Aristocrat not so big in Japan

To the casual observer, Aya Iseshima is an ordinary Japanese high school student, but in her spare time she battles other young women for a ‘platonic heart’, a special jewel that can grant any wish. She wants the wish to find her friend apparently, but if Aristocrat Leisure’s shareholders had one wish, it might be to find a formula for consistent success in the Japanese ‘pachislot’ market.

They’re likely to be disappointed. Zettai Shogeki 2, the latest pachislot game featuring Aya, has been the best performing game in the Japanese market this year, with Aristocrat selling 4,600 units in the six months to March. Not bad eh?

Not quite. In the prior period Aristocrat’s Black Lagoon and Kyojin no Hoshi V sold 8,376 and 5,688 units respectively. In days gone by, a blockbuster game might have sold tens of thousands of units; Aristocrat’s Kyojin no Hoshi 3 – a game about a baseball pitcher for the Tokyo Giants – sold 72,205 units in 2005 (and a few thousand more in 2006).

So despite the apparent success of Zettai Shogeki 2, Aristocrat’s earnings before interest and tax from Japan fell 98% in the first half, to just $200,000 in constant currency terms. Group earnings before interest and tax slipped 1% to $75.3m but, taking Japan out of the equation, it would have risen about 12%. Operating cash flow saw a much bigger fall, from $77.0m to $45.6m, again ‘predominantly reflective of the lower Japan trading activity’.

Doing it differently

Slot jockeys do it differently in Japan. In Australia punters play Queen of the Nile until their fingers fall off; in the US they love Wheel of Fortune; but in Japan the star games burn brightly and quickly.

There are around 12,000 pachislot halls in Japan and about 4,000 of them buy new games, with a fixed budget to spend each month. Typically a game will be on sale for a month before the market moves on to something else. New game releases therefore need to be planned carefully to avoid clashes with other potential blockbusters.

The remaining 8,000 halls, mostly in regional areas, soak up the second-hand games, but even they get through them quickly: Aristocrat estimates that of a total installed base of about 2.1m machines, slightly more than half will be replaced in the current year.

In 2009, under new chief executive Jamie Odell, Aristocrat adopted a new approach to deal with the volatility of this market, appointing new local management, removing fixed costs and focusing on design and development.

The company now aims for two or three game releases each year, but says it retains the capacity to deliver 20,000 units for a top selling game. Shareholders would give a platonic heart to see that tested; the reality is that while the volatility has been dampened, so have sales and profits, as Chart 1 shows.

Better news in America

There has been more joy in North America, where increased penetration of the company’s Viridian WS cabinet helped the company increase sales of new platforms (that is, a cabinet with a game pre-installed) by 14%. That was more than enough to offset a 12% fall in conversions (a new game to be installed on an existing cabinet). Overall, the region increased revenue by 12% and profits by 13% to $69.2m.

If the company makes the same again in the second half, it will still be a long way from the $252m it made in North America in 2006, but will nevertheless be the best result there since 2008 (see Chart 2).

The company has been helped by a shift in the US market towards video slot machines, and away from mechanical style (‘stepper’) machines. This appears to have accelerated in recent periods, with the video slots accounting for 62% of installed machines in the 2013 March quarter, according to the Eilers-Fantini industry survey, with steppers at 26%. That compares with figures of 49% and 35% 18 months previously.

The company also increased its installed base of leased machines in North America by 8.5% to 6,922, although they were only able to generate US$40.80 per day, down from US$42.99 in the prior period. The installed base is now not far from its 2007 high of 7,473.

This is a key area for the company as the return on investment on leased machines is about double that on those sold outright. The target is to get the fee per day up to $50 by installing more higher value products, in particularly those with multisite progressive jackpots, on which Aristocrat earns the most profit.

Australian increases

In Australia, profits fell 4% to $39.6m, but the comparison was affected by a jump in sales of refurbished second-hand machines in the prior period due to the deregulation of the Victorian gaming market. Excluding that effect, profit was up 5% on an 8% increase in unit sales. Average selling prices rose 13% to $16,847 reflecting the higher proportion of ‘rebuild’ sales in the prior period.

The company said its market share in Australia rose slightly in the period, which is a creditable performance given that management described Australia as ‘absolutely our most competitive market’.

The company maintained its strong performance in Asia, with a 50% floor share of the new Solaire Casino in the Philippines, with the hope of this increasing further. In Macau, for example, its floor share has risen from 40% to as much as 65%. So it’s encouraging to see the company starting as high as 50%. In Europe, sales grew 35% thanks to new product releases.

Investing for the future

The company maintained its commitment to design and development, spending $55.5m in the half, up from $54.6m in the prior period. On the conference call, management expressed high hopes for Product Madness, the recently acquired social media gaming platform.

When asked whether the company would consider ‘increasing the efficiency of its balance sheet’ by borrowing to buy back shares, it was good to hear Jamie Odell say the company preferred to keep debt low to maintain the flexibility to develop future products.

Given the board’s increased confidence in future cash flows, he said dividends were a better way to pass value to shareholders. This was reflected in an increase in the targeted payout ratio to 60%-80% of normalised net profit, from 50%-70%, with the seven cent interim dividend higher than the six cents paid for the whole of 2012.

Aristocrat has a long way to go to match the glory days of 2005-7, when the company made annual profits of around $250m and earnings per share of about 50 cents. But Jamie Odell has steadied the ship and pointed it in the right direction.

The stock is up 74% since we upgraded to Long Term Buy less than a year ago, on 2 Jul 12 (Long Term Buy – $2.45), and 33% since we moved to Hold on 7 Dec 12 (Hold – $3.21), putting it on a price-earnings ratio of 22, based on an estimated 19 cents of earnings per share for the full year.

That’s too high for a Buy recommendation, but we’re raising our price guides to take account of the improving outlook. We’re also increasing the maximum portfolio weighting from 3% to 5%. HOLD.

Note: Our model Growth Portfolio owns shares in Aristocrat.