IAG 2006-04-05 - Apr- May - page 18-19

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on apre-tax basis. ThereforeAruze is seemingly gettingnoor nega-
tive value for its Pachislot business. This couldbe legacybased since
itmissed Reg 4.5 and 4.7, however the company already has 10 Reg
5 approvals with an additional 14 in the pipeline ahead of a major
replacement cycle in2006/2007.
• Pachislot parlor operators are generally concerned, anticipat-
ing lower revenue fromReg5games. Thereforewhilemanufacturers
havebegunmakingReg5gameswedon’t anticipatedramaticplace-
mentsuntilReg4.5and4.7arescheduled for removal. Currently there
areonlyapprox.50,000Reg5units in themarket.
• By December 2006 1.2million Reg 4.5 units are required to be
replaced with Reg 5 (Diato’s Yoshimune represents approx. 350,000
of these and need to be replaced before July 2006; Sega Sammy’s
450,000 remaining Hokuto No Ken units are to be replaced before
November 2006). Approx.600,000Reg4.7units are scheduled for re-
moval by July2007.
• IGThasanengineeringandassemblyagreementwithSegaSam-
my forReg5whileAristocrathasaseemingly less favorablepartsdeal
withSegaSammy.
• IGThasguided to10,000Reg5units for its FQ206. Webelieve it
hasalreadyexceeded that amountwithNobunaga2 from its January
9th launch. Weestimate thiswill represent approximatelyUS$0.02 in
EPS (earningsper share) for IGT’sFQ2. Forperspective IGThascreated
the secondmost successful Reg 5 game to date. This is compelling
given the aforementioned Reg 4 replacement opportunity and that
single titles cangeneratehundreds of thousands of placements (like
650,000 for HokutoNoKenor 350,000 forYoshimune). Furthermore,
the new regulations will require games to be highly similar from a
technologicalperspective,makingcontent thekeydifferentiating fac-
tor – this couldbegoodnews for IGT.
UpdateOn Chinese VLT’s
•Wemetwithanassociateof theChineseWelfareLottery. Inorder
to curb illegal gambling and capture revenue, China is moving for-
wardwithaplan toaddvideo lottery terminals (VLTs–similar toslots)
toamultitudeof new,small parlorson themainland.
• The Chinese government plans to openmore than 10,000 VLT
parlors per year in each of the next few years. Each parlor will have
20-40VLTs suggesting this could represent upwards of a new 1mil-
lionunitmarket. For comparison, theUS has approximately 800,000
slotmachines.
•We estimate the currently small installed base of VLT’s in China
generateapprox.US$100-$200perday inwinperunit.
Supplier Risk Commentary
Themain risk toour investment thesis is an aggregate reduction in
casino capital expenditures (capex), specifically as it relates to slot
machines. However,we think that risk is waning for IGT,WMS and
SHFL. Due to the favorable economics of slot machine purchases
for casinos,we continue tobelieve that slotmachineswouldbe the
last item to be earmarked for a capex reduction program. Weak-
ness at the consumer level also represents a risk for the company,
specifically due to its increasing relative exposure to participation
games.
Operator Risk Commentary
The main risk to our investment thesis is potential deterioration in
disposable income and consumer spending, which could ultimately
have an impact on visitor volumes and spendper visit. Furthermore,
air-based terror activity could also affect visitation to Vegas-centric
companies.
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