A Bargain Hiding in A Bargain Hiding in Plain SightPlain Sight

Sellers Capital Investment Criteria

1. Moat2. Management3. Balance Sheet4. Margin of Safety

Goal: Avoid permanent capital impairment (risk). Hit singles and doubles. Look for 90% probability stock will be at a higher price within 3 years.

Today’s Presentation

• Premise: Bargains are “hiding in plain sight” in the large-cap area.

• Mutual fund investors pulling money out of this area. Contrary indicator.

• High-quality (wide-moat) large caps are the best bet.

• Examples of undervalued large-cap wide-moat stocks.

0

Style YTD % 1-Year % 3-Year % 5-Year %

Small Value -0.6 10.81 23.63 18.35

Medium Value 5.04 15.9 22.72 14.15

Small Core -0.47 10.52 22.66 13.3

Medium Core 1.12 13.26 20.01 11.42

Large Value 3.55 11.53 14.82 4.89

Large Core -0.55 8.07 11.73 -1.36

Small Growth -1.57 9.74 21.04 -3.52

Medium Growth 7.23 19.51 20.48 -4.7

Large Growth -1.26 4.58 7.43 -13.66

Domestic Mutual Funds – October 31, 2005

Source: Morningstar

Mutual Fund Flows – Predictive?

• Large cap growth has significantly underperformed other styles for the YTD and past 1, 3, 5 yrs.

• Research Firm Dalbar’s 2004 study -- The average investor earned 3.51% annually vs. 13% for the market over the past 20 years – Typical investor purchased funds that had already been going up

significantly and sold funds that had gone down.– Buy high / sell low.

• Evergreen Capital Management – 2005 study – Over past 23 years, outflows for a particular fund category are very rare and clearly indicative of extreme investor pessimism.

– “To actually force a mutual fund style into a redemption mode over an extended time frame requires an intense level of negativity by a large segment of the mutual fund population.”

– “a very clear inverse relationship between extreme inflows or outflows, and subsequent returns.”

Average 2-yr. Average # of Obs.

Style Event Excess Return Accuracy (By Quarter)

Large CapGrowth Outflows/Low Valuations 4.20% 100% 9

Large CapValue Outflows/Low Valuations 6.50% 95% 19

Mid CapGrowth Outflows/Low Valuations 10.30% 92% 12

Mid CapValue Outflows/Low Valuations 14.50% 91% 11

Small capGrowth Outflows/Low Valuations 1.70% 43% 7

Small CapValue Outflows/Low Valuations 17.80% 100% 18

All Styles Outflows/Low Valuations 8.70% 91% 76

Source: Evergreen Capital Management

Evergreen Capital Management – Study on Fund Flows

U.S. Equity Mutual Fund Net Flows ($B)

-50-25

0255075

100125150175200225250275300

1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Growth Value

Source: ICI, Sellers Capital 2005 Annualized

International Mutual Fund Net Flows ($B)

-25

0

25

50

75

100

1985 1990 1995 2000 2005

International

Source: ICI, Sellers Capital 2005 Annualized

Domestic Mutual Fund Net FlowAll Equity Sizes

-20

0

20

40

60

80

100

Large Mid-Cap Small Total

2004 Aug YTD 2005

Source: Morningstar *2005 YTD Numbers are Annualized

Large Cap Funds - Money Flow

-20

-10

0

10

20

30

40

50

Growth Blend Value Total

2004 Aug YTD 2005

Source: Morningstar *2005 YTD annualized

Wide-Moat Large Caps are Cheap• Ed Yardeni: “Large Caps look cheap with a P/E of 14.0 being a 3-

year low.”

• Grantham, Mayo, Otterloo (GMO) : “High quality large caps should outperform low-quality large caps by 10.6% per year, on average, over next 7 years.”

• Wall St. Journal: “Investors might have a rare opportunity to scoop up shares of sleeping giants that are cheaper than they'vebeen in years.”

• Bill Miller: “The old leadership in the market -- oils, utilities, REITs, commodity related names, and housing -- have all corrected….This often suggests a change to new leadership. New leadership usually consists of those areas that are cheap, have performed poorly, and where expectations are low. The leading candidate that meets those criteria is the mega cap S&P 500 names, the group that peaked in early 2000 and that has trailed the mid and small caps ever since.”

U.S. Large Int’l. Large2 Int’l. Small2U.S. Small

GMO 7-Year Global Equity Forecasts1

Value and growth within large and small stocks as of August 31, 2005

1 Real returns — long-term inflation assumption: 2.5%2 Return forecasts for international equities are ex-Japan.

Ann

ual R

eal R

etur

n O

ver 7

Yea

rs

Note: These forecasts are forward-looking statements based upon the reasonable beliefs of GMO.

