Fitch Upgrades Bally's IDR to 'BB+'; Bank Debt to Investment Grade; Outlook Remains Positive

Fitch Ratings has upgraded Bally Technologies, Inc.'s (Bally) Issuer Default Rating (IDR) and senior secured bank debt ratings as follows:

--IDR to 'BB+' from 'BB-';

--Senior secured bank credit facilities to 'BBB-' from 'BB+'.

The secured credit facilities are comprised of a term loan with $206 million outstanding as of June 30, and a $75 million revolver.

The Rating Outlook remains Positive.

The upgrade of the IDR reflects Bally's continued operational and financial improvement driven by its improving and broadening product pipeline, solid market position, and sustained debt reduction. In addition, the upgrade reflects resolution of previous accounting issues as the company's auditors no longer cited material weaknesses in internal controls over financial reporting in the recently filed annual report, which is the first time that has occurred since the company's turnaround.

Despite the difficult operating conditions for casino operators, Bally's operating momentum and solid product pipeline has continued to drive ship share solidly above its installed base market share, which has significantly improved the company's market position over the last few years and dramatically improved its financial results. As of the latest fiscal year-end (June 30,), Bally's latest 12-month (LTM) reported adjusted EBITDA increased 10 percent to nearly $300 million from $272 million as of fiscal year 2008 (FY08) and is up six-fold from its trough level of around $50 million in FY06.

However, the positive momentum has slowed as expected, and the operating environment is likely to remain challenging in upcoming quarters. Results over the past two quarters have been impacted by the pressure on casino operator capital budgets, which Fitch expects to continue. Resistance in purchasing decisions during the deepest part of the recession in calendar fourth quarter-2008 (Q4'08) and Q1'09 is affecting current results for Bally's systems business, as there is typically a two- to three-quarter lag from purchasing decision to reported results. There was a notable improvement in systems-related purchasing decisions in April 2009 that has been sustained, which should help results in calendar Q4'09 and Q1'10.

In the gaming equipment business, units sold declined by 30 percent-35 percent in calendar first half-2009 (1H'09), reflecting the industrywide pressure. However, the company's ship share over the last couple of years has consistently been in the low-to-mid 20 percent range, which is higher than Bally's roughly 10 percent-15 percent installed base market share, indicating its improved market position. In addition, average selling prices (ASPs) continue to grow despite the pressure on unit volume. ASPs increased about 6 percent-6.5 percent in calendar 1H'09.

The company's gaming operations business has benefited relative to competitors during the recession by having a greater portion of its mix skewed to a daily fee pricing model, which is less sensitive to reduced customer play levels. Of course, that also limits upside from the positive leverage associated with a rebound in consumer spending. The company has also improved asset utilization with its installed base, which has helped improve gaming operations margins and profitability, partially offsetting the recent pressure on its gaming equipment and systems business segments. Still, Fitch believes customer play levels are likely to remain under pressure into next year, and an ensuing recovery is likely to proceed slowly.

Although Fitch expects the current pressure on casino operators to continue to impact the operating performance of suppliers, there are some mitigating factors that support a more positive secular view. Upcoming unit sales will benefit from the supply increase in Las Vegas over the next 12-18 months. Longer-term, gaming expansion legislation was passed in Ohio, Illinois, Maryland, and Kansas, which represent new market potential if and when regulations are finalized and operations commence. Although replacement demand remains weak, casino floors are becoming aged, which will result in an eventual and inevitable cyclical pickup in replacement demand since the peak of the last replacement cycle was in 2004.

The primary credit concerns include technology execution, litigation risk, capital allocation decisions, and the limited tangible asset base.

Technology Execution:

The implementation and commercial rollout of the server-based gaming product cycle has been pushed back meaningfully, which enables Bally to continue to invest in product and game development and protect its competitive position. Due to its larger size, greater financial resources, and broader product pipeline, Fitch remains concerned that International Game Technology (IGT) could strengthen its competitive advantage in a replacement cycle driven by server-based gaming, although Bally also has competing server-based products and technology. The opening of CityCenter later this year could provide market feedback on the timing of a rollout and potential insight into the market impact.

Bally's product platform improvement over the past couple of years, its strength in its systems business, and recent success with products that offer some server-based functionality mitigates this risk somewhat. IGT has made a sizable R&D investment in server-based gaming over the last few years at the expense of its game content, which has enabled both Bally and WMS Gaming (WMS) to materially increase their market position. Still, the economics, timing, and market impact of server-based gaming have yet to be determined.

