Description

Short Investment Thesis:

BYI reported record-breaking EPS for both 4Q09 (June 30, 2009) and FY 2009 ($0.58 and $2.22 respectively), driven by increases in ASPs, margins, reduced working capital, and reductions in inventory write downs when compared to the two previous years - this in the face of the greatest recession in 75 years. The financial results "beat" expectations and the stock has enjoyed a healthy rally from $37.07 on August 20 to $43.01 today, approximately 16% (vs. 10% for the S&P 500), this despite already high valuation numbers. A closer analysis of the 10-K filed August 20, 2009 reveals that some "cookie-jar" accounting may have helped the historic performance, and the company is likely going to miss earnings in the next couple of quarters.

Background:

 BYI reports along four segments: Gaming Equipment (essentially slot machine sales), Gaming Operations (essentially slot machine profit-share with casinos), Systems (networking equipment to supervise slot machines, manage customer loyalty programs, and in some instances monitor an entire casino), and finally Casino Operations (BYI operates a river boat casino in Mississippi). Casino Operations only represents 5% of corporate revenue ($39.6mm FY09), has been steadily shrinking in absolute and relative terms over the last two years, and is not a focus of the company, hence we will ignore this business unit in the following analysis. As casinos face capex constraints, the most growth has been seen in the Gaming Operations unit whereby the casino operator only faces an opportunity cost of giving casino square footage to BYI machines and shares in the winnings with BYI - this arrangement is sometimes referred to as "rental". Conversely, Gaming Equipment (games sales) have been decreasing, offsetting Gaming Operations growth, but resulting in increased profits for BYI as Gaming Operations seems to have a stronger margin than Gaming Equipment. Given that under the "rental" system the gaming device capex as well as the game software development and deployment is borne by BYI, profits are essentially driven by whether BYI is able to develop a "hit" game or not. If the game is not a hit and does not attract players, then the game does not generate profits for either BYI or the casino operator. This makes for a very competitive environment where the differentiating factor amongst gaming equipment manufacturers  is the game software and game concept itself.  This has driven R&D expense steadily upwards, from $51.9mm (FY07) to $60.8 (FY08) to $77.3 (FY09). To quote from the 2009 10-K:

Competition among gaming machine manufacturers is intense and is primarily based on the amount of profit our products generate for our customers in relation to our competitors' products. Additionally, we compete on the basis of price and financing terms made available to customers, the appeal of game content and features to the end player, and the features and functionality of our hardware and software products.

The weakness in the underlying gaming equipment market is shown when one looks at Gaming Equipment sales. The fact that the corporation as a whole reported increased revenues despite the weakness in Gaming Equipment sales accentuates the importance that equipment "rental" in Gaming Operations has taken. Quoting the FY2009 10-K:

The replacement cycle for gaming machines in North America continues to be sluggish, but we are cautiously optimistic that gaming operators' replacement game buying demand will begin to improve in calendar 2010. During the years ended June 30, 2009, 2008 and 2007, we sold 16,848, 21,263 and 17,737 new gaming devices in the United States and Canada, respectively.

Finally, the company has steadily increased the size of its stock repurchase plan, reaching $100mm in authorized size as of August 12, 2008. 266,000 shares were repurchased in FY09 at a VWAP of $27.60 (nowhere near the low of $13.33 in the fall of 2008). Approximately $61mm remains to be spent in the plan as of June 30, 2009.

See the table below for a summary of financial results as presented in the FY09 10-K (excluding the Mississippi casino):

(1)

Gross Margin from Gaming Equipment and Systems excludes amortization related to certain intangibles including core technology and license rights, which are included in depreciation and amortization.

(1) Daily fee revenue from approximately 6,900 units included in the centrally determined systems end of period installed base total as of June 30, 2008 was deferred, and was not included in gaming operations revenue until the second quarter of fiscal 2009 when the completion of certain contractual commitments necessary to recognize the revenue under the Company's revenue-recognition policy occurred.

Analysis:

• 1. A very large and unusual deferral of revenue recognition from FY08 to FY09 artificially boosted FY09 margins and could be "cookie-jar" trickery.

