Turning gambling industry woes into a winning hand

Turning gambling industry woes into a winning hand

In our review of the poker machine manufacturing industry some time ago, we learned that demographics are playing a big part of the industry’s future. Put simply, younger people aren’t playing the slots or ‘pokies’.

We learned that gaming revenues in Macau had fallen almost a quarter in a single month – the sharpest drop on record – as mainland Chinese gamblers, amid the crackdown on corruption and conspicuous consumption, eschewed gambling as a form of entertainment.

And we learned of a wave of disruption, as financially strapped US state governments sought to boost tax revenues by opening the door to new forms of gambling including online gaming.

All the while, casinos were extending their replacement cycles of poker machines – in other words taking longer to replace ageing machines, and in turn of course, making them even less attractive to customers.

And then we witnessed a wave of debt-fuelled consolidation of the US poker machine manufacturers. In just 18 months, five multi-billion dollar mergers occurred.

Summarising this wave of consolidation; In October 2013, lottery provider Scientific Games Corp. spent $1.5 billion to buy slot machine maker WMS Industries. Two months later, gaming equipment manufacturer Bally Technologies finalized its $1.3 billion purchase of table game producer SHFL entertainment.

November 2014, Scientific Games spent another $5.1 billion to acquire Bally. In December, payment processing and ATM company Global Cash Access completed its $1.2 billion acquisition of slot machine company Multimedia Games. And in April this year, GTECH completed its acquisition of US gaming supplier International Game Technology.

Ostensibly seeking synergies and human resource efficiencies, through debt-fuelled mergers, but amid structurally declining revenues, is a poor yet oft-repeated strategy.

And it is that which triggered our Montaka Global Fund’s interest in Scientific Games (SMGS) as an investment that might profit from a declining share price.

Adjusting for the transactions in October and November of 2014, pro forma revenue in the first quarter of 2015 was declining 10 per cent year on year (YoY), within which product sales revenue (sales of machines, rather than revenue from gambling commissions/rebates) was falling by 32 per cent YoY. Research & development is the lifeblood of many companies and while it can crimp margins it is essential for future product sales and revenues. But R&D was falling by 25 per cent annually – faster than revenue declines.

By the second quarter of 2015, reported revenues were growing at 66 per cent annually but proforma revenue was falling at ten per cent per annum, and sales of gaming machines was down to just 20 per cent of total revenues. New shipments of gaming machines, on a proforma basis, was down 35 per cent YoY and free cash flow fell to a negative $34 million. This, for a company with a market cap of over US$1.2 billion, cash of a little over $100 million and debt of over $8 billion.

Despite all of this we noted divergent expectations. Analysts were still way too optimistic about the prospects for the business. Indeed, despite all of the evidence to the contrary, it appeared analysts were expecting four per cent total revenue growth for some years to come, their EBIT margins would have to include ongoing 20 per cent declines in overheads for years and the enterprise value of the company was 29 times EBIT (and EBIT looked unsustainable anyway).

The combination of deteriorating industry dynamics, asymmetric risk associated with the debt-laden balance sheet and divergent expectations, was the reason Montaka increased its short position in SMGS.

At the most recent third quarter results, performance turned decidedly south. The company announced a US$535 million writedown along with commentary that the review would be completed in the fourth quarter (suggesting further writedowns to come). The company’s negative equity quadrupled to a billion dollars, sales deterioration accelerated and despite cost cutting and R&D cuts there was no margin expansion.

It should come as no surprise that on the day of the announcement of the third quarter results, the shares fell 22 per cent in after market trading. Since the announcement, the shares have fallen from US$11.50 to $8.70. It seems consensus is catching up.

I am constantly surprised at how slow market participants are to recognize deteriorating industry dynamics. Whether it is due to a general unwillingness by broker analysts in the US to put sell recommendations on stocks or an unwillingness to slap a ‘sell’ on something that was previously promoted as a ‘buy’ this sloth like approach to keeping investors updated produces a regular stream of opportunities we call ‘Divergent Expectations’.

While a weak share price will see us cover some of our position on behalf of investors in the Montaka Global and Montaka Global Access Fund, the outlook does not appear to be improving any time soon.

If you wish to invest in the next monthly opening for the Montaka Global Access Fund (1 December), you will need to have lodged your application form and funds with Fundhost by 4pm on Tuesday 24 November 2015. To download the PDS and Application form click on this link.

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Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.