IGT is a stock that is currently associated with many bad things – Italy, gaming and leverage.  Each of these associations has led to a material decline in the stock price despite an incredibly stable (80% recurring) and growing business that has been beating street expectations, coupled with an unbelievably attractive valuation.  We think we are at the inflection of a material increase in free cash flow which should lead to increasing capital returns over the next 6-18 months (on top of the current 4.5% dividend yield). As we will explain in this writeup, IGT is primarily a lottery business (60% of EBITDA), which is recession resistant, and its exposure to Italy should not be a material concern.  Furthermore, we think there is material upside to its slots business as well as call options on sports betting, Brazil lotto and Canadian VLT.  IGT trades at a fully taxed 14% FCF yield to the equity, 8% FCF yield to the enterprise value and 7x EBITDA (minority adjusted).  Our range of outcomes suggest upside potential of 70% to 100%+. 

Why do we care on Italy? 

A little background on Italy.  This summer, two Italian populist parties, The League and the Five Star Movement, created a coalition which surprised the market, as their constituencies and policies tend to run contrary to each other. 5 Star is generally negative on gambling, while it’s not clear if The League actually cares at all about games of chance. Upon forming the coalition, these two nationalist parties, put a “governing contract” that on pg. 45 had a contradictory paragraph outlining their desire to regulate gambling. The market seemingly yawned at this as the paragraph seemed to target gaming machines (which has already been a longstanding focus of regulation). However, right after the formation of the coalition, IGT placed a secondary into a market that suddenly became wary of the populist’s rhetoric, and all assets with ties to Italy declined.  

Then came the actual regulation with respect to gaming. The new government passed a decree raising taxes on gaming machines and outlawing advertising. IGT quantified this as a 15m EBITDA headwind phased in over 3 years (less than 1% of EBITDA). IGT doesn’t think the advertising ban should affect it as it doesn’t heavily advertise given its large and visible retail base (the lottery / gaming machines are pretty ingrained in society).  

The limited focus on gaming seemed like good news. We think the market was starting to look past Italy risk until the Italian budget came into focus, creating extreme consternation in the market. Recently, Italian banks, the euro, etc. have all declined rather precipitously and IGT has followed.   

As the change in the Italian gaming machine EBITDA was de-minimis, the logical implication of the decline in IGT shares is that there is increased risk of an issue with their Italian lottery contract.  We struggle to understand why this is a meaningful risk given IGT has a bilateral contract for which it has just completed the payments ($2.2B in upfront payments with the last one to be paid in the next two weeks). 

While we don’t have the contract, we look to Atlantia (ATL-IT) and the rhetoric out of the government tied to the Genoa bridge situation to understand potential outcomes. Right now, there are serious questions if the Italian government will be able to pull the concession for Atlantia even though there was a large loss of life associated with the bridge that collapsed. Furthermore, the terms of the concession that have since been made public show that in order to revoke the Atlantia concession, the Italian government would have to pay the NPV of revenues associated with the contract to Atlantia (and because they are likely at fault, less a 10% penalty).  

It would certainly be negative if the Italian government pulled the lottery contract but we question why that would be a reasonable concern – we have never heard a rumor of the contract being modified, neither publicly nor privately. Of course, a government can theoretically do anything it wants, but Italy is not a frontier market and there are clear legal guidelines the government is obligated to follow as shown by Atlantia. This also ignores the fact that the government would be incapable of running the lottery and would most likely have to come up with a significant amount of money (~2bn) to, at a minimum, repay IGT its concession payment.  Furthermore, IGT is the incumbent and industry leader in Lottery systems and it would be unlikely the government would find a company that would be able, or willing, to make a materially improved offer to run the lottery concession (that was just recently awarded).   

As an aside, trading in IGT makes no sense relative to other public companies with Italian economic risk, and specifically Italian gaming risk.  Neither PTEC LN (it bought an Italian gaming operator) nor GAME IM (an Italian gaming machine company) move nearly as much as IGT on Italy news or general fear of regulation. It is shocking how Italian banks such as Unicredit are only down 25% on the year (where their business is tied to rate movements), while IGT is down greater than 35%.  With clarity that the new Italian budget, which should be finalized before year end, has no material changes to gaming, the risk/reward seems incredibly favorable based on the underlying fundamentals of the business. 

What is wrong with Gaming? 

There have been a few recent datapoints suggesting a modest slowdown in room rates in Las Vegas, primarily from CZR and MGM. IGT was somehow caught up in this meltdown despite Revpar having limited impact on IGT (gaming revenues are far more important).  Our understanding is that Vegas casinos are only a low single digit % of total IGT revenues (remember they are primarily a lottery company).  

