Still On My "Class II" Soapbox!

Even a decade ago, suggesting replacing a Vegas-style “Class III” gaming floor with “Class II” games would have been questionable for a Tribal casino and insane for a commercial casino. Dancing on the cusp of the third decade of the 21st century, that is no longer the case. In fact, with smart planning, the Class II model can far surpass traditional slot machine revenue models.

Technological improvements. Regulatory changes. New business models from slot manufacturers. New encroachments on Tribal sovereignty. These four, unrelated, movements have created a perfect storm for reevaluating the slot machine revenue paradigm for small and mid-sized casinos —both Tribal and commercial.

To be clear, for consumers the distinction between the two classes of games has become invisible; today it is all “back of the house”. That is a far-cry from the recent history of the classes of games.

Setting The Stage For New Revenue

Originally in the pre client-server computing world of 1986, the then-new Indian Gaming Regulatory Act defined three classes of games: Class I games were defined as “social games solely for prizes of minimal value or traditional forms of Indian gaming engaged in by individuals as a part of, or in connection with, tribal ceremonies or celebrations”; Class II games were described as “bingo (whether or not electronic, computer, or other technologic aids are used), but specifically excluded “electronic or electromechanical facsimiles of any game of chance or slot machines of any kind”; and Class III games were defined simply as “ all forms of gaming that are not class I gaming or class II gaming”.

In that world, slot machines indisputably were Class III games. Technology of the era limited “electronic, computer, or other technologic aids” for bingo to little hand-held electronic “dauber” units that could keep track of a hundred or so virtual bingo cards at the same time. With the computing explosion of the 1990’s, those electronic daubers transformed into large slot-machine-looking cabinets playing virtual bingo with virtual ball draws, cards, and daubs and represented by slot-machine-looking spinning video reels.

In response to those dramatic technological changes, Federal regulators began imposing all sorts of limitations on the play of Class II games. Double-daubing, triple-daubing, minimum number of players, connectivity, and a host of other restrictions kept Class II revenue significantly behind regular slot machines. Some of those rules slowed play to a third or less the speed of conventional slots and thus cut revenue by at least that much.

Fortunately, most of those restrictions were either overturned in court, defeated on administrative appeals, or withdrawn in deference to sovereignty.

The Inherent Benefits of Class II Games

Today, that performance is a non-issue. Modern Class II games play equally in speed and functions to most Class III games.

Retired slot machine guru (and former Vice President of Slot Operations at Pechanga Resort and Casino and others), Buddy Frank, once challenged my then-skepticism about that claim. He dared me to have a customer play a Class III machine on his floor and then a Class II game, and have the customer identify which was which; which was slower, less exciting, or paid less.

As with most things concerning slot machine performance, Buddy Frank was right on target; not a single player (and few industry employees) could tell the difference between a modern Class II game and a Class III game.

Beyond the look and feel of the games, is the issue of player interest in the games. With few exceptions, a slot machine’s revenue performance declines by 20% or more per year as the novelty wears off and newer titles or cabinet designs come to the casino floor.

Class II games are server based. The individual slot machine is only a “box” or a terminal to display graphics, themes, sounds, math, and the game itself; which are stored on the server. If the box is disconnected from the server, the game will not work. To change a particular machine’s theme, pay tables, or type of game requires only a download from that server to the terminal. The cost for such a change is nil; it’s a simple download that does not impact the hardware or software of the individual machine.

“I routinely change about 10% of my floor every month. If a game’s revenue falls below 70% of my floor average, I change it. Yesterday I changed 30 games; it took a phone call and about 45 minutes. And, it didn’t cost me anything; it was free,” explained Johnny Winokur, the CEO of Washington State’s Willapa Bay Enterprises and operator of the Shoalwater Bay Casino, and one of Class II’s biggest proponents.

In contrast, Class III games are free-standing machines. Changing a Class III game requires the casino to purchase a “conversion kit” to be installed in the slot machine by specialized software and hardware technicians; usually a costly undertaking. In many cases, conversions are not available and changing the game requires buying an entirely new machine.

In Indian Country, the most significant benefit of Class II games is that they are tax exempt. Only Class III games can be taxed; and Class III games can only be installed if they are authorized by Tribal compacts with State governments. Tribal sovereignty exempts Class II (and Class I games) from taxation or other State interference. That savings alone (ranging from 3% to 20% of revenue depending on the state) immediately offsets the earlier concerns about performance of Class II games.

The Revenue Model Is Stronger

In States (like Washington and Arizona) that allow compacted Tribes to sale or lease their Class III game allotments, there is the added bonus that in addition to tax-free revenue from Class II games, Tribes can generate revenue from not having Class III games (by leasing their rights to those games to other Tribes, for up to $20 per game per day).

