IGT Is No Gamble

At Morningstar GrowthInvestor, we think scenario analysis is an essential tool when analyzing growth companies. Predicting the future for any company isn't easy, but it's especially tough for rapidly growing businesses because they usually compete in markets that are always changing. One of the ways we deal with this is by performing scenario analysis.

We recently purchased  International Game Technology , the world’s leading maker of slot machines, for the GrowthInvestor portfolio. (I, too, own shares of the company in my personal account.) We think IGT has fabulous prospects, but sales have hit a lull because the growth of cashless machines has pulled demand forward and slowed the replacement cycle for slots. Although we believe this is temporary, performing scenario analysis on a range of outcomes was one of the ways we've developed greater confidence in this investment.

Base Case
Our base-case fair value estimate of $38 per share assumes that IGT's domestic business begins to rebound toward the end of next year after dismal 2005 results. We forecast international revenues to return to more normal growth. IGT has benefited from the growing popularity of slots in Japan, but growth rates are likely to slow as business expands. Finally, as the sales mix shifts back to the domestic side of the business, margins should gradually expand given that international revenue tends to be less profitable. These assumptions translate into IGT’s market share slightly eroding to the mid-60% range.

Bear Case
However, there are several factors underlying our fair value estimate that aren't guaranteed. One is our forecast that IGT's domestic business will begin to rebound next year. It's possible that the slowdown in the replacement cycle could continue, that IGT could give back some market share it gained from the growth of cashless machines, or that IGT's inability to seize the opportunity in penny slots could limit sales. We've also assumed price increases of 5% per year, but the number could be lower as casinos consolidate buying power. If we lower our revenue and profit assumptions accordingly, our fair value estimate is $27 per share.

Bull Case
A compelling bull case can also be made. Our forecasts for the domestic business may be conservative. The replacement cycle could rebound sooner than we expect, with new technologies like downloadable gaming spurring growth. Also, we may be underestimating domestic growth if states like Texas and Ohio embrace slots sooner than expected. And it's possible that international growth won't slow. If these assumptions prove correct, IGT would post significant growth in the next two years, resulting in a fair value estimate of $48 per share.

Conclusion
At $28.50, IGT's current stock price is only slightly above our most pessimistic scenario. This provides anyone buying the company near these prices with a nice cushion if our base case estimates don't come to fruition. It appears to us the market has a very shortsighted view. Lots of analysts have downgraded IGT in recent months due to what we consider to be very near-term concerns. But with a long-term investment horizon, we don't think there’s any question that this stock is worth more than what it trades at today.

Analyzing IGT
Scenario	5-Year Avg. Revenue Growth	5-Year Avg. Operating Income Growth	5-Year Avg. ROIC	Fair Value Estimate ($)
Base Case	8.5%	10.4%	21.6%	$38
Bull Case	11.7%	13.8%	23.1%	$48
Bear Case	4.2%	4.2%	17.8%	$27
Morningstar analyst estimates

This article originally appeared in the June 2005 issue of Morningstar GrowthInvestor.