Business Performance has been strong 

The stock performance (down 33%+) is startling compared with the stability and performance of the core business. This is what it has done YTD: 

To be clear, without incremental non-fundamental headwinds, IGT would have already raised the low end of its guidance through the top end set at the start of the year. Furthermore, sports betting has been legalized in more jurisdictions in the US, and IGT expects to be a participant. 

Is Boeing a good corollary? 

The recent substantial increase in the Boeing share price correlated with the transition away from the cash burning, pre-production period of a new aircraft launch, to the fat tail of free cash generation.  While Boeing earnings increased, the multiple expanded significantly to account for the transition to the cash generative period.  IGT is at a similar inflection to Boeing.  IGT has just completed the period of upfront payments to secure their long-term lottery contracts.  The last payment is this quarter.  There will be no payments for the next 8 years and no contract renewals until the end of 2025.  We think free cash flow will average over $500mm per year (assuming no growth) over the next 8 years (greater than the current market capitalization).  Why can’t IGT’s multiple expand ala Boeing?  At a 6-7% free cash flow yield, IGT is more than a double.   

Is leverage a problem?  

One pushback we consistently hear is around the leverage of the company. This is probably a holdover from when IGT was a more cyclical, pureplay gaming equipment company that was losing share.  

From a business standpoint, it’s hard to find a company under the broader gaming umbrella that is more suited to hold leverage. This might have been a more reasonable concern if the company was going into a re-contracting cycle, but as all the payments have been made, this company will be a FCF machine for the next 9 years. Given the recession proof nature of the lottery business, it is reasonable to assume that the FCF number will be solid for the next few years. While the business is currently 4.3x net levered (~5x min. adjusted), slightly elevated due to just completing its contracting cycle, within two years that number will fall to ~3.7x (4.3x min. adjusted) below the company’s target of 4x net levered. 

When we think about what the appropriate leverage is for this business, we look to other companies that are recession resistant and steady FCF generators. We would note, Tabcorp Holdings, an Australian comp that runs the Australian lottery business, is net levered 4.3x and there is no concern. Packaging companies, which are good comps as they are recession resistant and steadily growing businesses, are currently levered in the private market without issue above 6x. The bonds for IGT all trade in the debt market at above par and its bonds due in 2023 yield under 2.5% (vs. a dividend yield above 4.5%), suggesting a large disconnect between the credit market and equity investors. 

The real concern in our minds would be the leverage of this company going into a contracting cycle, as the company wouldn’t want to be caught dependent on the capital markets at a time where it needs to make lump sum payments. Thus, in our minds, the relevant analysis is what the leverage profile looks during a re-contracting cycle, and given where we are in the lifecycle of the company, we are not concerned.  

For example, under a very conservative assumption that IGT didn’t grow FCF for 9 years and continued to pay its dividend, the company would enter its next re-contracting cycle ~2.5x net leverage (~3x min adjusted net levered). Under a more reasonable scenario of low single digit growth, it’s easy to see the company having net leverage of just 2x (~2.4x min adjusted net leverage) going into its next contracting cycle. At these leverage levels, IGT would be materially under levered.  We would be disappointed should the company not supplement its dividend policy with additional capital return in the form of share repurchases as a result.   

Capital Returns? Soon? 

As IGT approaches its target of ~4x net leverage at the end of next year, we think the company will initiate a share repurchase plan. Some investors were disappointed by the lack of a repurchase plan this year, but we never thought a repurchase was in the offing, as the company has been incredibly clear that it needs to have “line-of-sight” into 4x net leverage before initiating it. That roughly corresponds to the middle of next year, as it should end 2019 around 4x net levered. Given that 40% of the float is held by a family and the current undemanding valuation of the company, we believe that a share repurchase plan could have a meaningful positive effect and would be very accretive from an FCF / share perspective. 

Business Details 

US Lottery Overview - (25% of revenue; 26% of min. Adjusted EBITDA) 

IGT is the number one lottery solution provider in the US w/ ~80% market share and broad diversity operating for 39 of the 45 US lotteries. IGT makes money principally as a % of total wagers (call it 1-2% depending on the state) as well as the sales of lottery systems and solutions.  

Source: Company Presentation  

The US lottery is an incredibly consistent and sticky business. As noted below, the lottery has grown consistently since the great recession and >90% of incumbents win their contracts back, giving IGT a leading market position. 

Source: Company Presentation  

In fact, the lottery is not only a consistent grower, it is also recession proof. As shown below, it has grown through both the tech downturn and the great recession. 

IGT has just gone through a re-contracting cycle and now has 70% of its N. America lottery revenue locked in for 8+ years. There is plenty of room to grow if you look across productivity per state as shown below. 