For Tribal or non-Tribal casinos, the most significant difference between Class II and Class III games is the revenue model. The paradigms are so different that they can impact the bottom line of the casino.

Class II games rarely are available for purchase. Almost universally, they are available only on a revenue-share lease basis. Those lease arrangements usually are for 20% of the net revenue of the games (with the casino keeping 80% of the win-per-unit-per-day).

Class III games, on the other hand, are available for purchase; either as a capital expenditure or a with lease-like deferred payment plan. Some Class III vendors also offer lease programs; though those are disappearing in today’s landscape. Generally speaking, Class III games are purchased and Class II games are leased.

Purchase of a new Class III machine from one of the top manufacturers typically costs between $18,000 and $24,000. Large, prestigious, or chain casinos often negotiate (or dictate) all sorts of variation “deals” modifying that range and setting their own terms for Class III purchases (or even leases).

For a small to mid-size casino, acquisition of 500 new machines could mean a capital expense of $12-million. With slot machines providing the vast majority of the revenue for those casinos and operating expenses of those casinos costing more than 50% of that revenue, such a huge capital outlay is much more than significant. With the 20% (or greater) decline in a game’s revenue from year-to-year, there are very few small casinos that can afford to spend that much (or more) every couple of years.

Consequently, for years, leasing games was considered a predatory offering; open only to small or failing casinos that couldn’t afford to buy slot machines. Regardless of the floor-average win-per-unit-per-day, a cursory analysis of the metrics of the lease model does not bode well in argument for Class II games.

To contrast the lease model to the purchase model, let’s assuming the lowest-priced new machine at $18,000 for a small to mid-size casino with a low-average win-per-unit-per-day of $150.

Under the terms of most lease agreements, when the game win-per-unit falls below a pre-determined threshold, the vendor will replace the game at no charge to the casino. Consequently, in the lease example above, the $150 win-per-unit-per-day first-year revenue is consistent for all five years of the lease. Over a five-year period, the leased game potentially earns $219-thousand (at $150 per day less the 20% lease fee).

In order to compare the leased game with five-year revenue for a purchased game, we have to: remove the 20% lease fee; deduct the purchase price of the machine; and take into account the average 20% annual decline in revenue. With the same $150 win per day, the purchase revenue chart looks like this:

Taking into account the annual revenue decline, it becomes clear that a five-year lease nets the casino $53-thousand more than buying the game. More poignantly, the 20% decline rate is an average, in many cases the decline is much steeper and after five years the games are practically worthless.

Even with increased win-per-day and the lease cost being a double to six-times “overpayment” for $18,000 games, these metrics hold true:

Beyond the lease-purchase comparison, the cost of operating a Class II slot floor is a fraction of the high-costs of operating a Class III casino.

 â€œWith Class III games I have to keep an inventory of parts, monitors, and repair equipment. That inventory is expensive; and so is keeping a staff of technicians to maintain owned games. With Class II, all of that is handled by the vendor and I don’t need a staff of technicians,” explains Winokur, whose track record of casino successes stretches back to the heyday of Las Vegas and properties including the Dunes, Tropicana, Aladdin, Sahara, and others.

Further strengthening the case for Class II, many of the larger Class III vendors have changed their business model to be more software centric. In the new model, games are functional only on specific software platforms and specific boxes. Rather than spending a few thousand dollars for a conversion kit (under the old model), casinos are forced to spend $18,000 to $24,000 on the new box and platform.

“Some larger casinos might be able to afford a new box and a new platform every few months; but a smaller casino can’t afford to hold a box long enough to amortize the costs of new games in that model,” super-operator Winokur explained.

Adding to the revenue benefits of the Class II model, many savvy operators also charge the slot machine vendors fees for connection to the casino’s player tracking and casino management systems. Winokur adds, “that way, I don’t have to pay for my systems; fees from my slot vendors cover that.”

Financial analysts often use a metric called Internal Rate of Return (IRR) as a decision tool to compare spending models. If a project will require capital (the purchase of games) that could be used elsewhere (operational expenses), the IRR measures the level of return from the project that is acceptable in order to justify the investment. The greater the IRR percentage, the better the investment.

At that low-end $150 daily win, even with s 20% annual declining revenue, the net profit of a purchased machine is more than $166-thousand for the five-year period. An IRR chart shows what a “cash-cow” a slot machine can be:

However, using the same metrics to measure IRR for a leased game creates an incalculable IRR of more than 437-million percent.

What We Can Conclude

Even if we ignore the complexities of this unusual use of IRR calculations, it is empirically true that the Class II model is more profitable for a casino in nine out of ten key measures, with a tie in the tenth area.

Unimaginable just a few years ago, today the case for Class II machines actually outweighs the case for Class III machines. With a Class II floor, the casino is positioned for a much stronger revenue model.