local governments looking to shore up their tax revenue. They also see increased tourist activity from building attractive casinos and offering the most innovative, popular games as being a significant catalyst.

International markets are also a key growth component. Non-domestic sales grew to 38.6% of total sales last year, up from 35.4% in 2010. WMS expects robust growth in Asia, Latin America, as well as Mexico, Australia, and the United Kingdom. New growth and a similar trend to increase tax revenue will help overseas growth continue. 
Risks to Consider: Obtaining approval to open new casinos takes time and is subject to unpredictable political negotiating. The industry is also competitive, with large domestic rivals and international players rushing to develop their own, technologically-advanced and appealing games. WMS has proven it is a leader in the space, however, and there is a steady wave of new casino development taking place across the world.

Action to Take –> WMS trades at about 16.5 earnings expectations for this year. Its fiscal year end is fast approaching in June. Next year, analysts project $1.60 in earnings per share, which puts the forward price-to-earnings (P/E) ratio in more reasonable territory at 13. Consider WMS’ five-year average P/E of about 26 which reflects its rapid growth period of just a couple of years ago. The industry average is also high at about 19.

With a year or two of solid sales and profit growth, WMS’ earnings will undoubtedly expand. The earnings valuation could also return to the higher end of its average range of the past five years, perhaps as high as 20. It is also reasonable to assume WMS reports $2 in earnings within a couple of years.. Multiplying the two (20 x 2) gets us to a potential share price of $40, or close to double current levels. So while WMS has started to rally so far this year, I see plenty of room for upside by 2015.