Striking It Rich With Gaming Stocks

High-tech slot machine makers stand to benefit from a new upgrade cycle.

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One of the hottest bets in Las Vegas right now is on the companies behind the scenes—specifically, the companies behind the slot machines. These gaming equipment manufacturers are even more resistant to economic downturns than casinos. "Slot machines aren't driven by the economy. They're driven by replacement cycles and technology," says Charles Norton, manager of the Vice Fund, which recently had more than a quarter of its assets invested in the gambling industry. "And we're about a year out from a monster slot-replacement cycle."

Today's slot machines—which bring in the lion's share of casino gambling revenue—are a far cry from the old clunky metallic boxes with spinning reels. The technology is evolving rapidly: Some of the newest machines, which feature flat-panel screens and surround sound, more closely resemble video games than slots.

The move to cashless gambling earlier this decade fueled the last major replacement cycle, boosting earnings and revenue growth for gaming equipment makers. The next big thing is server-based technology, which will allow casinos to link all slot machines on the floor and control their games, payouts, and promotions from one computer.

"Casinos have even been putting off replacements because they're waiting for this new technology to be put into play," says Dan Ahrens, manager of the Ladenburg Thalmann Gaming and Casino fund. Server-based gaming should begin to take hold in 2009, adds Norton, and the new technology will serve as an earnings catalyst for several years out.

Another trend that bodes well for makers of gaming equipment: More states are warming to the idea of gambling within their borders as a source of additional tax revenue. For example, California and Florida passed referendums that would add up to 23,000 slot machines in those states. Here are two slot manufacturers to consider:

International Gaming Technologies. Although this Reno, Nev.-based slot-machine giant isn't expected to roll out its complete system of server-based machines until 2009, the company is about to get a taste of what's to come. Last week, news broke that Harrah's Entertainment, the world's largest casino operator, plans to install more than 60,000 IGT server-based LCD machines in its casinos. These touch-screen LCD displays attach to slot machines and link to a network that tracks play, advertises promotions, and dispenses rewards.

The deal is not only a powerful marketing tool for IGT, writes Wachovia analyst Brian McGill, but a "strong testament that Harrah's is heading down the path on server-based gaming.... If the technology does prove to be successful, it should drive other casino operators to adopt it or be at a competitive disadvantage."

The $14.5 billion company, which controls 70 percent of the North American slot-machine market, is also expanding in Macao and elsewhere in the Far East. McGill sees strong earnings growth for IGT over the next few years and thinks the company's shares (symbol IGT), recently $47, could reach $54 within 12 months.

WMS. Server-based gaming should also provide plenty of growth opportunities for a smaller maker of slot machines and other casino games, WMS Industries. Despite slowing revenues from U.S. slots, the $2 billion company reported strong performance in the first half of its fiscal 2008 year, thanks to international sales and the growing popularity of WMS's new immersive games that use high-definition displays. "Management has done an outstanding job in growing revenues and improving margins during a tough period," wrote Stifel Nicolaus analyst Steven Wieczynski in a recent note to clients. "We feel once the domestic slot market turns, WMS should be well positioned."

In early February, WMS lifted its full-year revenue forecast to between $620 million and $632 million, up from a previous range of $595 million to $615 million. That represents sales growth of 11 percent to 13 percent in the second half of WMS's fiscal 2008 year, which runs through June. "We continue to believe that WMS should generate positive momentum over the next 12 months due to the company's innovative product pipeline and cutting-edge games, which should allow the company to continue to gain market share," wrote Wieczynski, who raised his price target from $40 to $42. The shares (symbol WMS) recently traded at $40.