Luck's a Fortune

Flying at its present high altitude, the Australian stockmarket has little tolerance for any company that wobbles. Anything less than good news is caned '” and that’s what happened to gaming machine manufacturer Aristocrat Leisure last week.

At its AGM, Aristocrat announced a $30 million pre-tax hiccup in its Japanese profits and the market immediately wiped about half a billion dollars off the company’s capitalisation. Despite the Japanese problem '” a change in regulation that will delay sales '” growth in Aristocrat’s other markets should result in a steady first-half profit, but that clearly wasn’t good enough for share traders.

Aristocrat has been one of the market’s star performers over the past three years, a massive turnaround story after the problems it suffered under previous chief executive Des Randall and chairman John Ducker. Admittedly, the share price had run particularly hard in the two months leading up to the AGM, leaving the company at risk of a sharp correction, but you still might wonder about the time frame Aristocrat investors are operating in when the reaction is so sharp.

In the accompanying video interview with Aristocrat chief executive Paul Oneile, we try to get back to the basics of just what Aristocrat Leisure is. Everyone calls it a poker machine manufacturer but that description sells it short. It’s decreasingly a manufacturer and increasingly an IT company.

Aristocrat is riding an international wave of gaming liberalisation, with industry growth predicted to be 5–15% compound over the next five years. Investors have to make their own decisions about the ethics of a company whose success is based upon the ability to encourage people to lose money on a machine, but there’s been no doubt about the bottom line. The shares you could have bought for less than $2 three years ago were worth more than $15 on the eve of the AGM.

The clean-out and clean-up under Paul Oneile has focused the company on its growth potential. From the suburban pokie parlour near you to Macau, Nevada, Vietnam and Russia, Aristocrat is the world’s second-biggest gaming machine supplier.

There are specific issues still for Aristocrat. At the AGM shareholder activist Stephen Mayne highlighted the peculiar nature of Aristocrat’s balance sheet: it reports net assets of just $351 million when the stockmarket values it at $7 billion. Well, it was $7 billion at the start of the meeting anyway. Chairman David Simpson responded that the annual report was the result of international accounting standards, while the market capitalisation was dictated by the market.

Writing for Crikey.com.au, Mayne suggests a more sinister motive: “Sin industry companies have long had a tradition of understating their worth because they don't want regulators or victims of their products (problem gamblers) to cotton on to the scale of their bonanza.”

The balance sheet clearly doesn’t account for Aristocrat’s biggest asset: its intellectual property. If the company wasn’t so flush with cash, it would be paying for that through a lower-than-deserved credit rating.

And then there is Aristocrat’s welter of legal cases. In some it’s fighting for money, but in others it is on the defensive. The best publicised has been the shareholder class action that is seeking money from the company over the market not being informed when it was having troubles under Randall in South America.

Aristocrat seems determined to fight this class action hard. It would appear to be limited to a rather small number of shareholders who would have had to purchase their shares just before the company came clean on South America and then sold out at the bottom of the ditch that Aristocrat shares fell into. Those who hung on have nothing to complain about.

Michael Pascoe: Aristrocrat’s obviously one of the great turnaround success stories on the Australian stockmarket in the last few years but from the point of view of the long-term investor, what does your business actually do?

Paul Oneile: We’re in the business of supplying what they call gaming solutions to the global gaming market. By gaming solutions I’m talking about content, so that’s poker machine content, computer technology to drive that content, the systems that drive and control the casino floors and then all aspects of the support service that goes behind the scenes in supporting the casinos.

So you’re really a computer company.

Yes, we are a computer company, a technology company. All of our games are now '¦ all now reside on computers rather than physical mechanical machines.

You still make boxes that sell for a lot of money.

We do indeed. We still certainly manufacture and export a lot of boxes out of Roseberry.

The track record of Australian manufacturing at present is '¦ it’s not lasting. Are you different or are you in the process of getting out, cutting down on manufacturing?

We will always be a manufacturer and at the very least an assembler of the product. There are certain parts of every machine that we want to keep in-house. These are particularly in the areas of the technology that we think is core to our overall business, but the physical manufacture of the boxes is becoming a part of the product that we will continue to outsource.

