Ainsworth spins the reels in Vegas

When the then 72-year-old Len Ainsworth started Ainsworth Game Technology (AGI) in 1995 he was met with a mixture of curiosity and amusement. A year after handing his poker machine empire Aristocrat Leisure to his seven sons, sparking a family feud, he was surely just trying to teach the next generation a lesson.

The scepticism continued when AGI listed on the ASX in 2001 and promptly missed its prospectus forecasts. But in the 13 years since, the company has increased sales from $22m to $244m and, after making losses in seven of its first nine years as a listed entity, it's now making net profits of more than $60m. Strong cash generation has enabled the company to almost eliminate its debts and in 2013 it even started paying a dividend.

This wild ride has also played out in the company's share price. After listing at $1, the stock fell to 4.6 cents in November 2008 before rising a cool hundred-fold, to $4.79 in October last year. Ainsworth's 49% stake in AGI now almost matches the family stake in Aristocrat – in less than half the time – so if Len was trying to teach his boys a lesson, they should consider themselves educated.

Some of the gloss has come off over the past year, however, with the stock falling more than a third despite an 18% rise in net profit, presenting a fresh opportunity to buy this fast-growing, cash-generative company.

Ainsworth gets stuck in

Nowadays, AGI is mostly run by the youthful Daniel Gladstone (at a mere 59 years) who, as chief executive since 2007, has been the architect of AGI's sharp improvement. But at 91, executive chairman Len still finds time to roll up his sleeves and get stuck in – quite literally when he dug the first sod of earth for the company's new offices in Las Vegas earlier this year.

The company's new $30m Vegas facility follows a period of rapid overseas expansion, centred on the famous 'sin city'. Overseas revenue has more than quadrupled in the past three years to $101m – 90% of it from the Americas – outpacing growth in local revenue, which has merely doubled (see Chart 1). The question is, can this growth continue?

The company has been a big beneficiary of a recent uptick in the 'replacement cycle' (see Shoptalk), after years in the doldrums following the global financial crisis. But results from US pokie giants International Game Technology (IGT) and Bally Technologies back in January this year raised fears that the cycle might be about to turn down again, with US casinos purchasing fewer pokies than anticipated. This caused share prices in the sector to plummet, with Bally and IGT each falling about a third before merger excitement helped them gain much of it back.

Big deals

The biggest – between IGT and Italian GTECH – has created a global goliath with revenues of $6.7bn – dwarfing Aristocrat's $1.1bn and AGI's $244m. In the US, IGT and Scientific Games (which bought Bally in August this year after its acquisition of WMS Industries in 2013) are almost totally dominant, with Aristocrat a distant third – even after it's recent purchase of VGT (see Odell bets his reputation from 14 Jul 14 (Hold – $5.40)). On the scale of these leviathans, AGI is but a minnow with a US market share of less than 1%.

Small it may be, but AGI's machines occupy a popular niche with the punters. A 2013 survey of NSW and Queensland clubs found that its games such as Reels of Wheels earn more for clubs than other manufacturers' machines and conversations with pokie machine managers at various clubs confirm this is still the case. This gives the company an edge when casinos, hotels and clubs are deciding which machines to purchase to replace older, lower performing machines, although AGI will need to ensure it continues to come up with games that punters like playing.

As well as direct sales, the company is aiming to increase its installed base of machines leased rather than sold to casinos, on which it can earn a percentage of daily revenue. Such 'participation' is prohibited in Australia, but it's permitted in the US and can lead to significantly higher margins. Margins could get a further leg up if the recent merger activity has reduced the number of suppliers in the industry and potentially removed some of the irrational pricing that has been occurring as certain players attempted to gain market share.

The new $30m Vegas facility – due for completion in 2016 – should get the company's machines further into the hearts and minds of US punters and casino executives, and help its push for licences in other states. Since the beginning of 2014, AGI has successfully obtained licences in states with more than 100,000 pokie machines, and it's waiting for approval (which, we stress, isn't guaranteed) in states with 50,000 more.

Slow growth in Australia

To put these numbers in perspective, poker machine numbers are capped at 200,000 machines in Australia. The company generated 59% of its revenue at home in 2014 – with its total of $143m fast catching the $180m achieved locally by Aristocrat in the year to September 2013. Due to the cap on machines, growth in the home market will be harder to come by, but we expect AGI to at least maintain its market share here.

Concerns over problem gambling in Australia have led to calls for clampdowns on pokies, which in turn could reduce the number of gaming machines allowed. Yet state governments do very well from taxing pokie machine revenue and so, despite public pressure, we doubt they'll be willing to give up the millions of dollars in revenue they earn.

Growth is more likely to come from the international business: in the Americas, as we already highlighted, and also from moving its games into Asia and Europe, which currently account for less than 10% of revenue.

What's more, the rise of the internet presents both an opportunity and a threat as punters increasingly turn to games on mobile divices. Aristocrat Leisure, for one, is working hard at moving its most popular game titles online, helped by the acquisition of social media gaming platform Product Madness. By comparison, AGI has so far only taken baby steps in this area but its titles should transfer easily to the new realm through third-party licences.

Lumpy profits

AGI is not a stock to purchase for its meager 3.3% unfranked yield. Profits in this business are notoriously lumpy, thanks to swings in the replacement cycle and the success or failure of new games. AGI is also competing against companies with far larger resources. However, casinos won't want their suppliers to consolidate much further, so they are unlikely to want to squeeze AGI out of the market, especially given the current performance of its games.

At some point, of course, Len will take his place in the great casino in the sky and the market may react negatively to his passing. However, the company has other strong management in place – most notably chief executive Daniel Gladstone – and with Len firmly into his 90s it seems likely that the market has already taken account of this possibility.

These risks are more than balanced, however, by the opportunities for further growth and for the first time in a little while the stock is attractively priced on a price-earnings ratio of 16. We recommend it as a Buy up to $3.30, with a recommended maximum portfolio weighting of 3% to reflect the risks. With the company also due to update investors at its AGM on 19 Nov 14, it may also be worth starting well below this level to give room for a top-up if better opportunities present themselves. BUY.

Note: We're buying 2,400 shares in Ainsworth Game Technology in our model Growth Portfolio at $3.03, for a total consideration of $7,272.00