By Greg Hoffman
More than 50 years ago, an engineer at the Ainsworth Dental Company put it to the proprietor's son, Len Ainsworth, that their factory had all the equipment necessary to build a prototype poker machine.
He'd never heard of a poker machine but Ainsworth Snr was soon convinced. In 1953, 'The Clubman', the first poker machine from the company that was to become Aristocrat Leisure, rolled off the production line.
The legalisation of poker machines in NSW in 1956 was a boon to the company. And in 2000 the granting of licenses for the firm to manufacture, sell and operate gaming machines in Japan and Nevada (including Las Vegas)—the world's largest poker machines markets—echoed this good fortune.
Aristocrat is now the world's second largest maker of pokies with regional offices in Russia and Macau, the industry's newest growth regions. The potential of these markets set fire to investors' imaginations, pushing the share price up to $17 in February 2007. Today, it's below $4 mark and has found its way onto our team's value-seeking radar.
Troublesome cargo
Opportunities to buy one of Australia's greatest exporters at a knock down price usually entail some troublesome cargo. So let's see what's in the hold.
Gambling predates biblical times, which may speak to the industry's resilience. But the ferocity of the recent downturn extinguished the myth that this particular pokie manufacturer was 'recession resistant'.
There's been a precipitous fall in poker machine revenue across Nevada, including the Las Vegas strip, with slot jockeys betting 7% less in September 2009 compared to a year earlier. There are no green shoots here.
Strong headwinds
Dwindling gambling profits and a tight credit squeeze on operators has also made conditions difficult for the latest game releases. Replacement sales in Australia are glacial, suggesting machines now have an expected life of 35 years; a rather unrealistic assumption which points to a future bump in replacement sales at some point. The same figure has reached an historic 18.5 years in the US.
Lower game cabinet sales are not the only way Aristocrat is suffering. Around 40% of US profits come from leasing machines to operators. Average daily revenue per cabinet from this source dropped from $US54 in 2005 to $US37 in 2008.
The combination of lower play levels and uncharacteristically frugal casino operators has given Aristocrat the kind of painful one-two combination normally only seen ringside at the MGM Grand.
Scant insulation
In gaming at least, the slowdown was global and synchronised. After frenetic growth in Macau, where Aristocrat commands a 60% market share, development ground to a halt. In the US numerous projects have been abandoned or lie incomplete. In Japan, where profits are erratic at the best of times, new regulations slammed the brakes on sales. And smoking bans in Australia and New Zealand and a strong Aussie dollar are crimping profits. Finally, there's a potential $US233m legal settlement with US bondholders. A troublesome cargo indeed.
Yet, as the term implies, cycles do turn. Aristocrat is adept at modifying products to oblige regulators and we're hopeful the company's legal wrangles are mostly behind it. Our major concern lies with a potential loss of competitiveness.
Aristocrat specialises in video games, in contrast to its three major US rivals that also offer a wide range of 'stepper' cabinets where you crank the handle, a machine still popular in the US. Sales at IGT, the industry's dominant player, and Aristocrat are flagging, while smaller competitors Bally Technologies and WMS Industries boasted record profits in 2008. But Aristocrat's performance more likely reflects poor management than trouble developing cutting edge games.
New CEO
New CEO Jamie Odell (formerly of Foster's Group) has addressed the elephants in the room by addressing Aristocrat's R&D program and staff morale; both vital first steps on a path to recovery.
And, despite Aristocrat's extensive laundry list of worries, there are reasons for optimism.
Barriers to entry in this highly lucrative industry remain high; Aristocrat's games satisfy regulations across 162 jurisdictions, a formidable hurdle for new entrants. New jurisdictions also offer growth opportunities. As wealth spreads across emerging economies, so do casinos. Aristocrat has been highly successful riding the casino coat tails, as its success in Macau demonstrates. And US states previously hostile to poker machines may also have a change of heart as public debts pile up.
As it has in the past, the replacement cycle should turn. And when it does, it will swell a wave of demand for the latest innovative games. That bodes well for the company.
Aristocrat's finances are healthy—it's remained profitable throughout the downturn—and Odell is ridding the company of lousy investments and distracting legal action. The company has a history of occasional mismanagement, and surviving it, as good businesses tend to do. We're betting it will eventually prosper again, although it's important to recognise that this is a turnaround situation and sometimes turnarounds don't turn.
We recommend Aristocrat as a LONG TERM BUY for up to 5% of a well diversified portfolio, leaving some scope to buy a little more if the price falls further.
This article contains general advice only (under AFSL 282288).
Greg Hoffman is research director of which provides independent advice to sharemarket investors. readers can enjoy a free trial offer at website.
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