Japan Cash Machine - Short Thesis

Japan casino legalization has long been rumored and finally appears to be moving forward with several casinos now expected to open in time for the 2020 Olympics. A number of Japanese stocks viewed as “casino stocks” have recorded significant gains this year driven by speculation to find the potential beneficiaries of casino legalization. Japan Cash Machine (“JCM”) is one such stock but we think the near tripling of the stock in the past 18 months is largely unwarranted. As we will show, the company is unlikely to generate more than US$1-2m in profit from the new casinos and only a fraction of this in ongoing replacement demand after the casinos open. The market cap has increased by ~$350m this year and the stock is trading at extremely high absolute and relative multiples (~37x P/E and ~20x EV/EBITDA). In the Japanese stock market, it is often better to travel than arrive and we think as the casino news flow diminishes and the market starts to realize the limited impact Japan casinos will have on JCM, the stock will deflate.

Business Description

JCM manufactures money handling machines for domestic and overseas markets. Looking at the most recent fiscal year ending in March 2013, 40% of revenue was from the Japanese pachinko industry, 40% from overseas gaming markets, and 20% from other end markets including financial institutions, retail, and public transportation. The depreciation in the yen vs. the USD and Euro and a recent decline in the domestic pachinko business reduced the domestic portion of revenue from ~50% in FY3.13 to 32% in the first six months of FY3.14.

For the domestic pachinko industry, JCM supplies Automatic Token Supply and Collection Systems, which automatically feed pachinko balls to the machines, and Token Lenders, which accept bills and dispense tokens. JCM has #3 market share (15-25%) in this market with the major competitors being Jetter, Oizumi, Japan Game Card, and Mars Engineering. JCM’s pachinko business rebounded from FY3/09 through FY3/12 as pachinko halls recovered after a steep decline caused by an adverse regulatory change which reduced pachislot machine popularity. However the market has declined by around 20% over the past twelve months as pachinko halls profits are declining due to shrinking player population and waning popularity. JCM management is not optimistic on this market over the next twelve months either because pachinko halls have decided not to pass on the consumption tax hike to players, which could further pressure industry profits and curtail investment.

In the overseas gaming market, JCM mainly provides built-in bill accepters for slot machines. JCM partners with IGT and other major slot machine manufacturers for the supply of this equipment and commands 60-65% market share in North America and Europe. Major competitors are MEI and Cash Code (both subsidiaries of US-listed Crane Co), and Innovative Technology. JCM also provides equipment which checks, sorts, recycles, and stores currency for casinos but bill acceptors is by far the most important product. The North American market has been strong for JCM recently because slot machine sales picked up in the past few years. This has partly been driven by a modest rebound in the replacement cycle but more importantly there has been a pick-up in new venue openings. This may pose a risk for JCM in the next 1-2 years as the sales into new venues decline (the VLT markets in Illinois and Canada have been a particularly important source of growth over the past year but look set to decline in 2014). Europe has also been strong in the past year because the company introduced a new bill recycling machine which has been popular with the AWP casinos.

JCM also provides money handling equipment for financial institutions, retail customers, and public transportation. Examples of products include bill acceptors for small ATMs, self-service gas stations, vending machines, and train and subway fare machines. This business is split about equally between the domestic and overseas market, with overseas being heavily focused on financial institutions. Domestic market share is 30-40% and Hitachi, Omron, NEC, Fuji Electric, and Glory are the major competitors. Overseas market share is around 50% and MEI and Cash Code are the major competitors.

JCM is managed and controlled by the Kamihigashi family, which has a 33% shareholding. Manufacturing is based in Japan, China, and the Philippines.

Recent Financial Performance and Company Guidance

JCM has recovered since posting a large loss in FY3.09. Sales have recovered nearly 50% from the bottom as the company’s end-markets have recovered. While profits have also recovered, they are still well below peak levels. This is mainly due to a structural decline in gross margins which have declined to 36-38% from 45-49% pre-crisis and still show no sign of bottoming. Offsetting this somewhat, JCM implemented some restructuring post crisis and cut SG&A which allowed them to improve operating margins to around 6-7% over the past few years. Return on capital has been mediocre over the past eight years and is currently only around 4-5%.

Company guidance for this year implies revenue growth of 16%, operating profit growth of 40%, and net income growth of 0.6% (last year benefited from a low tax rate and an FX gain). We estimate that more than half of the expected growth in operating profit this year is being driven by yen depreciation.