The company's revenue recognition policy  states that if payment can be reasonably expected within 24 months, then revenues should be recognized. From the 10-K:

revenue is recorded in accordance with the terms of sale for contracts with payment terms of 24 months or less, or as cash is received for contracts with payment terms in excess of 24 months

It therefore seems odd that a sales contract that was struck sometime in mid 2008 was not deemed likely to close within 24 months, only to then close a few months later, conveniently in late 2008 which is FY09. Furthermore, the 10-K describes this as a daily fee arrangement, so it would seem that this kind of arrangement would lead to regular cash payments from the counterparty. From the 10-K footnotes:

Daily fee revenue from approximately 6,900 units included in the centrally determined systems end of period installed base total as of June 30, 2008 was deferred, and was not included in gaming operations revenue until the second quarter of fiscal 2009 when the completion of certain contractual commitments necessary to recognize the revenue under the Company's revenue-recognition policy occurred.

 Whether or not this was an intentional move by management is somewhat moot, however, since the effect on the financials is what really matters - though the SEC investigation detailed later in this analysis certainly leads one to doubt management. The effect on the financials is clear: 6,900 gaming systems were moved from FY08 to FY09, representing about 16% of "centrally determined games" (a high growth segment primarily used by Native American casinos). Had this shift not occurred, sales of centrally determined games, which is closely watched by analysts, would have been down year-on-year instead of up. Specifically FY08 would have reported 51,129 units and FY09 would have reported 42,024 units, approximately 18% down y-o-y. This would have led analysts to rightfully question whether the Native American casino gravy train was slowing down. In fact, the Native American Finance and Gaming Weekly Update of Nov 26 2008 shows that Native American gaming revenue growth has trailed off from double-digits in the early 2000s to approximately 5% in 2008, showing a slowdown as markets get saturated. Assuming that gaming operations were down 16% y-o-y, would have led that segment to report $64.2mm less gross margin. Given that net income margin is approximately 24% of gross margin, that would have meant $15.4mm less earnings, or $0.28 on an EPS basis. Subtracting that from the $2.22 reported would yield $1.94 in EPS for FY09, down from $1.97 reported in FY08.

Furthermore, it stands to reason that the pricing environment having materially weakened in FY09, the shifting of these sales to FY09 served to significantly boost FY09 margins, since the sale agreement occurred before the start of the recession. Strengthening margins was a claim that was repeatedly emphasized during the 4Q09 conference call, and the change in margins was small enough to potentially be driven only by the large deferral of revenue. From the August 12^th, 2009 conference call:

Robert Caller, CFO: [...] Our operating margin increased to a record 24.3% for the fiscal year as compared to 22.1% in the prior fiscal year.

However, even if margin improvement were a result of operational efficiency moves, those moves are at best one-time changes that are not reproducible. According to management, the main driver of margin increase was re-arranging where the gaming devices are physically located on the casino floor to better locations - ostensibly higher visibility / higher traffic locations within the casinos. From the August 12, 2009 conference call:

David Katz [question]: I wanted to, I guess, focus on the pieces within gaming ops, and try to get a sense for what the trends are. We've certainly seen some of the newer generation, premium daily fee games rolling out there and then, I guess ones that we would put more in a legacy category [...]

Richard Haddrill [CEO]: Basically, within our game ops unit, we had good growth [...] The premium units were kind of flat during the quarter, but like you've seen from us in the last two three quarters, we've been managing that asset-based [sic] more effectively, so despite the slow consumer spend, we have higher revenues from a  flat premium base as we move units from less optimal locations to better locations.

• 2. R&D costs are continually increasing both in absolute terms and relative to revenues, and show no sign of slowing down thanks to intense competition in the gaming space. R&D is not growth Capex, but maintenance Capex.

R&D expenditures increased 27% between FY 08 and FY 09 ($77.3mm and $60.8mm respectively), and increased 17% between FY 07 and FY 08. Meanwhile corporate revenues increased by 15% on an annualized basis over the same period. From the 10-K:

The demands of our customers and the preferences of the end players are continuously changing. As a result, there is constant pressure to develop and market new game content and technologically innovative products. As our revenues are heavily dependent on the earning power and life span of our games and because newer game themes tend to have a shorter life span than more traditional game themes, we face increased pressure to design and deploy new and successful game themes to maintain our revenue stream and remain competitive.