1.7%1.4%1.7%2.3%1.9%

-1.3%-1.6%-1.4%-0.9%-1.6%

-6.2%

2.5%

2.0%

2.5%2.5%2.5%

2.5%2.5%

2.0%2.1%2.1%2.0%

2.0%

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

S&P 500 US LargeGrowth

US LargeValue

US HighQuality

US LowQuality

US Small US SmallGrowth

US SmallValue

EAFE IntlGrowth

IntlValue

IntlSmall

Intl SmallGrowth

Intl SmallValue

0.4% 0.4%

4.4%4.8%

4.2%3.7%

4.2%3.9%

1.9%1.2%

0.7%

4.4%

0.7%

Other Evidence of Large-Cap Outperformance

• Barron’s – U.S. public corporations have more than $2 trillion cash on balance sheets.– Announcing massive buybacks (Time Warner $12.5B;

Microsoft $19B, Intel $25B).– IPO market not bad, but NET stock issuance negative.– Less supply of stock. Supply/demand imbalance.

• Morningstar conclusion (10/31/05): A disproportionate share of cheap stocks belong to high-quality companies.

• Robert Stansky leaves Fidelity after outflows.

Wide-Moat Stocks with Attractive Valuations

• Home Depot• Wal-Mart• McDonald’s• Coke• Microsoft• Pfizer

• UPS• Berkshire Hathaway• Stryker• Avon Products• Washington Post• International Game

Technology

Summary

• Mutual fund inflows/outflows are inversely predictive of future returns.

• Domestic large-cap mutual funds, particularly blend and growth, have seen outflows recently.

• U.S. large-cap blend and growth stocks have performed poorly, now are very cheap.

• High quality large-cap growth stocks are a good bet over the next few years.

A Bargain Hiding in A Bargain Hiding in Plain SightPlain Sight

Case Study

International Game TechnologyTicker: IGT

NYSE

All fundamental data as of 09/30/05

$9.4 billion slot machine and gaming operations company

IGT “No other form of gambling manipulates the human

mind as beautifully as these machines. I think that’s why (they) are the most popular form of

gambling….”Dr. Nancy Petry,

Professor of Psychiatry, University of Connecticut School of Medicine

$1 billion daily placed in slots ($365 billion yearly)• $30 billion in Slot Revenues Annually

• $7 out of every $10 of gambling revenues

Sources: Fortune Magazine and New York Times

IGT – Price Graph Since IPO

Economic Moat • Industry Characteristics

– 3 largest industry players = 90% market share. • IGT is the largest, with 70% market share.

– Significant Pricing Power.• Competitors don’t compete on price. • Casino payback less than 60 days for an average $15,000 machine.

– Recurring revenue – about 50% of revenue is recurring, IGT shares a portion of the slot take with the casino.

– Barriers to entry – patents, unique legal challenges in each jurisdiction, high R&D spending required, extensive intellectualproperty portfolio.

• IGT spends about as much on R&D as next 3 competitors combined.

– 4 to 6 year replacement cycle based on new technology/IP. Fairlypredictable cycle.

• Server-based games coming next.

US Market Share 2004

IGT

Aristocrat

WMS

Alliance

Other

Source: Bear Stearns

Historical Profitability

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Op. Margin 26.9% 27.3% 30.4% 32.0% 29.7% 32.1% 26.3% 35.0% 37.6% 38.8% 28.6%

Net Margin 14.9% 16.1% 18.4% 18.5% 14.6% 13.8% 17.8% 15.7% 17.6% 20.1% 18.3%

LT Debt 107.5 107.2 140.7 322.5 990.4 991.5 987.7 971.4 1146.8 791.8 200.0

Shr. Equity 554.1 623.2 519.8 541.3 242.2 96.6 296.1 1433.1 1687.5 1976.6 1,906

ROC 15.4% 17.7% 22.7% 19.8% 13.4% 16.9% 19.7% 13.7% 14.8% 19.3% 18.9%

ROE 16.7% 18.9% 26.4% 28.2% NMF NMF NMF 20.2% 22.2% 25.3% 22.9%

Source: Value Line, Sellers Capital

Moat (cont’d)

• Average ROE 1995-2005: 22.6% (excludes 3 years of negative capital and infinite ROE).

• Average ROC 17%.

Conclusion: This is a Wide Moat Company.

ROC significantly above Cost of Capital, and is expected to stay that way.

