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Investing The Hard Way: Can IGT Maintain Its Current Run?

TAGs: bwinparty, Caesars Entertainment, david roberson, Double Down Interactive, Editorial, Entraction, igt proxy fight, international game technology, investing the hard way, jason ader, Patti Hart, Vince Martin

Investing The Hard Way: Can IGT Maintain Its Current Run? Nearly a year ago I wrote an article for this site in which I called for International Game Technology CEO Patti Hart to be fired. I questioned a number of Hart’s decisions, including the 2011 purchase of Entraction, an oddly timed accelerated stock buyback, and the half-billion dollar acquisition of Double Down Interactive in 2012.

To be fair, I wasn’t the only one who was critical of Hart. Less than three months later, activist investor Jason Ader would launch a proxy fight against the company in an effort to put three new directors on the IGT board and, potentially, remove Hart in favor of a new CEO. Amidst the fight – which would quickly turn nasty – IGT employees aired their concerns about morale and the company’s direction to sites such as Forbes and Gambling911.com. But Hart would survive the proxy battle; one board director, David Roberson, was removed, but Hart’s position at the company seemed solidified, at least for the time being.

In the wake of the proxy battle, not only has Hart survived, but IGT shares have thrived. IGT stock is up 66 percent in the eleven months since I called for a new CEO, and over 26 percent since the proxy fight was settled a little more than six months ago. The company has posted consecutive solid earnings reports, and substantially raised its dividend. IGT stock is at its highest level in over three years, and has now better than doubled since Hart took the corner office on April 1, 2009.

So has Hart proved her doubters – myself included – wrong? Not yet. The Double Down purchase remains Hart’s most controversial decision; analysts roundly criticized the purchase price at the time, and no less than bwin.Party Digital Entertainment CEO Norbert Teufelberger criticized the price and the company, calling Double Down “an inferior product and software.” But with Double Down now creating substantial revenue growth, becoming accretive to profit by the first quarter of next year, and seeing bookings per user some six times that of former social king Zynga (ZNGA) and nearly double that of any other social gaming operator (according to Hart on her company’s most recent earnings conference call), Hart and her defenders are arguing that Double Down is more than justifying its price tag.

But as impressive as Double Down’s growth – and bookings – have been, the half-billion dollar price tag still seems awfully high. Caesars Entertainment (CZR) built a social gaming unit through two acquisitions: Playtika in 2012 and Buffalo Studios in 2012. According to figures released in conjunction with the company’s planned interactive spinoff, the total price paid for the two purchases was a little over $150 million, one-third of the price IGT paid for Double Down. For that price, it was Caesars – not IGT and Double Down – who acquired the top spot in social gaming market share.

It’s also not clear how much of Double Down’s growth is coming from the assets IGT purchased, as opposed to the legacy games IGT had already developed. On the company’s second quarter conference call, Hart bragged that the IGT content library “is now driving over half of our revenue in the Double Down Casino.” But that leaves two key questions: if IGT’s existing content is driving revenue and bookings, why, exactly, did IGT need to spend half a billion dollars? And what, exactly, did it spend that cash for if IGT, not Double Down, is supplying the majority of the games on Double Down Casino?

The larger problem for IGT is that very real concerns were raised both before and during the proxy fight about Hart’s decision-making, and yet neither Hart nor IGT showed much humility during the process, or even seemed to admit any understanding of why shareholders might be frustrated with a stock that had been flat for a decade and had massively underperformed its peers during Hart’s tenure. (Indeed, the company wrote that IGT stock had risen “significantly” in its own proxy statements, choosing to ignore the fact that IGT’s returns, even when including dividend payments, were well below that of the broad market and, to use the company’s term, “significantly” below those of the gambling sector as a whole.)

At a JP Morgan conference in March, the day after the proxy vote took place, Hart was asked directly by Morgan analyst Joseph Greff what she had learned from the proxy fight. Hart, once again, did not admit any mistakes, failing to mention the $115 million wasted on Entraction, or addressing long-standing concerns about IGT’s relatively stagnant share price. Rather, Hart claimed the issue was a failure of communication on the company’s part, and again defended the $400 million accelerated repurchase I criticized last year.

To recap, that repurchase was announced sixteen days before IGT announced a disastrous quarter, an earnings report that dropped the stock twenty percent. IGT missed revenue estimates by eight percent; that may not sound like much, but for a well-covered company with substantial recurring revenue from its installed base, it is a huge miss. So bad was the quarter that it dropped the stock by twenty percent in a single day, despite Hart saying on the conference call that she didn’t think the report was all that bad, and claiming that “we had very strong revenue growth in the quarter,” a claim that was technically true but essentially false. (Nearly all of the growth came from the purchase of Double Down; IGT’s legacy business grew less than 2 percent year-over-year.)

But Hart told Greff that the repurchase “was a great trade for us,” noting that the $400 million was spent to buy the stock at the exact price at which it closed the day before the repurchase was announced. This was because the price of the stock was set to be the average of the stock’s closing price  over the next 90 days. But there was no need – literally, none – to start that 90-day period ahead of a report that IGT executives simply had to have known would disappoint analysts and send the share price down. Because IGT shares rebounded in the months following the earnings disappointment – and continued to rise – the company got a good price for the shares relative to its current price. But it could have received an even better price had it simply waited to execute the buyback until after the weak quarter. Hart’s argument is akin to a blackjack player staying on 15 against a 10 and then pointing out that the dealer turned up a 6 and a king. The play may have worked out; but that doesn’t mean the decision-making process was correct.

As for Double Down, Hart correctly pointed out that criticism had changed, saying that “people have moved from ‘we don’t want you to be online’ to ‘maybe you paid a little too much.’” (See above.) She summed up by saying “we need to do a better job of helping [the market] see what we see when we make decisions.”

Perhaps. Or perhaps shareholders and analysts have legitimate concerns about precisely that decision-making process, or Hart’s role in a resume scandal during her tenure on the board at Yahoo! (YHOO), or the multiple reports filled with anonymous complaints from IGT staffers. At employer review site Glassdoor, IGT receives just a 2.5-star rating out of 5 from its employees. Perhaps most notably, just 20 percent of reviewers approve of Hart’s performance as CEO.

Of course, investors may be less concerned with what employees think and more concerned with what the market thinks. And with the stock at a multi-year high, it would appear the market is pleased with the company’s profit potential. Adjusted earnings per share for 2013 are guided to be between $1.26 and $1.32 per share, implying year-over-year growth of 22-28% according to the most recent post-earnings conference call. IGT stock has gained after each of its last three earnings reports, as the company has surpassed analyst expectations each time.

But there are concerns there as well. Earnings per share growth is boosted by the buyback (fewer shares increases EPS), meaning some of that growth is essentially purchased with shareholder cash. Meanwhile, revenue growth is lagging earnings growth; in the first nine months, year-over-year growth was just 12 percent. Over half of that growth came from Double Down (again, growth purchased with shareholder funds.) Gaming operations revenue actually fell year-over-year; only a boost in product sales, driven by VLT (video lottery terminal) sales in Canada and Illinois created growth in IGT’s legacy slot machine business. That growth, according to the Q3 conference call, is expected to taper off after the fourth quarter, and without it, IGT is left without a clear path to further increasing its revenue  going forward.

So while Double Down is expected to boost profit next year, it’s not entirely clear that IGT’s slot business will be able to create much, if any, growth of its own. So while IGT shares look strong right now, there are still tests to come. Patti Hart may be off the hot seat; but her company, clearly, still has a long way to go.

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