Source: Company Presentation 

IGT’s N. American Lottery business is a growing, recession proof business that operates as the market leading player in a sticky business with high barriers of entry. 

Italy Overview (~37% of revenue; ~36% min. Adjusted EBITDA) 

Italy has three subcategories; Lottery (~43% of Italy Revenue), Gaming Services (~40% of Italy Revenue), Other Services (~17% of Italy Revenue). 

Starting with the Lottery, IGT operates as part of consortium that runs Italy’s lottery in its entirety. IGT owns ~63% of the consortium and thus consolidates EBITDA. Therefore, as referenced throughout as min. Adjusted EBITDA, one must remember to deduct the minority stake from consolidated EBITDA figures for valuation purposes. For the purposes of this write-up we estimate the EBITDA adjustment at ~250m (the Company has guided to ~200m adjustment from a CF perspective). 

IGT makes money a similar way in Italy as it does in the US, with one crucial difference from a contracting standpoint. IGT must make much larger upfront concession payments in order to secure the contract, but is then afforded higher recurring royalty rates throughout the life of the contract (6% vs. 1-2% for the US). IGT will complete the last installment of these payments in the next few weeks and will proportionally have paid $1.2bn dollars during the last two years. This locks them into the Italian lottery revenue stream for the next 9 years. 

While the Italy is a more mature market with lower growth in general - the lottery, like the US, is recession proof, extremely stable, and sticky by design.  

The rest of the market is either similarly stable (AWP / VLT) or growing quickly (Interactive / Betting). 

A word on VLT / AWP’s and the regulatory front within Italy. AWP and VLT’s are essentially slot machines where the VLT is generically more interactive and technology forward than the AWP (with correspondingly much higher margins). The Italian government has been regulating AWP’s over the last few years as they have been seen as too prevalent in public. This has led to a steady reduction in the number of AWP’s and tax increases on the machines. The new government, while maybe more verbally enthusiastic about their potential regulation, is doing nothing radically different on that front. That is why Italian gaming machines comps generally have had lower multiples than US comps. 

I would note - lottery makes a up a much larger portion of Italian EBITDA. By our estimates, on a minority adjusted EBITDA for Italy of ~500-550m, we think the Italian lottery could be almost 350m of that.  

While we underwrite a lower multiple from a valuation standpoint, Italy is a sticky market where IGT has a monopoly, and the majority of EBITDA comes from a recession proof business that will be a cash flow machine for the next 9 years. 

North American Gaming (~20% revenue; ~22% of min. Adjusted EBITDA) 

This segment is probably what IGT was traditionally known for, delivering slot machines and gaming systems/services to casinos for either a single payment or for a recurring revenue lease model. 

IGT was historically poorly run and underinvested, having lost significant share of shipments in the market over the last 14 years (70% share in 2003 down to 22% share today according to the company). Gtech merged with IGT a few years back and has invested significant money and resources in order to turn around this division. Between new hires, a large number of cabinet refreshes, and exciting new content, IGT has finally begun to stabilize shipment share and grow its installed base sequentially for the first time in over 4 years. The replacement cycle for slot machines is also at a cyclical low, having stagnated in the low 50k slot range vs. a recent peak of over 80k replacement. 

The combination of an operational turnaround as evidenced by stabilized install base and replacements in conjunction with an uptick in the refresh cycle could create significant operating leverage for this segment. 

International (~18% of revenue; ~15% min. Adjusted EBITDA) 

The international segment sells gaming machines and delivers lottery solutions around the world. Around 40% of revenue (and probably a disproportionate amount of profitability) within this segment comes from international lotteries, with the remainder coming from machine sales and other services. 

While lumpy, this business has consistently displayed steady growth with Lottery outpacing the rest of the global market. International is a steady growing business with a host of greenfield opportunities to further increase value. 

Valuation 

We value this company on a SOTP basis. Below we detail our thoughts by segment for EBITDA multiples. 

US Lottery 

We believe US lottery to be the crown jewel of this company. The business model is akin to a short cycle infrastructure asset. In return for an upfront investment, IGT is entitled to a stream of revenue for the next 8 years that generally grows through recessions. The only other real growing comp in a developed market is Tabcorp Holdings, which runs the Australian lottery. If you read the Australian research, analysts DCF the income stream at an extremely low WAC (similar to infrastructure assets), and end up at 16x EBITDA multiple which they use in their SOTP. 

For the US Lottery, we use an 11x EBITDA multiple as our base case. 

Italy 

For Italy we underwrite conservative multiples given the regulatory climate. 

For the gaming component, we use a 5x multiple, in-line with publicly traded Gamenet’s multiple and a discount to the 6.2x takeout multiple for Snaitech that PTEC LN paid. 