Management & Corporate Governance• Corporate governance: good, not perfect

– Insiders own 1.5% of stock.– CEO has been there for 3 years – but part of

gaming operations acquired since 1986.– Clean accounting.– Executive pay – not outrageous.– The best people in the industry at almost every

position.– Increases buybacks when share price low, not high

(bought back 20% of shares in 1999 at low price).– Issues a lot of stock options (negative).

Conclusion: Pretty good (but not perfect) governance. Gets a B grade.

Cumulative Share Repurchase History

0

50

100

150

200

250

300

1997 1998 1999 2000 2001 2002 2003 2004 2005

Mill

ions

of S

hare

s

5274

162

224234

249257 261 271

Total $M $225 $122 $361 $318 $101 $214 $161 $130 $355 $1,987

Avg Cost $4.32 $5.51 $4.15 $5.09 $9.95 $14.70 $19.13 $31.81 $27.71 $7.27

*As of November 11, 2005

Source: IGT and Sellers Capital

Balance Sheet

• Operating earnings are more than 37 times larger than net interest expenses. – Free cash flow normally greater than net

income.– Debt is equal to just 12% of equity and 6% of

total assets.

Conclusion: Rock solid financial health.

Margin of Safety

• Valuation -– Conservative DCF model estimates fair value $38-42.– Stock price is ~$28. Margin of Safety: 30%.– Forward P/E multiple: 21 at trough of cycle.– P/E of 15 based on average of $1.80 EPS next cycle

(does not include effect of stock buybacks).– Analysts have history of underestimating earnings

during peak of cycle (i.e. 2000, 2001).• Avg machine price has grown 80% since trough of last cycle.

Historical Growth

1 YR 3 YR 5 YR 10 YR

Revenues -4% 9% 19% 14%

Operating Income -18% 1% 16% 15%

EPS -9% 13% 22% 21%

Source: Value Line, IGT 10-Q

Growth Prospects• Int’l growth 30%/yr. – Macau/China, other Asia, Italy,

UK, Russia. • Non-machine revenue (casino mgt. software, IP, parts)

growing 30%/yr. – Gross margins >65%!

• Growth in # of U.S. and worldwide gambling jurisdictions as govts. seek to raise revenue.

• Stock buybacks provide springboard for jump in EPS when cycle turns.

• Price increases 3-5%/yr. + 5-6% unit growth = huge margin expansion in next upgrade cycle (late 2007) on fewer shares outstanding.

Ownership

• Private Capital Mgmt. owns approx. 10%.• Ruane, Cuniff: Largest new purchase in Q1

2005. Bought more shares in Q2.• Insider buy: 2.4 million shares @ $27

recently by member of B.O.D.• Management: Owns about 1.5% of

company.

Why is the Stock Cheap?

• Normal herd behavior – Most investors are selling as an industry cycle bottoms out, just as they are buying when the cycle is peaking.

• Recency – ttm growth negative.• Timing of next product cycle has been pushed out

from mid-2006 to late 2007 – timing is uncertain. • Analysts not positive yet, still waiting.

– In 2005, IGT has been downgraded 9 times, upgraded only once. (from “sell” to “neutral”).

• Typical analyst comment: “No near-term catalyst.”

Historical High/Low Prices

Source: Value Line

1989 1990 1991 1992 1993 1994 1995 1996 1997High 0.5 0.63 3.00 6.6 10.35 8.5 4.25 5.88 6.73Low 0.3 0.28 0.45 2.73 5.95 3.73 2.7 2.7 3.83

1998 1999 2000 2001 2002 2003 2004 2005

High 7.18 6.08 12.35 17.98 20.03 37.00 47.13 34.6

Low 4.03 3.53 4.35 8.925 11.9 18.05 28.23 24.2

IGT – EPS Growth vs. Change in Stock Price

IGT - EPS Growth vs. Stock Price

-50%

-30%

-10%

10%

30%

50%

70%

90%

110%

130%

150%

19891990199119921993199419951996199719981999200020012002200320042005

Year

Ret

urn/

Gro

wth

EPS GrowthReturn

Year 1994 1995 1996Stock Price -46% -30% 72%EPS Growth 31% -32% 30%

1998 1999 2000Stock Price -3% -16% 136%EPS Growth 19% 2% 31%

2004 2005 2006Stock Price -2% -18% ?EPS Growth 26% -11% ?

IGT – What Happens When Cycle Bottoms?

Investment Conclusion

• Wide moat. • Excellent long-term growth prospects. • Healthy industry structure, competitors don’t compete on price.• Great balance sheet.• Insiders, renowned investors buying.• Good management team. • Significant margin of safety in valuation. • Analysts are pessimistic.• No short-term “catalyst.”

Conclusion: Very low probability of permanent capital impairment.

Risk/reward ratio good.The stock is a “buy.”