B-52ed

The stock's new and "improved" valuation has some on Wall Street suggesting that it's now more than worth the gamble. Today we'll lay out their argument, and explain why Election Day could prove pivotal for Multimedia, whose shares turned up recently in our Contrarian screen.

Contrarian investors search through stocks that investors are running away from in order to determine if any of them are due for a bounce. It's an aggressive form of value investing, and one that requires the ability to move against popular opinion. But when it's successful, the profits can be plentiful. For example, Westell Technologies (WSTL), the subject of our last contrarian screen on July 28 ("Modem Operandi"), is already up 15% in the past five weeks, compared with a 1% rise in the Standard and Poor's 500.

Two steps are critical when reviewing contrarian candidates. First, make sure you understand why the shares are falling. And second, have cause to believe that the problem, whatever it is, is likely to be fixed. Our contrarian screen looks for lousy stock performance over the past 13 weeks, and weeds out companies with average analyst recommendations of Buy and Strong Buy — such popularity is unwelcome in a value screen. But it also looks for manageable debt levels, profitability, and price/earnings-to-growth, or PEG, ratios that are below 1.0 — a sign that companies' problems are already more than discounted in their shares.

Run our contrarian search anytime you like using our stock screener and the recipe listed to the right. Recently, it produced a list of 29 companies, including Multimedia Games.

With a market value of $441 million and trailing-12-month sales of $455 million, Multimedia Games is firmly in small-cap territory. But until its recent woes began, it didn't look likely to stay there for long. Shares of the company during the past five years are up 712%. Through July 29 they were up 1,205%.

Multimedia Games makes so-called Class II and Class III electronic gaming systems — which are sold under revenue-sharing agreements, and for up-front fees, respectively. The company's games are interconnected within and between facilities, allowing players to compete for pooled prizes. Its customers include Native American gaming locations in Oklahoma and a handful of other states, and charitable lotteries. Multimedia Games supplied the central operating system for New York's video lottery system, which is more-or-less a casino that operates at four racetracks and is expected to be rolled out in others in 2005.

Third-quarter results for the company (ended June 30, reported July 29) showed sales slipping 2.6% to $36.9 million and profits increasing 11.0% to $9.8 million. Per-share profits of 32 cents missed analysts' projections by two cents. Management blamed a decline in the number of terminals deployed on "ongoing proliferation of games that may not meet the legal requirements for Class II games." What are those guidelines? Lawyers and politicians are arguing on that very question right now.

It's not clear, say industry watchers, which types of games are allowed in Oklahoma. One-touch games, for example, operate much like slot machines, which are specifically under current state law. Multimedia Games has elected not to provide these games for now, sending casino operators to the company's competition to buy them. Oklahoma State Question 712, due to be decided by voters in November, asks whether these games and others should be allowed. Recent polling suggests the broader gaming guidelines will be approved by a narrow margin.

David Bain, an analyst with San Francisco-based stock research firm Merriman Curhan Ford & Co., thinks the vote could prove a catalyst for the stock no matter the outcome. If the measure passes, Multimedia stands ready to release several new games that take advantage of the new rules, including its MegaNanza, which Bain notes is the most profitable game in Oklahoma for casino owners. "It would be a regulated market, and Multimedia should receive a higher multiple for the revenue generated in Oklahoma," he wrote in an Aug. 30 research note. If it fails, Bain believes, the National Indian Gaming Commission will likely crack down on illegal operators, which could give Multimedia more floor space.

The release of 600 downloadable games later in September might prove an equally lucrative event for Multimedia Games. Downloadable games offer casino owners the opportunity to change content quickly — slots for the old-timers on weekday afternoons, video poker for the construction workers stopping by after quitting time and tournament games for the late-night high-rollers. Increased profitability for casino operators could not only win Multimedia more customers, but would increase its take of the earnings, too.

How do shares look next to analysts' forecasts for the company? They trade at 10.1 times fiscal 2005 earnings, compared with an average of 17.9 for gaming-equipment suppliers. And Multimedia Games is projected to improve its earnings by 20% annually over the next five years, faster than the group's 13%. That gives the stock a PEG ratio of just 0.51, well lower than peers' 1.38 and the S&P 500's 1.54, suggesting it may be time for contrarians to ante up.