• 3. BYI generates very little free cash flow on a normalized basis.

Cash from Operations in FY09 were $165mm, with many one-time effects. For instance, there was a big reduction in inventory over FY08 which resulted in a lot of cash being liberated out of working capital. For both FY08 and FY07, inventories were a drain on cash of $92mm, whereas in FY09 they added $5mm to cash, for a change of $97mm year on year. If the economy indeed were to turn around and the company would resume building gaming equipment in order to satisfy demand, working capital would have to swell again. Hence on a normalized basis, it would be more reasonable to expect cash from operations to be around $165-97=$68mm. Subtracting the additional $10mm in principal repayments that a new credit facility requires in FY10 over FY09 reduces free cash flow to nearly $58mm. On a FCF multiples basis, this translates into 39.5x free cash flow at current stock prices!

• 4. Inventory write-downs are inconsistent with past write-downs, let alone the economic climate facing the gaming industry

Inventory write-downs were $14.2mm (FY06), $10.5mm (FY07), $9.2mm (FY08), $4.5mm (FY09). In a period with weakening slots sales in general, one would have expected write-downs to remain at least similar as a percentage of revenues to previous years. For FY 08, write-downs were 1.08% of revenues and in FY 07 1.65%. However in FY 09 write-downs were only 0.54% of revenues. It would be quite a feat if in the span of a year, BYI were suddenly able to forecast demand so much more accurately than it ever has in its past, in order to halve write-downs - especially in the face of an "outlier" year in the industry. A more normalized write-down number would have been ~$12mm, or a reduction of approximately  $0.09 on EPS (bringing overall EPS to $1.85 for FY09 when including #1 above).  

• 5. SG&A efficiency gains appear fictitious.

From the 10-K:

Selling, general and administrative expenses decreased $4.8 million, or 2%, in fiscal 2009, when compared to fiscal 2008.

This was a much trumpeted fact by the CEO during the Q4 conference call.

However, examining the footnotes of the financials reveals that:

During fiscal 2009, the Company negotiated an insurance settlement related to the 2005 U.S. Gulf Coast hurricane damages which destroyed or temporarily shut down certain gaming operations in the Gulf Coast region. The Company received a final payment of $3.0 million for business interruption, which was included in selling, general and administrative expenses.

Hence of the $4.8mm in SG&A savings, $3mm were a one-time, non-recurring benefit, accounting for 2/3 of the SG&A savings. 

• 6. Share repurchases seem like a bullish indicator yet they are entirely offset by egregious stock-based compensation for the top executives

Stock-based compensation for the top five[1] executives has averaged approximately $15mm per year for the last three fiscal years. Another $18.5mm are due in the next year and a half, between restricted stock and stock option grants. This translates into $63mm of stock-based compensation for the executives over approximately 4 years. Per the 10-K:

Pre-tax share-based compensation expense was $16.4 million, $13.0 million and $15.1 million during the years ended June 30, 2009, 2008 and 2007 respectively. As of June 30, 2009, there was $11.3 million of total unrecognized compensation expense related to the unvested portion of stock options which will be recognized over the subsequent 1.67 years. In addition, as of June 30, 2009, there was $7.2 million of total unrecognized compensation expense related to the unvested portion of restricted stock and Restricted Stock Units ("RSUs") which will be recognized over the subsequent 1.86 years.

Meanwhile, stock repurchases over the last three fiscal years have amounted to $55.4mm dollars, not enough to offset the stock-based compensation that has either been paid out or promised to the executives to date. The aggressive share-repurchasing no doubt serves as a technical support to the share price, and many analysts erroneously note how the company is virtuous in its share repurchasing plan. However, the dilution from stock-based compensation schemes more than offsets the share repurchases. Per the 10-K:

During the year ended June 30, 2009, the Company repurchased 1,557,216 shares of common stock for $38.3 million under the share repurchase plan. During the year ended June 30, 2008, the Company repurchased 436,200 shares of common stock for $17.1 million under the share repurchase plan, excluding 149,253 shares repurchased from a related party for $6.0 million as discussed in Note 9 to the consolidated financial statements, Related Party Transactions . During the year ended June 30, 2007, there were no repurchases of common stock under the plan.                

