Investing The Hard Way: Why IGT CEO Patti Hart Has Got To Go
Last week I noted the negative impact that poor management can have on publicly traded companies and their share prices. But in discussing the collapses in stocks like Zynga (ZNGA), Caesars Entertainment (CZR), and Groupon (GRPN) – falls that were, at least in some part led by management – I only listed stocks that investors should have avoided in the past, as opposed to pointing out which stocks investors should avoid going forward.
Of course, it is easier to recognize poor management in retrospect. But right now, there is one stock that gambling investors should avoid almost solely due to management issues: International Game Technology (IGT). My choice of IGT might seem surprising; at first glance, the tenure of CEO Patti Hart appears to be a moderate success. Indeed, IGT’s stock price has risen nearly 35 percent since her arrival in April 2009, and adjusted earnings have risen modestly under her tenure amid a highly competitive industry and a still-dormant economy.
But note Hart’s first day: April 1, 2009, when the stock market was just rebounding from its lows following the financial crisis. IGT’s 35 percent gain pales in comparison to the nearly 120 percent gain posted by the Market Vectors Gaming ETF (BJK), comprised of 47 gambling stocks worldwide; the 150 percent rise by competitor Bally Technologies (BYI); or the 12-fold share price growth at Las Vegas Sands (LVS). In fact, IGT’s share price is actually down 40 percent over the last three years; its gain under Hart’s tenure comes solely from a strong jump in Hart’s first two months on the job, while the CEO was still adjusting to her new position.
It’s not hard to see why; IGT may still be the world’s largest slot machine manufacturer, but even its supporters would be hard-pressed to argue it’s firing on all cylinders right now. Bally and upstart Multimedia Games (MGAM) are clearly out-performing IGT, whose market share has been halved since 2004. But beyond the shrinking share and sluggish performance, the key reason to avoid IGT is Hart, a leader whose performance as CEO simply should not inspire any confidence.
Hart opened the year by acquiring social game developer Double Down Interactive in a $500 million deal. Analysts at the time were critical of the deal and its price tag; months later, Union Gaming analyst Bill Lerner told the Las Vegas Review-Journal that the acquisition was likely responsible for a more than 25% percent drop in IGT stock price over the summer, noting that the acquisition was “dilutive toward earnings.” But in an interview with the paper last month, Hart defended the purchase, telling columnist Howard Stutz “at some point…it will be the best investment we ever made.” Her reasoning for that optimism was questionable – at best. Hart excitedly noted that management turnover in the Seattle headquarters of Double Down had been “almost zero” since the acquisition. “That’s almost unheard of in IGT deals,” she added. But in acquiring Double Down, IGT promised some $85 million in retention payments over two years to a company, that according to multiple sources, had only 80 employees at the time of acquisition. Thus, Hart is bragging that IGT maintained Double Down’s staff by paying them an average of over one million dollars each over two years, a figure that is likely also “unheard of” in deals at IGT – or anywhere else. With that kind of incentive, the only surprise in the retention figures is the “almost” in “almost zero.”
Hart defended the steep price tag as well. “People were shocked by the sticker price,” she admitted. “It’s a big sticker price, but that’s what it takes to play.” That’s not necessarily true. bwin.Party has created its own social gaming unit an estimated cost of $50 million, 10% of what IGT paid for Double Down. Indeed, bwin.Party Digital Entertainment (BPTY) co-CEO Norbert Teufelberger said on a conference call in April that Double Down offered “an inferior product and software,” going on to criticize the generally inflated valuations in social gaming at the time. In IGT’s third quarter conference call, Hart discussed the bright future prospects for the Double Down-centered interactive division, specifically citing the “continued repurposing” of IGT proprietary games such as Da Vinci Diamonds for the Double Down casino. But that begs the question: why did IGT need to spend half a billion dollars when it had already developed the games that will eventually dominate the Double Down product line?
Meanwhile, monthly users for Double Down dropped from Q2 to Q3, though bookings per user rose from 25 cents to 24 cents. That hardly represents the “rapid user and revenue growth” promised when the acquisition was announced. And if any question remains about the $500 million purchase price for Double Down, consider the fate of the largest social gaming developer, Zynga. On the conference call discussing the Double Down acquisition, both Hart and CFO Patrick Cavanaugh justified the half-billion dollar price tag by pointing to Zynga’s valuation. But after its long fall, Zynga’s market capitalization is now about $1.78 billion. The company has $1.43 billion in cash and investments, net of long-term debt and liabilities, meaning its enterprise value – the value placed on its operating business by the market – is about $350 million. Zynga has trailing twelve-month net revenues of $1.27 billion; Double Down in Q3, based on information in IGT’s earnings release, created somewhere in the range of $33 milion in net revenue. (The company did not disclose the exact figure.) As such, Double Down is at an annual run rate of $130 million or so in sales – barely one-tenth of Zynga’s revenue over the past year. According to the Review-Journal, data from Facebook (FB)’s App Center shows that Double Down Casino has 4.8 million users; some 15 percent of the 32 million-strong user base for Zynga’s Hold ‘Em Poker app. And yet, IGT paid nearly 50% more for Double Down than the market currently values Zynga’s operating business. Clearly, IGT overpaid for Double Down.
