In hindsight, nobody should say they couldn’t see it coming.

The mergers this summer of International Game technology (IGT) and Bally Technologies with lottery suppliers GTECH and Scientific Games have both re-formed the gaming industry and brought its actual shape into focus. A stagnating market always consolidates in the service of profits and a new growth story. The controlling narrative for the leading suppliers is now total gaming; selling content to regulated gaming operators the world over, into whichever segment happens to have access.

The stagnation was the U.S. brick-and-mortar casino industry revenues, which have been flat-to-down since 2007 in many key markets. False economic starts and tepid recoveries have put operators in cost reduction mode; suppliers failed to come up with a new technology that could re-ignite the replacement cycle as ticket-in/ticket-out technology once did; and new competitors came along to soak up a growing portion of the ever smaller number of new machine orders that were out there.

“The simple fact that there was no discernable relief on the replacement cycle front really put these guys in a tough spot,” said Christopher Jones, managing director and senior research analyst, Telsey Advisory Group. “What pushed things over the edge was the influx of competitive pressure in the marketplace. IGT was consistently losing market share and WMS [Gaming] had collapsed after a great multi-year run and then you had new entrants in a market that wasn’t necessarily growing. If anything, it was actually contracting. The environment was just leading to continued misery.”


A NEW DAY FOR OPERATORS

The “Big Five” suppliers that used to stand atop the slot world has been reshaped. Bally, IGT, WMS, Konami Gaming and Aristocrat Technologies are now owned by four different companies, but two of those companies are distinctly larger in size, with a range of product that sets them apart from the competition, and that figures to have an impact on pricing.

“This is a pretty important event for the industry,” said Jones. “What we have is a duopoly. You won’t have operators out there trying to split their order book. Operators loved the diversity of the gaming technology space because they could play one against the other. They could say Manufacturer A has a box for $18,000, why should I buy your $23,000 box when it does just as good as yours? Now you’re really going to have to go with one of these two combined entities for the bulk of your floor. Konami, Multimedia [Games] and Aristocrat are not going to be able to fill your casino floor. Their offerings are very limited, their systems backbone is focused on somewhat smaller casinos and they’re just not as broad-based. You’re going to have to embrace these larger platforms. Some of the power swings away from the operators toward the manufacturers.”

Jones and others see the potential for incrementally more consolidation in the industry, even if last month’s purchase of Multimedia Games by Global Cash Access (GCA), two companies with limited overlap, didn’t exactly conform to Wall Street’s expectations.

“Aristocrat/VGT is still relatively small; Konami is going to have a difficult time on a per-machine basis when all is said and done, “said Jones, who sees real pricing power accruing to the Big Two. “Your biggest competitors are going to come in with a system that includes table games technology, gaming ops and games for sale. The price is going to be one number; they won’t give you per-unit pricing and you’re just not going to be able to compete. There’s no reason to give a smaller competitor significant market share because there’s not going to be a lot of upside to that development. Power has very much swung back to the manufacturer as a result of these deals.”

Not everyone agrees on the amount of pricing power that GTECH and SciGames will have in the casino business, but there should at least be some relief on the discounting side, said Todd Eilers, director of research, Eilers Research.

“I don’t think things are so consolidated or will be with the deals still to come, that vendors are going to have pricing power,” said Eilers. “You still have Konami; Aristocrat; Multimedia, even though it’s owned by GCA; Aruze; Ainsworth; up and up-and-coming companies like Incredible Technologies. There are alternatives out there and some of them are still pretty sizable, with quality product and shipping a good amount of games. I think the consolidation will relieve a little bit of the pressure in terms of discounting and things like that. But I don’t think things are going to so consolidated that these guys are going to have the power to raise prices.”


SYNERGIES & NEW MARKETS

The price tags on the IGT and Bally deals are $6.4 billion and $5.1 billion respectively. The deals will be paid via a combination of realizing cost synergies and gaining access to new revenue potential, with a heavy emphasis on the former.

There will be no shortage of pressure. Alex Bumazhny, director Fitch Ratings, wrote in a note last month that the suppliers are “sizably exposed” on the variable rate debt side and thus vulnerable to any rise in short-term interest rates, which he deems “likely” over the next one to three years. Including Aristocrat’s earlier $1.3 billion purchase of VGT, the four acquisitions announced among casino suppliers over the past three months, “places about $22 billion of debt on about $3.7 billion of EBITDA excluding synergy benefits. This equates to an aggregate 6X debt/EBITDA ratio for these suppliers compared to 2X debt/EBITDA in 2012, before the wave of consolidation began. Higher leverage and rising interest rates may make refinancing on acceptable terms challenging when the suppliers’ cheap short-term rate debt starts coming due in early 2020s.”