• 7. A nearly 3 year SEC investigation regarding financial reporting compliance does not reassure the investor

In February 2005, the SEC initiated an informal inquiry and requested documents and information regarding matters related to the allegations in a class action suit brought against the Company. In September 2008, the SEC and the Company reached a settlement in which the Company, without admitting or denying the SEC's findings, agreed to a cease and desist order that mandates compliance with federal securities laws and regulations related to financial reporting, record keeping, and internal controls

The company quickly distanced itself from the two executives who were ostensibly responsible of the fraud. An article from CFO.com reveals more:

Gaming Firm Gets Off Lightly; No Dice for Ex-Execs

Bally Technologies faces no monetary consequences for an alleged revenue accounting fraud, but two former top finance executives are on the hot seat.
Stephen Taub, CFO.com | US
September 25, 2008

Bally Technologies said it has settled with the Securities and Exchange Commission over an investigation of its historical revenue accounting.

However, the SEC filed a civil injunctive action against two former accounting executives of the gaming-machine maker.

Under the settlement, no fines, civil penalties, or other monetary sanctions were imposed on Bally, formerly known as Alliance Gaming Corp. The company consented, without admitting or denying the SEC's findings, to a cease and desist order requiring it to remain in current compliance with federal securities laws and regulations relating to its reporting, record keeping, and internal controls.

Bally stressed that the SEC made no allegations of fraud against the company.

"We are pleased with this resolution of the SEC investigation, which allows us to put these matters behind us as we continue to execute our strategies for the long-term success of our business," said Richard Haddrill, Bally's president and CEO.

Not so fortunate were former CFO Steven Des Champs and former vice president of finance Martha Vlcek. The SEC accused them of fraudulently and artificially inflating the company's reported revenue and giving misleading information to investors about the company's earnings.

The SEC's complaint alleges that from the fourth quarter of fiscal year 2003 through the second quarter of the following year, the pair fraudulently recognized revenue on bill-and-hold transactions, made misleading disclosures and omissions regarding revenue recognition, and made materially false statements to the company's outside auditors when they represented the transactions were proper under generally accepted accounting principles.

The improper bill-and-hold sales led to a 25 percent overstatement of Bally's reported earnings per share for the fourth quarter of fiscal 2003 and to 33 percent and 27 percent overstatements of Bally's quarterly EPS numbers in the first and second quarters of 2004, respectively, the SEC added.

The complaint also alleges that in the second and third quarters of 2005, Des Champs fraudulently recognized revenue on transactions where he knew that the company could not reasonably expect that it would be paid and again made materially false statements to the auditors about his knowledge of the improper accounting, among other things.

As a result, the SEC alleges that Bally was later required to reverse $6.3 million of the $10.6 million of revenue originally recognized.

The SEC charged the two individuals, among other things, with aiding and abetting Bally's violations of securities rules. In addition, Des Champs was charged with falsely certifying the accuracy of Bally's financial statements. The Commission's complaint seeks permanent injunctions, disgorgement of ill-gotten gains, third-tier civil penalties, prejudgment interest, and an officer and director bar against both defendants.

Neither Vlcek nor Des Champs could be reached for comment.

[1] The executives are RICHARD HADDRILL, CEO/Director; ROBERT CALLER, CFO/Executive VP/Treasurer; MARK LERNER, Senior VP/General Counsel/Secretary; MICHAEL ISAACS, Executive VP/COO; RAMESH SRINIVASAN, Executive VP, Divisional

Catalyst

Catalyst:

A miss on quarterly earnings, or comparables reporting poor numbers that take the wind out of this over-hyped stock. The company has guided for FY 2010 (6/2009 - 6/2010) EPS to be in the $2.25-$2.50 range, which would be another record-breaking performance.