For the lottery component, we use a 7x multiple to underwrite the slower growth potential and large upfront payment vs. the US comparison. 

For the interactive and sports betting component, the smallest piece of the business, we underwrite an 8x multiple, a discount to the public peers. 

Put together and weighted, we use a reasonable 6.7x EBITDA multiple in our base case. 

US Gaming 

For US gaming - we can first look at comps. 

This seems slightly aggressive, so we look to what IGT was acquired for. GTECH paid 9.4x EBITDA for IGT. They had synergies, but when you look at the proxy, a private equity firm offered to pay $17.25/share, which corresponds to ~.4x discount, or a standalone takeout multiple of ~9x. This also foots to the Bally’s transaction which SGMS acquired for 11.2x pre-synergies, or 9.4x after synergies.  

For US Gaming, we discount these data points and use an 8x EBITDA multiple as our base case. 

International 

International has a high component of lottery, grows overtime, and has significant greenfield opportunities. Thus, we ascribe a multiple between US lottery and US gaming. 

For International, we use a 10x EBITDA multiple as our base case. 

Base Case Upside 

Putting this together - we come out to an 8.6x base case multiple and ~70% upside. 

Using the company’s FCF guidance of $500m for next year, this corresponds to an ~8.6% FCF yield to the equity (with no accretive stock buyback factored in) 

Upside Case 

We assume higher multiples for the US lottery, International, and NA Gaming more in-line with peers for our upside case, while keeping Italy the same to get to an ~100% upside. 

We believe management’s guidance for 500m FCF is conservative, so using $540m for next year, this target price results in a ~7.8% yield to the equity (again, before any accretive share repurchases) 

Downside 

Ultimately, we believe the downside comes from Italian regulation. In this case we assume IGT loses ~120m of EBITDA from gaming machines. Keep in mind, the Italian government already instituted tax increases for the next 3 years. To believe this scenario you have to think that 3 months AFTER they already passed regulation, the government revisits the subject and regulates machines basically out of existence, as under this scenario there would be essentially no incentive for IGT to continue operating their machines. Note, the Government needs the tax revenue for its large spending proposals. 

Even though the Italian multiple should expand under this scenario (it will be more weighted to Lottery), we significantly haircut that multiple in addition to all of its other businesses. 

Assuming FCF is cut by the tax affected amount of lost Italian gaming machine business, we arrive at 420m of FCF with our downside price corresponding to a ~14% FCF yield. 

Free Options 

None of the above work embeds a few “free options” that could all conceivably hit within the 1-2 years and if so, could be fairly meaningful from a valuation perspective and lead to positive earnings revisions. 

Sports Betting 

A few months ago, every single gaming analyst was discussing just how big sports betting was going to be and who was going to benefit. Now, you’d be lucky if someone is willing to discuss anything else with you beyond intra-quarter Vegas Revpar or Macau GGR reads. 

Sports betting is admittedly very hard to figure out – what is the size of the market?  What will the economics look like? who will take share? and how will profit be distributed?  Luckily, for IGT, we like to think you get that option for free. We’ve laid out some broad assumptions below but it’s fairly easy to see at a minimum that this is a value-positive option. 

We think $5-10bn is ultimately a reasonable guess looking at Sports betting / capita of the UK and Nevada locals market. The market share and economics is purely a guessing game but regardless of where you shake out, it should be meaningful to the equity. 

Brazilian Lottery 

Last year the Brazilian government put out a bid for a Brazilian Scratch & Win lottery concession. The economics of the project were unfavorable and the Brazilian government didn’t receive any bids. Ultimately, we think this project will be re-cut and rebid. First of all, the fact that no one bid for a less economic lottery contract exemplifies the rational competitive dynamic within the industry. Secondly, any incremental lottery opportunities would be positive from a growth standpoint even if the economics are hard to model at this time. 

Brazilian Gaming 

In addition to the lottery, the Brazilian government tabled a bill to legalize gaming machines. Again, the sizing of the opportunity varies wildly both on the number of machines and the ASP of the machines but this could be a meaningful and lasting tailwind to EBITDA. 

Canadian VLT 

Every 6-7 years Canada replaces its VLT machines over a 4-6 quarter cycle. The company has spoken to this potentially coming up in the next year or two. Last time the company captured 70% of the market share and saw 35k machines replaced. This could provide a meaningful tailwind to numbers as the street only models 30m of EBITDA growth. 

In summary: Buy IGT 

IGT is cheap, is misunderstood, is operating well and is recession resistant.  The company sports a dividend yield of 4.5% and has 50-150% upside.  They operate in a growing market, with substantial long-term upside.