Gtech's Y2K Tardiness Represents Big Gamble for Investors

The company's last-minute preparations for Jan. 1, 2000 have some on the Street predicting doom.
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Remember the Y2K problem?

Planes were gonna crash. Nuclear power plants were gonna melt down. Generally, the world was gonna turn into a very expensive Hollywood movie.

Well, no one seems to be thinking much about Y2K anymore. The

Federal Aviation Administration

has pronounced itself satisfied that the U.S. air traffic control system will be ready for Jan. 1, and who could doubt the FAA? After spending tens of billions of dollars to comb through and debug their computer code, most U.S. companies have pronounced themselves largely satisfied with the state of their Y2K readiness. And investors have moved on to more important topics, like

Amazon.com's

(AMZN) - Get Report

earnings.

And then there's

Gtech

(GTK)

.

The Rhode Island company, which runs lotteries for 28 states and 34 countries, came into 1999, looked around and realized that, hey, the year 2000 was getting pretty darn close. In Gtech's most recent 10-Q for the quarter ended Nov. 28, the company disclosed that it had barely begun planning for Y2K.

How far behind is Gtech? In the filing, the company said it had completed just 45% of the first phase of its six-phase program, "compiling a comprehensive list of software and hardware technologies in use by the company." In other words, Gtech still hadn't figured out what kinds of computers it owns. Another sign of its tardiness: In the filing, the company said it had spent just $1.5 million of the $25 million budgeted for its Y2K fix.

Since the filing, Gtech has apparently made some progress. Spokesman Stephen White says the company has now completed the inventory phase of its Y2K project, as well as the "assessment" and "planning" phases. But what about actually fixing the problem or testing the fixes? White won't say how far along the company has come on those crucial steps, insisting only that Gtech is "on schedule." According to the 10-Q, that means that the company expects to have its computers debugged and tested by September, just three months before Y2K.

White also declines to disclose crucial details about the scope of Gtech's problem. For example, how many lines of software code are in the company's systems? No comment. Does Gtech expect to have to examine each of the 300,000 lottery machines it has installed around the world? No comment. What contingency plans does the company have? No comment.

Still, White insists his company will be finished in time. "One of our competencies is being able to implement systems on very tight deadlines that cannot be missed. That's what we do."

"It's certainly something we're very concerned about," says Charles Strutt, executive director of the

Multi-State Lottery Association

, which runs the

Powerball

lottery. Still, Strutt says he expects Gtech and other vendors will be able to test and pass their equipment "in time."

But some Y2K experts are skeptical. "They're really far behind, and what's interesting is they're so ignorant that they're happy to put those details in a public report," says Stephanie Moore, a director at the

Giga Information Group

, a technology consulting firm that hasn't consulted for Gtech. "For a company that needs to spend $25 million and has only spent $1 million, that means they have a significant Y2K problem and there's a lot of work to be done. ... They're way, way, capital W-capital A-capital Y behind."

William Ullrich, president of the

Tactical Strategy Group

and another Y2K expert, is even more pessimistic. "They're looking at a life-cycle project of two years ... and they're trying to squeeze it into six months," Ullrich says. "They're probably going to have a lot of problems, and what they need is a good contingency plan. ... Their contingency plan may be to shut down and head off for the Cayman Islands."

On a more serious note, Ullrich says Gtech may be able to squeak by because other companies have already finished their Y2K efforts, creating a pool of consultants and software engineers that the company can tap to create multiple teams to attack its problems. But that step could be very expensive and may not work in any case, Ullrich warns.

"They've got a huge problem on their hands, and it takes a lot of time to go through those distributed systems," Ullrich says. "It just takes a lot of work."

Gtech's potential Y2K problem is especially acute because, as the company discloses in its 10-Q, state lottery contracts "provide for up to $10,000 or more in liquidated damages per minute for system downtime in excess of a stipulated grace period." Yes, you read that right. $10,000

per minute

.

All this bad news has caused at least one New York hedge fund manager to short Gtech. "If there's any glitch at all, there's double jeopardy," the manager says. "

The company will pay liquidated damages, and then you risk losing the contract when it comes up for renewal."

While Gtech is inexpensive, trading at just 10 times earnings for its fiscal year ending February 2000, compared to an average price-to-earnings ratio for the

S&P 500

of almost 30, the manager thinks the stock could fall further. He notes that, in addition to its Y2K problem, Gtech faces real competition in the lottery business for the first time, thanks to the proposed acquisition of

Powerhouse Technologies

(PWRH)

by

Anchor Gaming

(SLOT)

. On its own, Powerhouse was too small to give Gtech a run for big lottery contracts, which require a big up-front investment, the manager says. But Anchor, which generates solid free cash flow from its slot machine business, has the financial muscle to compete for even the biggest contracts.

Meanwhile, sell-side analysts have largely stopped paying attention to Gtech.

Merrill Lynch

,

Bear Stearns

and

Salomon Smith Barney

have dropped coverage, and about the only major gambling analyst left who's following the stock is David Anders of

Credit Suisse First Boston

In January, Anders cut his rating on Gtech from strong buy to buy and his 1999 earnings estimate from $2.74 per share to $2.62. (Credit Suisse has no underwriting relationship with Gtech.)

Anders says lotteries are "a relatively mature business" in the U.S. but calls Gtech "a cheap stock." As for Y2K, Anders says he's "not overly concerned. ... In the last conference call, they indicated they would be more than ready."

Good luck.