Seven months into his tenure, California Governor Arnold Schwarzenegger has become a gambling man, turning to casino revenue to fill gaps in his state's budget. Currently, Schwarzenegger is negotiating with California Native American tribes, allowing them to add an unlimited number of slot machines to their operations in exchange for giving the state a cut in the action. The new agreements, which are expected to become official in the coming month, could yield jackpots for some companies.

"Four Native American tribes in California have reportedly reached a tentative agreement with the governor in the current compact renegotiation and gaming expansion talks," said Marc Falcone, gaming analyst at Deutsche Bank. "While the governor has not released official word, reports out of California indicate that the tribes would be granted unlimited slots, doing away with the current cap of 2,000."

Without an official announcement, it's impossible to say exactly how the deal will look, but the change in approach could bring a windfall for the state. According to Falcone, under the tentative agreements reached this week, the state could see $1 billion from the four tribes, with $250 million a year after that, plus more, if other tribes sign on.

One thing is already clear: Schwarzenegger wants to expand gambling so his state can profit from it. In his new budget, the governor had a $500 million line item for revenue generated from tribal casinos, but in order to get the money, he had to reverse the state's historical opposition to gaming.

If You Can't Beat 'Em...

After spending years unsuccessfully fighting tribes in courts, California's about-face is remarkable.

In the early 1980s, the state fought against the bingo jackpots that were popping up on tribal lands, but in 1987, the U.S. Supreme Court ruled that the state couldn't stop the tribes, which are considered sovereign nations, from offering gaming. In 1988, Congress passed the Indian Gaming Regulatory Act, which allowed states and tribes to set up compacts governing gaming on a case-by-case basis, creating a regulatory framework.

For the next decade, from 1988 until 1998, California gaming existed in a gray area. The state government didn't legalize gaming, raiding the unsanctioned tribal casinos and seizing machines. But in 1998, tribes spent millions to back Proposition 5 on the California ballot, which legalized gaming in the state, passing it by a 2-to-1 margin. Proposition 5 was later struck down by the state courts, but tribes and voters were undaunted, overwhelmingly approving Proposition 1A in 2000, which finally legalized gambling in the state.

Soon after, then-Gov. Gray Davis signed compacts with nearly 60 tribes, paving the way for the explosive growth in California gaming over the last four years. But having opposed gaming for so long, the state's compacts instead tried to limit it -- capping casinos at 2,000 slot machines -- and left the state in no position to capitalize on it. For the last four years, California has not received one cent from gaming revenue.

California: Bigger Than Vegas?

That, of course, is what Schwarzenegger is about to change. With the state angling for its cut, a second wave of Californian growth is at hand, and that could help the market eclipse Las Vegas as the most lucrative gaming region in the world. Already, California brings in an estimated $4 billion in gaming revenue a year vs. roughly $5 billion for Las Vegas.

"Near term, the renegotiated compacts could add an additional 10,000 to 15,000 machines to the state," estimated David Barteld, gaming analyst at Wells Fargo, in a research note. "The unlimited slot provision, however, would likely be a catalyst for expansion of existing casinos and business of new casinos in the state."

Barteld estimates that as many as 15, or about a quarter, of California's tribal casinos are large enough to expand beyond the 2,000-slot-machine limit. And with casinos poised to add more machines, companies such as

International Game Technology

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Alliance Gaming

(AGI) - Get Report

are positioned to prosper, because they make the kinds of machines the tribes favor.

"Not only would an expansion of the slot base contribute to more game sales and ultimately a larger replacement market, but California tribal casinos have among the highest number of revenue participation games of any major U.S. gaming jurisdiction," said Barteld. "This bodes well for growth."

Many of these machines will end up in markets where demand is already quite strong, such as southern California and outside Sacramento and San Francisco -- places where gaming operators such as

Station Casinos

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have already formed partnerships with tribal casinos.

Pull Into the Station

Of all the casino operators, Station may be the best positioned to capitalize on the spread of gaming in the state.

Over the last year, Station has spread beyond the Las Vegas local market it now dominates, signing management deals with tribes. In exchange for fronting the cash and using its clout to help tribes secure financing for fund construction, the company signs long-term deals to manage the casinos, and it receives more than 20% of the profits. Such deals are extremely low-risk for Station, which is reimbursed -- and then some -- once the casinos are up and running.

The Thunder Valley casino, a partnership between Station and the United Auburn Indian Community that opened a year ago, is a good illustration of how powerful tribal partnerships can be. Before it opened, Station fronted the tribe $47 million and guaranteed a $215 million loan in exchange for taking a 24% cut of profits over the next seven years for managing the casino.

In its first year of operation, analysts say, Station will earn between $65 million and $75 million in management fees from Thunder Valley, and that will increase if the tribe can add more slots.

"The United Auburn tribe is reportedly close to renegotiating its compact with the state," said Falcone. "Clearly, this is a positive for Station, which also has three other management contracts with tribes in California."

Indeed, the success of Thunder Valley has inspired Station -- and rivals such as

Caesars Entertainment

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-- to court new tribes. Already, Station has signed a deal with the Mechoopda Indian Tribe to develop a casino in Chico, Calif., and another with the North Fork Rancheria of Mono Indians to develop a casino in Madera County, Calif. Station expects its four California tribal partnerships to fuel growth, with earnings per share growing between 25% and 28% through 2007.

Depending on the specifics of the renegotiated gaming compact between the United Auburn tribe and the state, the company hopes to take on new partners. And there's no shortage of potential players; of California's 108 federally recognized tribes, 54 already have casinos, while another 26 are in the proposal stage, according to a study from the California State Association of Counties.

"We do have an interest in taking on additional agreements in California," said Glenn Christenson, CFO of Station Casinos. "Once this particular compact gets signed, it will help everyone understand what the economics might be. In order to change the existing compact, tribes will have to agree to some increase in taxes. Right now, everything is up in the air."

Ultimately, with Thunder Valley boasting 1,906 slot machines on its gaming floor -- and Station generating 85% of its income from slots -- the coming expansion makes the company a decent bet, in the eyes of analysts.

"Other than Station, California is really a manufacturer's story. But Station's done a good job getting contracts in California and a good job finding great locations," said Lawrence Klatzkin, a large-cap gaming analyst at Jefferies & Co. "If I had to pick one place where I'd want to be in the next few years,

Station's local market in Vegas is a great place to be, as is the local California market."