We often hear that the $40 billion spent on video games worldwide dwarfs the amount spent on the motion picture industry. But another form of mass entertainment dwarfs them both: the lottery business. According to a Morgan Stanley study, sales of lottery tickets around the world will top $160 billion in 2004.

You should be thankful for the lottery business this week as you write a check for your tax bill. That's because you'd probably owe a lot more if not for your fellow citizens' crazed desire to get rich quick.

Forty states and the District of Columbia currently sponsor lotteries to raise money for everything from old-age homes and kindergartens to veterans' services and state parks. Six more states that have resisted so far are edging closer to entering the game.

Experts expect that by the end of this decade, just two states will not have a lottery: Nevada, where the casino lobby will block it until Doomsday; and Utah, where the anti-gambling Mormon church holds sway.

For investors, the curious thing about the lottery business is that once you peel back the glossy governmental layer, it's virtually a duopoly. Practically all of the games in this country are managed directly or indirectly by just two companies: Rhode Island-based GTech Holdings ( GTK) and New York-based Scientific Games ( SGMS).

And it's even more curious that these two mid-cap companies, while not extraordinarily cheap at the moment, aren't really expensive either. Each sports a forward price-to-earnings multiple of around 20. For GTech, the larger of the two, that's only about half again as big a multiple as its estimated 12% to 15% growth rate. For Scientific, it's considerably less than its estimated growth of 20% to 35%.

An Industry You Can Bank On

It doesn't take the hyperactive imagination of a weekly Lotto punter to figure out that an investment in either of these two companies is a lot smarter than playing the numbers. If you believe the growth estimates, which might actually be a little low, you should be able to earn 20% to 25% annually on Scientific Games over the next few years.

Compare that to the 1.4% you'd earn investing the same amount of money in the U.S. government with a one-year Treasury bill, or the 8% annual return you can probably expect from the roulette wheel known as the S&P 500, and the idea becomes more compelling. The nice thing is that you don't have to make any bet on economic growth to get at these numbers, because states tend to boost the number of games during downturns to make up for a shortfall in payroll taxes. In better times, lottery growth may slow, but historically it has never declined.

The industry's strength is most impressive when you compare it to the reliability of just about any other. No one can say for sure whether the wireless Internet will be around for more than another couple of years. And who knows whether fuel cells, nanotech or gourmet coffee will be viewed as curios or commonplace by our kids?

But if there is one thing you can count on lasting until the end of time, it's governments' desire to separate citizens from their money without taxing them. Morgan Stanley reports that 200 jurisdictions around the globe have authorized lotteries; Oklahoma is probably next in line in the U.S. to add one, and it could be followed thereafter over the next few years by Mississippi, North Carolina, Alaska, Alabama and Arkansas. Overseas, lottery fever is reportedly flaring up in Russia, China and Thailand.

Lotteries aren't new, of course. Historians say the Great Wall of China was partly funded by a form of lottery, as were Harvard and Yale in the 18th century. A type of lottery funded much of the Revolutionary War.

Lotteries funded a variety of U.S. state functions in the 19th century, but corruption and scandals led to a congressional prohibition on interstate lotteries until the 1960s, when New Hampshire set up a lottery that it coyly called a "sweepstakes." New York and New Jersey timidly followed in 1967 and 1970, and soon industry and state lobbyists managed to get federal law changed to permit the rapid expansion of games elsewhere.

Limiting the Players

Two key types of games are run today: "Instant ticket," in which players scratch a rubbery coating from a printed ticket to determine whether it's a winner; and "online," in which a player picks five to seven numbers at random and learns whether he's a winner in a weekly televised drawing.

GTech and Scientific Games make most of their money by skimming a percentage off all revenue of the games that they create -- typically $6 to $12 per 1,000 tickets. So they have incentive to try to create increasingly fun contests in dizzying variety with names like "10 Times Lucky" and "Payday Tripler," which draw in new players and encourage regular players to bet more.

The companies also take hardware and software development, licensing and maintenance fees, and they're moving into the more comprehensive role of running entire lotteries on an outsourced basis in place of an entire state bureaucracy. Most of the growth is in instant-ticket sales -- about 15% in 2002 and 10% in 2003 -- because they feed gamblers' quest for a quick adrenaline rush. In May, the Iowa lottery will debut a game by Scientific Games that resembles the dynamics of a slot machine. A push is on to ramp up distribution by creating self-service kiosks, and partnerships with IBM ( IBM) and NCR Corp. ( NCR) have led to cash registers that can print lottery tickets.

Investors always need to focus on business' barriers to entry because competition drives down prices and profit margins. This is where GTech and Scientific Games sparkle. Several factors have limited the number of players, but the most important seem to be:

  • The need to prove the security of the ticket-printing process.

  • The difficulty in managing the regulatory process and the need for proprietary software.

  • Hardware terminals that interoperate across state boundaries with 99.999% reliability.

Every lottery director fears the week he might need to put out a press release that says the week's drawing is canceled because of a software glitch. Contracts are awarded for three to five years and typically renewed automatically. Historically, once a company has won a state's business, it rarely loses it.

The Smarter Bet

Which one is the better bet? GTech is no slouch, but the nod now probably has to go to Scientific Games. It's the pioneer in instant-ticket games, the fastest-growing segment of the business, and recently bought an online unit from industry titan International Game Technology ( IGT) to bolster its ability to expand in that area.

New contracts include an instant-ticket win in Wisconsin worth about $3.5 million per year. Analysts believe the company will win a comprehensive lottery-services contract in Virginia at the end of April that would start at $4.6 million per year. It's on track to win the California instant-ticket business. The company's efforts in Europe are paying off with an Italian instant-ticket contract, and contracts in Germany and Spain also loom.

Plus, Scientific Games has leveraged its know-how in secure printing into the creation of a large prepaid-phone-card business. And you can't leave out its growing business in horse racing, where its "totaliser" systems provide the hardware and software required by tracks to take wagers, figure odds and payouts and manage the entire parimutuel betting process.

Scientific Games has guided analysts to expect earnings of 76 cents to 83 cents per share in 2004, but given the gaming that goes on with such guidance, so to speak, you can probably expect it to come in at more like 85 cents to 90 cents. A company growing at 30% that sports a forward P/E multiple of around 20 is not much of a gamble. Because there is some earnings risk in the first quarter due in part to the lack of big Powerball jackpots, you might wait until after it reports next Thursday and try to pick it up under $18.

Stick the IRS in the eye by investing some of your tax refund here. In a couple of years, maybe you'll win back all of your 2003 taxes.
Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jdmmail@fastmail.fm. At the time of publication, Markman had positions in the following securities mentioned in this column: GTech.

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