Casino Opportunity

In early 2013, after many years of hope and rumor, the resurgence of the pro-business LDP ruling party led by Shinzo Abe increased the likelihood of casinos being legalized. Stocks that might benefit from casino legalization started rallying as early as March and had an especially strong move in May. Tokyo’s winning bid for the 2020 Olympics also arguably added urgency to the casino legislation. Finally on December 6, Japan’s legislature introduced a bill to legalize casinos. The bill still needs to be debated and passed so there are many unanswered questions. But at this stage it seems likely that legislation will be debated in spring 2014 and some form of final legislation could pass between mid-2014 to mid-2015. There are indications that the bill will propose two large-scale casinos in major cities (Tokyo and Osaka likely) and two in regional areas. Additional casinos in other regional areas could be approved at a later stage.

There are a number of Japanese stocks that have been bid up by investors in anticipation of the casino legislation including Fuji Media, Sega Sammy, Konami, Universal Entertainment, and Japan Cash Machine. Most of these stocks are believed to have the potential to be part of a consortium that will win an operating license for one of the new casinos. We agree that being a part owner in one of the casinos could be very lucrative. It’s easy to see why investors and international casino operators are excited by the opportunity. With over 5 million installed pachinko and pachislot machines nationwide, Japan already has one of the largest gambling markets in the world albeit a semi-legal one in its current form.

However, JCM has no aspiration or intention to be part of a casino consortium. JCM’s opportunity is to sell built-in bill acceptors for slot machines and other money handling equipment for casinos. Management estimates that each casino may install approximately 2,000 slot machines and the company could generate approximately 200m yen of installation revenue from each new casino. There will eventually be some replacement demand revenue from the new casinos, but this will only amount to a fraction of the initial installation revenue on an annual basis.

To analyze how meaningful this opportunity is for JCM, let’s assume the following:
-Four casinos open in 2020, with 2,000 slots each
-JCM generates 200m yen of revenue from each of the four casinos
-JCM earns an incremental operating margin of 20% on this revenue (a generous assumption)
-The domestic  tax rate is 38%

We then arrive at total net income of approximately 100m yen from the four new casinos. This equates to about US$1m of incremental earnings in 2020. This compares to the company’s forecasted FY3.14 earnings of about US$14m and JCM’s increase in market cap this year of about US$350m. Alternatively, the 800m yen in incremental revenue in 2020 is approximately 3% of the company’s forecasted FY3/14 revenue. We think this analysis shows that the Japan casino opportunity is largely irrelevant to JCM given the limited potential size of the market, and it certainly shows that the stock has priced in an unrealistic scenario.

Valuation

As previously mentioned, the stock is trading at 37x P/E and 20x EV/EBITDA based on company guidance for FY3/14. Historically the stock has rarely traded above 20x P/E or 10x EV/EBITDA. Excluding benefits from yen depreciation, we don’t believe the company is like to grow at more than a mid-single digit rate over the medium-term with mediocre return on capital so this multiple seems very hard to justify.

Risks

Japan casino news flow is a risk. We found it encouraging that the stock did not react positively to the introduction of casino legislation in early December. In fact the stock has sold off. However there will be significant casino news flow in 2014 when they start debating the legislation. We think the stock has more than priced in the casino news now but investors could bid up the stock again when the legislation debate begins.

JCM has developed a new table game bill validator which they believe is a new growth opportunity. They system targets high-volume table games like baccarat where frequent buy-ins with banknotes slows down play and occasionally leads to human error. They have partnered with a leading table game manufacturer to target the Asian table gaming market, with Macau being the biggest potential market. They originally exhibited this at the Asian Global Gaming Expo two years ago and have been refining the system, with sales expected to start in the second half of 2014. The product will be sold for around $8,000-9,000 so it’s more expensive than the slot machine bill acceptor which is around $650-700. Assuming they sold one for every table in Macau and Singapore, which have ~7,000 combined tables, it could be a $60m revenue opportunity. However there is still a lot of uncertainty around customer acceptance and even if it is successful, it would likely take multiple years to achieve high penetration in the market.  But if this product is successful it could be much bigger than the Japan casino opportunity.

A meaningful improvement in slot machine sales in North America and Europe would be a big positive for JCM. As previously mentioned, however, there are signs the market may be more likely to decline over the next year as new venue openings slow.

JCM will release its new mid-term management plan sometime in January. Typically Japanese companies announce mid-term plans for the next 3 years. If the company releases a very bullish plan, this could be taken positively by the market. However it is also possible that it will highlight the lack of earnings contribution from Japan casinos over the next 3 years and act as a negative catalyst.

Further depreciation of the yen vs. the USD and/or EUR would flatter sales and profits reported in yen. This is mostly translational because the majority of production is in China and the Philippines but also somewhat transactional due to higher G&A denominated in yen. According to management, a 1% depreciation in the yen vs. USD increases yen profits by ~0.9% and a 1% depreciation vs. the Euro increases profits by ~0.5%.

Realization that Japan casinos will not have a material impact on JCM.

Buy the rumor, sell the news mentality causes retail investors to lose interest and sell the stock.