Gambling on an Ainsworth jackpot

PORTFOLIO POINT: AGI has strong potential to grow its ship-share in Australia and the US. It’s all about investing with the highest safety margin.

American economist and investor Benjamin Graham is famous for saying that investing can be reduced to three simple words: “Margin of Safety”.

Should the price of a business, valued at $2, fall from $2.40 to $1.80 or even lower, our risk falls and our potential return goes up. And that flies in the face of decades of investment teaching. We are taught higher risk equals higher returns. This is nonsense. Paying top dollar is higher risk but the higher the price you pay, the lower your return. So, in this case, higher risk equals lower returns.

Falling prices excite me, and I will wait patiently, preserving and protecting capital through the safety of bank term deposits until the prices of extraordinary businesses fall. An example of an opportunity I am watching for a bigger margin of safety to appear is Ainsworth Game Technology (ASX: AGI), which was founded by Len Ainsworth, now aged 88, in 1995 (and who still holds 57% control). I hold shares in AGI, but for reasons articulated below you will see why I’d like to own more.

AGI develops a range of poker machines – both the base unit that sits on the floor and also the games that are installed onto each machine. In Australia, around 200,000 machines are presently operating.

As these machines age and require updating – to keep punters happy (keep in mind James Packer’s recent observation that the vast majority of gamblers enjoy it as a form of entertainment) – they need to be replaced with the latest and greatest designs. It’s here that the Australian market turns over around 40,000 machines annually. The percentage share of this annual turnover that a company can grab is called ‘ship-share’.

AGI is currently the number two player (behind Aristocrat Leisure, which was also founded by Len Ainsworth) in gaming machine sales in Australia, with a 25% ship-share. That equates to around 10,000 machine sales annually for AGI, at roughly $20,000 each.

Market expectations are for AGI’s ship-share ratio to grow to 30% in the near term and, if industry scuttlebutt proves correct, the actual ratio might be closer to 35%. Either way, it’s estimated that Australian sales are likely to grow at satisfactory levels for the foreseeable future.

The business has been aggressively taking market share on the back of three years of very strong growth following the release of its new A560 cabinet machines and suite of games. In fact, again according to industry feedback, it’s one of a few businesses in the gaming machine industry (both locally and internationally) that has invested heavily into product development at a time when many others have been capital-constrained. And this includes global competitors in America, dominated by IGT (International Gaming Technology), which like Aristocrat in Australia has the lion’s share of the market (about 50%), followed by Bally at 15%, WMS at 15%, and a number of other players at 5%-10% including Konami.

It’s in the US market that the opportunity for AGI gets exciting. There are about one million machines in the US with a replacement cycle of just 70,000 per annum. Conditions are slower in the US than Australia due to the country’s economic challenges, but again, if industry pundits are right, as the economy continues to improve, the expectation is for the potential addressable market to double from here.

Applying an estimated US ship-share ratio for AGI of 10%-15% on current replacement conditions (AGI’s ship-share there is less than 1%), the company has an addressable market in the range of 7,000 to 10,500 annual machine sales. Double this if the market returns to historical averages from bottom of the cycle sales levels.

If all the ducks lined up – the US annual replacement doubles and AGI captures 10% ship-share – the revenue benefit would be in the hundreds of millions, and on similar margins to those in Australia. CEO Danny Gladstone recently relocated to Nevada (Las Vegas) specifically to target the US opportunity.

At its peak, Aristocrat had a 10% market share in the US and 70% in Australia. If analysts are to be believed, AGI is expected to capture similar levels in the US and a 30% share in Australia over time. With Ainsworth and his very experienced management team behind him (200 years’ collective experience), and given very strong sales growth momentum, it’s entirely possible that these current expectations may prove conservative.

Could AGI replicate the past success at Aristocrat? While I’m sure its competitors will pull out all stops to prevent losing buckets of market share, it has been an interesting exercise to graph Ainsworth’s revenue growth over the past few years with that of Aristocrat’s from the mid 1990s.

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Sales for Aristocrat grew strongly from $258 million in 1996 to $1.3 billion at their peak. Revenues for AGI are presently $150 million and forecasted to grow to $235 million in FY15. The potential for AGI is still 5.5 times larger based on Aristocrat’s success.

In FY15, AGI will have only caught the tail of Aristocrat’s revenue, just before it went parabolic.

In 1996 Aristocrat had 1.3 billion shares on issue and earnings of 0.02 cents per share. In 2012 AGI had 322 million shares on issue and normalised earnings (backing out the sale of a property for example) of 0.095c per share.

Aristocrat was not generating this level of EPS until it had $500 million revenue. Also, AGI has gross margins of 66% (measured over two years) vs 63% for Aristocrat measured since 1996. On net profit after tax margins, AGI is again far superior at 20% vs Aristocrat’s 11%.

AGI’s share price will likely perform spectacularly well in comparison to Aristocrat’s in its parabolic sales stage. This assumes AGI management can replicate Aristocrat’s revenue trajectory.

AGI has controlled costs on a higher revenue base (not so for Aristocrat), resulting in more of the revenue dropping to the bottom line. Early evidence is of a highly scalable operation and a management team that has the formula set very right this time round.

With Benjamin Graham in the back of my mind however, and noting that I prefer to be conservative when factoring in ‘blue sky’ growth, I would consider a lower price – and lower than $1.80 as offering a large enough margin of safety to begin being interested by this opportunity. The shares have recently fallen from a high of $2.75, so only a little more patience is warranted.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.