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International Game Tech (IGT): Sell IGT following deeper analysis of Double Down acquisition

January 17 2012

After further analysis of IGT's Double Down Interactive acquisition we have grave concerns related to 1) potential consequences for its core slot machine business and 2) stewardship of capital - given the magnitude of the transaction and the decision to buy versus build. These concerns prompt us to recommend selling IGT shares and to lower our FY12 and FY13 estimates further below consensus. We recommend investors swap into shares of BYI or SHFL, core gaming holdings in our view.

Details of IGT's Double Down deal - Last week IGT announced the acquisition of Double Down Interactive LLC for up to $500mm. The deal is structured with an immediate $250mm cash component, $85mm in retention payments (over two years, for 15 employees we believe) and another $165mm in incentive payments if Double Down can exceed certain financial benchmarks. Double Down Interactive is an online social gaming company that develops the popular DoubleDown virtual casino game and other interactive games for Facebook, where approximately 90% of its revenues are generated. Currently, the Double Down casino has 4.7mm monthly active users (MAU's), while Facebook has over 800mm global users.

Three major casino operators are irritated that IGT has chosen to compete with them - We believe that three major casino operators have taken exception to IGT's acquisition of Double Down. These operators represent about 13% of North American gaming devices, and are an excellent proxy for other casino operators' view/behavior. This is mostly via first-hand discussions we've had with leadership at these companies. They suggest that they will react negatively especially if IGT pushes around content that they cannot have access to. They also are concerned about how IGT will treat poker once they launch it and when it is legalized. They highlight that IGT is going directly to the end-user, which contrasts with IGT's view that they are B2B and not B2C. We believe this could manifest in retaliatory purchasing behavior, ultimately reducing IGT's replacement ship share in a noteworthy manner, perhaps even before the acquisition closes.

Our updated Double Down estimates - In order to more competently forecast Double Down's revenues and EBITDA we dug into social media math. We have monitored AppData's metrics for the DoubleDown Casino Facebook page to verify the 4.7mm MAU disclosure, which has been steadily increasing. More importantly, we use AppData's daily active users (DAU) of 1.3mm as a revenue input. We estimate $4-to-$5 in monthly revenue per user to arrive at run-rate gross billings (before Facebook credits) of $70mm. We assume EBITDA margins of 25% to arrive at $18mm in EBITDA. We are cognizant of Zynga's (as an aspirational comparable) prior 40% EBITDA margins, that are now approximately 25% as they aggressively re-invest in their business. We believe that Double Down's move into mobile and poker among other casino games suggests a similar investment phase margin profile, when part of a large platform like IGT.

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