Fitch Rates Alliance Gaming Bank Debt 'B'; Negative Outlook.

NEW YORK -- Fitch Ratings has assigned a 'B' rating to the secured bank debt of Alliance Gaming Corp. (NYSE: AGI). The facility comprises a $317.5 million term loan and a $75 million undrawn revolver. The Rating Outlook is Negative.

Ratings reflect the precipitous decline in AGI's operating performance in recent quarters, its increasingly constrained liquidity, and a high risk of further covenant breaches over the next two quarters if operating results do not improve. AGI is facing increased competition from better-capitalized operators and generally weak projected industry demand through at least 2007. Turnaround of operations is contingent on the successful release of a relatively unproven technology platform (Alpha) in May 2005. Continued cost-cutting (as the company strives to meet second-half profitability expectations) and top management changes in recent quarters could make roll-out targets difficult to meet, and sales may be pressured by reliability concerns and content issues that have plagued AGI in the past.

In general, industry demand has been affected by a variety of challenges over the past two quarters. First, the shorter replacement cycle driven by cashless slot technology (which drove record earnings growth over the past couple of years) largely peaked at the end of fiscal 2004. Second, expansions of slot machines into new jurisdictions such as New York, California, and Pennsylvania, as well as the U.K. have taken much longer than previously expected, and are now more likely to be calendar year 2006 events. Third, re-emergence of WMS Industries (WMS) as an industry player has intensified an already competitive market. Over the past year, WMS has grown market share of slot sales to 15% from almost nothing, largely at the expense of existing suppliers.

On a company-specific level, AGI is struggling to maintain market share in key markets due to its limited content and relatively weak legacy software platform. Problems with its EVO video platform, which caused slot downtime issues, have raised concerns of product unreliability and hurt sales. AGI also faces declining market share in its systems business, which is clearly being successfully targeted by its much better capitalized competitor, International Game Technology (IGT). IGT has won the contracts for both major casino openings this year (WYNN Las Vegas and Lake Charles). AGI's research and development spending is a fraction of IGT's, making it very difficult to retain its leading position in this market. Recent acquisitions (most notably that of Sierra Design Group) have taken a toll on margins, and AGI is still struggling to absorb high related costs. Management has acknowledged that it lost focus during the transition to a new CEO in recent quarters and underestimated the strength of competitors' offerings. This has precluded management from providing reliable forward guidance and has raised uncertainty regarding their ability to engineer a turn-around.

Management has indicated that it expects operating results to rebound in the second-half of the year. Catalysts for the turn-around may include pent-up demand from mega-merger participants' postclosings and/or release of the Alpha platform in April, followed by the enhanced Game Maker II platform shortly thereafter. Alpha is apparently testing well; however, continued aggressive cost-cutting to meet second-half profitability expectations may make it more difficult for AGI to remain on track. In addition, continued reliability concerns and/or a lack of content may continue to hinder sales.

Balance Sheet/Liquidity

AGI's turnaround may also be hindered by a seriously constrained balance sheet and limited liquidity. In December 2004, the company was forced to seek covenant relief to accommodate quarter-end leverage of 3.9 times (x). AGI's bank group agreed to increase leverage covenant levels over the next three respective quarters to 4.25x, 4.50x, and 4.75x, while increasing pricing and reducing revolver availability to $75 million from $125 million. While management has expressed confidence that there is sufficient cushion in the amended covenants, Fitch believes compliance with these levels would require a strong second-half rebound (i.e. second-half EBITDA in the range of $45 million-$55 million versus $25 million in the first half), which may not materialize.

Liquidity consists of $15 million in cash (excluding cage cash and jackpot reserves) and $18 million under the revolver, access to which is currently constrained by high leverage. AGI's cash levels declined from $30 million in the previous quarter, reflecting negative free cash flow for the second consecutive quarter. Management expects availability under the revolver to expand to $40 million as covenants loosen, but this implies strong second-half EBITDA growth, which is questionable. Nonetheless, with less than $40 million in maturities prior to 2009, a liquidity crisis is not imminent provided the bank group grants additional waivers over the short term if necessary. Notably, sale of the Rainbow Casino at the current time is unlikely to bolster liquidity, as proceeds would reduce the size of the bank facility and is also currently a key source of cash flow.

Recovery Prospects

Recovery prospects in a liquidation scenario appear questionable despite the significant level of capital invested in AGI technology. Goodwill and intangible assets represent a material 37% of total assets. These assets are notoriously hard to value, and regulatory restrictions can make their sale to outsiders difficult. Various intangibles are currently subject to patent infringement lawsuits brought on by players such as IGT, Shuffle-Master, and Action Gaming. AGI has very little in the way of hard assets aside from the Rainbow Casino property, and asset quality appears to be deteriorating. AGI has written down $14.3 million fiscal year-to-date as it migrates to the Alpha platform, and further impairments are possible. Receivables have dropped sharply in recent quarters and receivable provisions increased. At the same time, more short-lived gaming equipment assets continue to rise.

This rating has been initiated by Fitch as a service to its subscribers and investors. It is based principally on publicly available information.