Gaming Plays: Interview with Gerald F. LaKarnafeaux, CFA

Tell us a little about yourself and how you became interested in gaming stocks?

I've been a securities analyst since the 60s. I started out with an international firm back east and then moved to California where I was with a couple of regional firms. I've been functioning as an independent investment banker for the past 10 years focusing on early-stage companies.

As a sell-side analyst, I'd been disturbed by the conflict of having revenue sources from investment banking and activities other than research. Intrigued by the emerging concept of an independent analyst working on a fee basis, I began work about three years ago an independent contractor with a firm, Investrend, that distributed research over the Internet. There I met John Dutton, who was director of research and a gaming specialist. John invited me to help him identify changes and opportunities that existed in the gaming industry in general and in particular where we saw the Internet developing as a vehicle to create incremental gaming revenues for operating companies.

What areas does 'gaming' cover and what are some of these changes and opportunities?

Horse racing, sports betting, lotteries, and casino -including table games and slots both land-based and over the Internet - are the four major components of the gambling sector.

Traditionally, the horse racing industry has been around with a high degree of respectability as a sport of kings. There have some interesting changes going on in that industry. Track attendance has been declining on a secular basis and yet the handle, or amount wagered, is growing as a result of off-track betting. So there's a whole structural change taking place in that industry.

Then you have the lottery industry, both domestic and international, where there is a substantial amount of money in the aggregate that individuals are willing to wager. Internationally, it's about $130 billion, domestically roughly $50 billion. The lottery area hasn't been growing as much in recent years in the aggregate as it had in the 70s and 80s when it was reinstated as a legitimate pastime. But some structural changes going on in that industry segment, particularly the tug-of-war over using the Internet to sell lottery tickets, could stimulate tremendous growth.

Then, of course, there's casino-type gambling. Within the land-based casino market, which at one time not too long ago was just New Jersey and Nevada, there are a growing number of venues, including scores of tribal casinos and in the past decade a number of states have legalized riverboat-type gambling. So that's creating net growth but intense competition..

Casino-style gambling on the Internet is showing some dramatic growth as well as dramatic dislocation. Online gaming is probably running at the annual rate of in excess of $6 billion. While illegal in this country, there are clearly over 1,500 websites that offer online gambling in real time with real money. Of course, U.S. citizens are not supposed to be participants, and that's an area that's got to be clarified, especially as the major land-based casinos, like MGM and Harrah's which currently have websites for fun and not cash, stick more than just their toe in the water.

In addition, within just the last 90 days, the state of Nevada passed legislation permitting online casino-type gambling without restriction as to the source or location of the bettor.
While that sounds like a real breakthrough, the legislation really just authorized a massive study and the development of regulations in some coordination with the federal government. The Justice Department has been sitting on the sidelines ready to pounce if there's an indication that the 1961 Interstate Wire Act is being violated.

So there are still a lot of uncertainties but also opportunities.

In aggregate is gaming outperforming in this economy?

There are two schools of thought on whether or not gaming is a counter-cyclical activity. Gambling is maybe around 1% of disposable income, and as disposable income contracts that's going to impact the entertainment dollar and the gaming dollar. On the other hand, entertainment historically has held up during recessions.

What might have a greater impact in a recession is that the states have gotten used to a free lunch in a sense in that lottery revenues and casino tax revenues have become built into their budgetary structures. The surpluses which the states experienced with great jubilation in the 90s are now disappearing. The state governments are going to look for ways to stimulate gaming activities in order to maintain this non-tax revenue source.

What are some gaming companies that can benefit most from these trends?

Most of the companies we'll be following will be the smaller-capitalization companies that are more or less orphans as far as research is concerned. There are a couple of intriguing ones within this group, both oriented to the lottery. These are MDI Entertainment (LTRY), which has a very interested niche within the instant ticket lottery market, and eLOT (ELOT), a company that has positioned itself waiting for the time that lottery tickets can be retailed over the Internet. It's a gamble on their part. They are generating some interim revenue through other businesses, but the real play here is they have the software platform that will enable the states, when they retain eLOT and its technology, to sell lottery tickets over the Internet.

Assuming states do this - that is go against the moral minority and permit the sale of lottery tickets online -- a ticket distributor such as eLOT will benefit. The Internet may increase lottery sales by bringing new people in or increase the amount that existing lottery players purchase. Again, this could be very significant to eLOT. When you figure that retail commissions are about 6% of the roughly $50 billion of the amount wagered in lotteries, just a small piece of that 6% for an early stage or speculative company could be very significant. And there doesn't seem to be a number 2 , 3 or 4 company positioned right now. Although a few will surely emerge, eLOT has an edge. The company has been around for several years telling its story to all the lottery directors and staffs, and they're a known entity.

Both eLOT and MDI are speculations in the sense that they're smaller companies. Both are having very good years on a fundamental basis, although both have recently been knocked off the Nasdaq Smallcap Market to the Bulletin Board because the listing requirements of both companies have not been maintained. But that can change over the next six months or so, and I'm not even sure how negative being on the Bulletin Board is. It certainly limits the institutional participation, but these are hardly institutional stocks anyway.

Are there any other companies you like?

Another one that looks very interesting is Scientific Games (SGM), formerly Autotote. They have the dominant market share in the production of instant lottery tickets domestically with about 65% and also on an international basis have about a 25% position. The lottery end of the business was acquired a year ago. The historical Autotote business is paramutual horseracing. The company's products consists of the computer hardware and software that ties in the off-track-betting infrastructure of the horseracing industry.. So if you want a direct, undiluted play in gaming, Scientific Games is a good vehicle.

Chartwell (CWH) is another company that looks very interesting to us because of their proprietary software that is sold to the online casinos. The online casino business is a very fragmented, crowded business at this point, although in some case of software suppliers, the margins are still pretty good. Chartwell uniquely sells proprietary flash casino software to those that actually operate the online casino sites. Selling the software is less competitive, has more value-added, and you're not looking over your shoulder at the threat of the major land-based companies who, when they eventually decide they want to go online, are going to cause the other thousand or so online casinos to run for cover. Another gaming software developer is Dot Com Entertainment. This company is to the game of Bingo what Chartwell is to casino games. Don't laugh, Bingo is a $70 billion market.