Jones said the GTECH/IGT deal is compelling from the standpoint of being less leveraged than SciGames/Bally. “I like the capital structure a little bit better,” he said. “There is also going to be a tax benefit because of the UK listing. I do like the merger of two companies that are 900-pound gorillas in their environment. I think GTECH will probably do what everyone has been telling IGT to do for a while, which is to decide whether they are based in Reno or Las Vegas and realize some of those corporate efficiencies sooner rather than later.  I do think that some of the success they’ve had with DoubleDown adds to the synergies; there’s not a heck of a lot of overlap. It really feels like a true merger of companies where 1+1 will equal 3. I think they’re going to have much better distribution, although I would have preferred to see a much better Asian distribution from one of those companies. I think they’re still a little bit weak on the Asian exposure and the electronic table games area as well, which I think is an area where IGT has taken its eye off the ball. They’re trying to play catch-up with their new partnership with LT Games.”

As for SciGames/Bally, they’ve come out with a $220 million synergy number which suggests there is a fair amount of overlap, said Jones. “Certainly, there is a significant amount of overlap between Bally and WMS on the gaming ops side of the business. They have insisted they are going to run the ops business as separate companies but I find that can’t be true because they, hopefully, will develop a joint protocol which would give them more leverage. It would be silly not to use the same purchasing environment and not gain leverage on a buy; the last thing in the world you’d want to do is compete with each other on a purchasing environment.”

On the revenue side, there is enthusiasm for the total gaming vision that is implied by the combination of leading slot machine and lottery suppliers.

“Whether you’re running a lottery, a racino or a casino, the back-end system is all pretty similar; they’re all running off the same platforms and accounting systems, ” said Brent Pirosch, director of gaming consulting for CBRE’s Global Gaming Group. “IGT/GTECH and Bally/SciGames have become the touchpoint for the whole industry by virtue of their back-end systems. “Anywhere you think there might be growth coming, they are now well-positioned for the future. IGT and GTECH are the first guys on the ground in any jurisdiction. If you’re one of those guys who believes that airports are next in terms of being good new locations for slot machines, or whichever branch grows the fastest, they’ve got a pretty deep hook into it.”

For GTECH and SciGames, the increased range of opportunity addresses problems on the lottery side of their business which are not dissimilar from challenges faced by the casino segment.

“Growth in lotteries has slowed; privatization was supposed to be a big opportunity and that never really materialized,” said Eilers. “Where it did, it was not necessarily a good thing for the vendors, i.e., GTECH in Illinois. A logical expansion strategy was to get involved with the commercial casino business. SciGames made that bet with WMS. They saw a tremendous opportunity to roll up the companies in the domestic space here and saw a lot of cost synergies. What I’ve seen over the years is that lotteries are kind of a me-too business model; whatever one does the other emulates.”

With that, Eilers said it made perfect sense that GTECH would do a similar deal to SciGames/WMS. “When IGT was up for sale it made logical sense for GTECH to come in. They’ve already partnered in Italy with the VLT market there.  There’s an opportunity to take that land-based slot content and apply it to a government-sponsored VLT arena, whether it be Italy, Greece or a commercially distributed market like the UK betting shops. Having access to that content and being able to deploy it across VLT or VLT-like markets is a benefit of owning a traditional slot company. That also creates an advantage when they go after new VLT markets.”

On the interactive side, lotteries, like casinos, are interested in building out interactive businesses. “That marries nicely with what some of the slot vendors are doing in that space,” said Eilers. “Casinos and lotteries are faced with similar problems in trying to tap into a younger demographic in particular. Lotteries are making efforts on the interactive side. Mobile is a big opportunity. I think you’ll continue to see state lotteries be just as aggressive, if not more so, in the area of Internet-based sales. In a lot of cases, it’s a bit easier for lotteries to get into that market because they don’t necessarily need to pass any sort of law. It varies and it can be complicated, but, in a lot of states, the argument can be made that lotteries are allowed to sell games over the Internet. In states without a large casino lobby, you’ll see lotteries continue to be aggressive on this front.”


MORE TO COME?

The flurry of deals in the slot space still leaves the door open for further combinations, even one that might involve another lottery player. The name that comes up most often is Intralot, an Athens, Greece-based company which generated about $2 billion in revenue in 2013. The firm recently made news in Ohio, where it placed 750 of its EZ Play gaming terminals in fraternal organizations throughout the state under the auspices of the Ohio Lottery.

“It would make perfect sense that they would be interested in doing something, but I haven’t really heard their name mentioned as an interested buyer,” said Eilers. “They have a decent U.S. presence, more so on the draw-based lotto side. In my mind, they would be a logical buyer.”

Absent another big lottery/casino supplier deal, Eilers thinks it would make sense for smaller companies to team up. There are, as he points out, extenuating circumstances though.

“It would have made sense for Konami to buy Multimedia, for instance, but you have to take into account that they’re part of a larger, Japanese organization and the Japanese culture is traditionally not big on M&A,” said Eilers. “Aruze has a large owner who is very wealthy and is not driven by the same issues and concerns as a public company; he doesn’t necessarily have to sell or buy. In general, I think you should still see consolidation occurring in the industry. As these big deals ripple through the industry, the lower- and middle-tier players are going to have to do something as well. You’ve already seen that with Global Cash buying Multimedia.”