Litigation Risk:

The gaming supplier industry is highly litigious with respect to patent infringement, and market-leader IGT and Bally have a few outstanding lawsuits. Patent infringement lawsuits in the gaming supplier industry, as well as the broader technology industry, often result in some sort of settlement or licensing agreement and seldom go to trial. In Fitch's view, the most meaningful of Bally's current outstanding lawsuits is the wheel-based games lawsuit, in which Bally received a favorable ruling in October 2008, but IGT is appealing. More broadly, the litigious nature of the industry necessitates companies, particularly second-tier companies like Bally, to maintain low levels of debt leverage.

Capital Allocation:

As Bally's financial position has improved significantly over the past couple of years, capital allocation decisions with respect to potential M&A and share repurchase are likely to impact the credit. Both are permitted, but limited by the term loan agreement. Bally is permitted to repurchase shares or pay dividends in an amount up to $50 million annually if leverage is above 1.0 times (x), and up to $70 million annually if leverage is below 1.0x, with the cumulative amount of cash returned to shareholders not to exceed $220 million over the life of the term loan, which matures in September 2012. Fitch believes Bally is likely to use free cash flow to repurchase shares liberally in the absence of any attractive growth investments, such as potential acquisitions. Bally is permitted to use up to $250 million in cash and equivalents to make acquisitions and is allowed to issue up to $150 million in senior unsecured debt.

The term loan balance as of June 30, was $206 million and LTM EBITDA was nearly $300 million, resulting in leverage and gross interest coverage of 0.7x and nearly 16x, respectively. The company's strong financial profile allows for some additional leverage given the current business risks. Fitch believes the company will use free cash flow (FCF) rather than additional debt to fund share repurchase, while preserving the additional debt capacity for potential growth opportunities. Given the principal amortization of the term loan, the share repurchase restriction, and more attractive credit facility pricing at leverage below 1.0x, Fitch believes Bally is likely to remain below that leverage level in the absence of a potential acquisition.

LTM FCF was $131 million and should remain solid, but the company's EBITDA flow through to FCF is likely to be somewhat impacted as Bally extends additional financing to strained casino operators. Still, Fitch believes FCF should comfortably cover required term loan principal amortization of $32.5-$45 million annually over the next three years, continuing to improve Bally's credit profile, while leaving ample residual FCF for share repurchase. In addition to the solid FCF profile, Bally's liquidity position is strong relative to its cash needs, with $61 million in available cash (net of cage cash) and an undrawn $75 million revolver.

Future Rating Considerations:

The Positive Outlook reflects Fitch's view that the industry and Bally exhibit a number of sustainable investment characteristics, which support the potential for an investment grade IDR:

--oligopoly industry structure: four main players (although Konami has been making strides to make it five)

--high barriers to entry: licensing requirements, brand/game title recognition

--recurring revenue sources: gaming operations, systems maintenance/service revenue, growing installed base of replacement units

--strong free cash flow generation capability: low capex requirements

However, those attributes are offset by the secular uncertainty of technology and litigation risks. As a result, Fitch believes that while an investment grade IDR is achievable for Bally, those risks necessitate maintaining low levels of leverage compared to other investment grade industries. The credit facility's maintenance leverage covenant is currently 2.25x, which will decline to 2.0x as of June 30, 2010.

A further upgrade to an investment grade IDR would be supported by the continued broadening and penetration of the company's product portfolio, as well as increased penetration geographically. Specifically, an improved market position in progressives and video products and increased international penetration would be positive factors. In addition, Bally's performance and market position relative to a server-based rollout will be closely monitored, and an adverse change in ship share could result in an Outlook revision to Stable.

Term Loan Upgrade:

Bally's credit facility rating was upgraded to 'BBB-' from 'BB+'. As an issuer's credit profile improves and the probability of default reduces, the impact of over-collateralization and recovery prospects on an issue-specific rating becomes less meaningful. As a result, the notching of issue-specific ratings relative to the IDR is compressed as the IDR increases. Therefore, Fitch upgraded the credit facility by one-notch, compared to the two-notch upgrade of the IDR.

The credit facility is secured by substantially all of Bally's domestic property and is guaranteed by each of its domestic subsidiaries except for its interest in the Rainbow Casino. While Fitch recognizes that much of the company's value outside of the Rainbow Casino is in the form of intangible assets, it continues to believe the credit facility is currently highly over collateralized, and the recovery prospects are strong given the rapid principal amortization of the term loan.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, 'fitchratings.com'.

((Comments on this story may be sent to newsdesk@closeupmedia.com))

Related terms: accounting, acquisition, annual report, bank, business, commercial, consumer, debt, dividends, ebitda, environment, expansion, financial results, illinois, investment, kansas, lawsuit, legislation, market, market share, maryland, ohio, patent, pipeline, prices, products, property, regulations, revenue, sales, ship, technology, trial, video