To be fair, Hart’s public optimism on the deal is somewhat understandable; there is still the possibility that IGT’s interactive division will grow and the Double Down acquisition will seem more reasonable in hindsight. IGT backers would surely argue that it’s far too early to admit defeat – or even to admit that IGT got the raw end of the deal. It’s also worth noting that IGT’s market capitalization has dropped by $1 billion since the purchase was announced, meaning that much of the negative sentiment toward the acquisition has been priced in to the stock by now.
But of course, Double Down wasn’t Hart’s first major buy; that was Entraction, bought for $115 million in May 2011. At the time, Hart said the acquisition of the Swedish poker network “advances IGT’s position in legalized interactive gaming markets” and “will drive enhanced value for our global customers.” Sixteen months later, Entraction was shut down. In a telephone interview with Bloomberg, Hart noted that European iGaming had “shifted from dot-com to dot-country,” crushing profits in the unit. But as our own Jamie Hinks noted, two key markets – France and Italy – “had already either moved over or were in the process of doing so before IGT acquired Entraction.” And the continued regulatory uncertainty in Europe, including the effects of high taxes and the common contradiction of national and EU policies, had been well-known long before IGT’s Entraction purchase. Hart’s failure to foresee those difficulties in the Entraction purchase means investors should question her optimism about Double Down’s future.
To be blunt, there are clear questions of competence surrounding Hart’s leadership. Those questions came into national view earlier this year, when then-Yahoo! (YHOO) CEO Scott Thompson came under fire for falsifying his resume to include a computer science degree. Within days, Thompson resigned, after just four months on the job. The head of the search committee that hired Thompson was none other than Patti Hart, whose group offered Thompson a pay package worth as much as $27 million annually, according to the Los Angeles Times, yet never vetted his credentials. (Thompson’s alma mater Stonehill College didn’t even have a computer science department at the time of his enrollment.) Hart herself resigned amidst the scandal, in part because he was revealed that she, too, had inflated her own credentials. Sources told All Things D that it was the IGT board that asked her to leave the Yahoo! board to, you know, “focus on the company she actually runs.”
Perhaps the board should have simply asked Hart to stay over at Yahoo! For if there was any doubt that Hart was incapable of properly managing IGT, it was erased over the summer. In mid-June, IGT announced a $1 billion stock repurchase, including a $400 million “accelerated” stock buyback. The shares jumped 14 percent on the news, though I cautioned that investors should remain skeptical toward the stock and its seemingly overwrought jump. Six weeks later, IGT reported disastrous third quarter earnings, and the stock – the same stock Hart had spent $400 million of shareholder cash to repurchase as quickly as possible – fell 20 percent.
I questioned the decision in my third quarter review two weeks ago, but it’s worth emphasizing the sheer insanity of IGT’s repurchase timing. When the repurchase was announced, there were barely more than two weeks left in the fiscal second quarter. Hart and IGT management simply had to know the quarter would disappoint Wall Street. Wall Street analyst estimates are widely reported, and one would think that IGT was well aware, with only 16 days left in the quarter, that its results would come in below expectations, and its stock would fall. Hart’s decision to not only buy back shares ahead of the earnings release, but to do so on an accelerated basis, is simply dumbfounding.
In fact, on the post-earnings conference call with analysts, the very first question asked referenced the “curious” timing of the buyback. After CFO John Vandemore noted that the company “tend(s) to manage the business on an annual basis,” Hart chimed in with an answer that was nothing short of delusional. She opened by arguing that “we don’t see the quarter as having missed on every item as you’ve indicated.”
It’s worth pointing out here that IGT in the quarter reported earnings of 23 cents per share, adjusted for one-time costs related to the Double Down acquisition, while the Wall Street consensus estimate was 29 cents per share. Revenues were projected by analysts at $564 million; IGT reported sales of $532.8 million. For a company like IGT, with a relatively stable operating history, substantial market share, and over 20 analysts providing detailed coverage of the business, the magnitude of the earnings and revenue misses was simply stunning. Indeed, the 20 percent drop caused by the miss is exceedingly rare for a company of IGT’s size; that quarter was one of the worst in IGT’s history, and resulted in one of the biggest single-day plunges in the gambling sector this year.
And yet, Hart seemed to be arguing that the quarter wasn’t that bad, going on to add that “we had very strong revenue growth in the quarter.” That statement is simply untrue; revenue grew 9 percent in the quarter, compared to 15 percent at Bally and 21 percent at Multimedia Games. But nearly all of that growth was purchased from Double Down; excluding growth in interactive, revenue growth in the quarter was less than 2 percent year-over-year. That is not “strong revenue growth” by any measure. Hart wrapped up her defense by echoing her CFO’s long-term focus, noting that “when we deploy capital, we look at a much longer time frame than just one month or two.” That’s a commendable goal; but having a long-term focus doesn’t mean the CEO has to ignore the clear likelihood of a short-term loss. There was simply no reason that the $400 million accelerated repurchase had to be executed in June; indeed, with the likelihood of a weak quarter coming up, there was no reason for the repurchase to be accelerated at all. If Hart truly had the long-term focus she claims, she could have announced a standard $1 billion repurchase authorization, then used the expected weakness post-earnings to opportunistically pick up IGT shares on the cheap.
Hart simply appears out of touch with her business, and overmatched as a CEO. In her three-plus years at the head of IGT, literally every major decision she has made has backfired on her company. In last week’s piece on management, I noted that investors must trust the CEOs of the stocks they own to be careful, cautious, and responsible stewards of their hard-earned capital. Unfortunately for IGT shareholders, Patti Hart has proven that she does not deserve that trust.