You’re selling boxes. They’re manufactured. Are they like other manufactured goods '” if the price keeps coming down that you’re facing competition from China?

Well, quite a lot of our manufacturing is now done in China so we’re getting already the benefits of their lower cost of production. However, our real growth in the years ahead is going to come from the software, so from the actual computer programs and from our game content.

This is the side that the punters never really see.

Well no, they don’t. But behind every poker machine is in fact a very complex set of algorithms that manifest themselves as a game.

And that’s where the assets of Aristocrat are? That intellectual property?

Most definitely. Yes. And the reputation the company has built up over the last several years is that it does provide content or games of world-class standard to the global gaming market.

How much of this is art, how much science? Obviously the algorithms define the payout ratios.

Indeed. And that’s the science.

That’s the science. The art is making a poker machine seductive enough for people to want to lose money on them.

The art certainly is an important component of the player’s satisfaction, but our games are based purely on the content and the skill of the mathematicians to come up with exciting and interesting games for the players. Our games are aimed at the recreational player and it is largely driven by the excitement that can be generated by the maths that sit behind the game.

As a non poker machine player, I find that very hard to understand why anyone wants to sit there and put money in a machine knowing they’re going to get back less, but how important is that? The music, the art, the makeup of the machine?

It’s part of the overall experience. It’s like any other form of entertainment. You just can’t take a particular piece in isolation and say, 'Well, that's what led to me having a greater satisfaction level than something else'. You’ve got to look at the whole package and the whole package comprises the game, the lights, the sound, the environment in which the machine is placed; whether the ambience of the environment is satisfactory; whether there’s a lot of external noise that’s interrupting; the excitement of the player or the entertainment of the player '” all those things are part of it.

Roughly three-quarters of your revenue now is coming from overseas. That trend’s continuing. Where’s your growth?

Yes the international component will continue to grow. The Australian market will continue to grow for us in terms of revenue and profitability. But it’s contribution as a percentage of our overall profit base will continue to decrease as it has over the last five years. Where the growth’s going to come from is basically from the entire global gaming market. We’ve made great inroads into North America. We’re enjoying a lot of success in the Asian markets, principally Macao, but we’ve also had very strong sales into Vietnam, into Cambodia, into the Philippines. The Singapore Government is currently in the process of licensing two new casinos and we would expect to see some growth out of that market. In Europe, the Russian market is currently going through a regulatory change and once those new regulations are in force we expect to see very significant growth come out of the Russian market.

Why is that? Obviously the headlines recently about PBL wanting to get involved with casinos there?

Obviously PBL have identified Russia as a real opportunity for them. We have identified the Russian market from a supply point of view about five years ago. The company in the last 12 months has set up an office in Moscow because we believe that significant growth’s going to come from the Russian market once the regulations are in place.

Gaming is an international trend, is seeing more liberalisation, more markets. When you come to a new market what are you competing on? Why buy Aristocrat as opposed to brand X or brand Y.

The excitement of our games. The entertainment value of our games. The fact that they perform strongly in every market in which we’ve entered, but equally important to our ultimate bottom line is the after-sales service and the ability of our games to continue to perform very very strongly for a number of years.

The price of each box continues to decline like everything else?

The box as a component is the least important part of our product. The real strength of the product is in the maths and in the graphics that sit in front of the maths.

You invested in a couple of US companies that have different games. One electro magnetic games, the other one an electronic poker machine table. Is that part of the diversification away from the standard poker machines, slot machine?

We’re licensed in over 200 jurisdictions around the world and we’ve got the infrastructure to actually distribute many many products in excess of what we currently manufacture or develop ourselves, so we’re starting to use our distribution infrastructure and just broaden our product range overall so we secured the distribution rights to a company’s product called Poker Tech, which is the electronic poker table that you referred to. We intend to take that product to the world. We’ve taken a 50% stake in a Slovenian company called Electroncek who develop electro-magnetic games so it’s computerised bingo, computerised roulette, computerised Sic Bo and there is quite significant demand in many markets around the world for this product.