Inside Asian Gaming

17 16 on a pre-tax basis. Therefore Aruze is seemingly getting no or nega- tive value for its Pachislot business. This could be legacy based since it missed 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 in 2006/2007. • Pachislot parlor operators are generally concerned, anticipat- ing lower revenue from Reg 5 games. Therefore while manufacturers have begun making Reg 5 games we don’t anticipate dramatic place- ments until Reg 4.5 and 4.7 are scheduled for removal. Currently there are only approx. 50,000 Reg 5 units in the market. • By December 2006 1.2 million 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. 600,000 Reg 4.7 units are scheduled for re- moval by July 2007. • IGT has an engineering and assembly agreement with Sega Sam- my for Reg 5 while Aristocrat has a seemingly less favorable parts deal with Sega Sammy. • IGT has guided to 10,000 Reg 5 units for its FQ206. We believe it has already exceeded that amount with Nobunaga 2 from its January 9th launch. We estimate this will represent approximately US$0.02 in EPS (earnings per share) for IGT’s FQ2. For perspective IGT has created the second most successful Reg 5 game to date. This is compelling given the aforementioned Reg 4 replacement opportunity and that single titles can generate hundreds of thousands of placements (like 650,000 for Hokuto No Ken or 350,000 for Yoshimune). Furthermore, the new regulations will require games to be highly similar from a technological perspective,making content the key differentiating fac- tor – this could be good news for IGT. Update On Chinese VLT’s • We met with an associate of the ChineseWelfare Lottery. In order to curb illegal gambling and capture revenue, China is moving for- ward with a plan to add video lottery terminals (VLTs – similar to slots) to a multitude of new, small parlors on the mainland. • The Chinese government plans to open more than 10,000 VLT parlors per year in each of the next few years. Each parlor will have 20-40 VLTs suggesting this could represent upwards of a new 1 mil- lion unit market. For comparison, the US has approximately 800,000 slot machines. • We estimate the currently small installed base of VLT’s in China generate approx. US $100-$200 per day in win per unit. Supplier Risk Commentary The main risk to our 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 to believe that slot machines would be 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 spend per visit. Furthermore, air-based terror activity could also affect visitation to Vegas-centric companies.