Description

Introduction: a value trap cracked open

Japanese value trap has discovered the power of buybacks, still trading at ~3x EV/EBIT having bought back 24% of shares in L12M alone, still with 50% mkt cap backed by net cash position, with positive FCF in all but 1 year since 2000.

Following Sankyo’s previous market value peak in 2006, it wasn’t until Sep 2022, a full 16 years later, that Sankyo’s share price surpassed its previous watermark. Sankyo – whilst always screening dirt cheap at LSD EV / EBIT multiples – suffered from the hallmarks of a classic value trap: i) structurally declining top line and earnings in a shrinking market, ii) hoarding cash with little consideration for RoIC or shareholder returns. This essentially left shareholders owning a cashbox which would never open to them, leaving no valuation low enough for Sankyo’s equity in the eyes of the market. On both counts, this has now changed. A combination of the founding family selling down and the winds of change in Japan towards improving capital efficiency, the company has warmed to share buybacks in a meaningful way, having bought back 24% of shares outstanding in the last 12 months alone. Meanwhile despite the Pachinko market showing little sign of rejuvenation, Sankyo has stolen a march on it’s peers and doubled market share over the past 2 years, leading to a tripling in earnings. Despite a >200% rally since early 2022, the shares still trade on ~3x EV/EBIT, anchored to a valuation regime of the past and poised to deliver >100% upside if Sankyo can hold onto its market share gains, while the sizable net cash position and compressed multiple ex cash provide significant downside protection if they can't.

Business overview

• Founded in 1966, Sankyo is the oldest of the major manufacturers of ‘Pachinko’ & ‘Pachislot’ gaming machines
• Pachinko
• Pachinko is an arcade type game played in dedicated gaming parlours across Japan, similar to a version of pinball
• Users purchase a certain number of steel balls to play with, firing them into the machine using a loaded spring, with prizes depending on whether their balls hit the various jackpots
• Modern machines typically combine the original steel balls with bright graphical displays, often anime themed
• Visual of 2 of Sankyo’s current Pachinko machines from the 4Q24 investor presentation
• 
• Video to get a better sense: https://www.youtube.com/watch?v=-tBy2jemw4s
• Pachislot
• Pachislot is another arcade type game machine, this one more similar to a traditional slot machine in a casino
• Users typically insert money into the machine, and are dispensed with physical coins (or ‘medals’ as they are referred to)
• These coins or medals are then inserted into the machine, and a lever is pulled to start spinning the 3 central wheels
• The user then has a button they can press to stop each of the three wheels, seeking to align icons in order to win prizes, similar to regular slot machines
• Gambling in Japan
• There is a long standing ban on most forms of gambling under Chapter 23 of the Criminal code
• The few legal exceptions are
• Sports betting (horse racing, motorsports racing)
• The lottery
• Football (soccer) betting
• Pachinko winnings – a legal loop hole
• In both Pachinko and Pachislot, the player receives balls (pachinko) or coins (pachislot) as payout from the machine
• The player can then exchange the balls for prizes (alcohol, trinkets etc) in the store, or they can take the token and exchange for cash in a separate store that is affiliated with the pachinko parlour
• The legal loop hole here being the players are technically not receiving cash prizes, instead they are selling their prize for cash in the separate store, thus circumventing the ban on gambling

Market overview

• Mkt size
• Pachinko market in decline, falling ~8% p.a. since 2007
• Pachislot market also declining over the longer term, but has seen a reversion over the past few years
• Largely attributed to the introduction of ‘smart machines’, which thus far has had a more stimulative impact on pachislot vs pachinko sales (more below)
• 
• Regulation
• Since the 90s, the pachinko industry has seen various forms of regulation to control the space and protect the players
• Regulation typically seeks to define winning odds along with the size of large jackpot wins
• Governing body responsible is the National Public Safey Commission
• Regulatory tightening in 2022
• New anti-addiction rules were introduced in 2018 that required Pachinko machines to reduce the size and ratio of winning payouts
• The changes were part of a compromise policy deal offered in exchange for legalising casinos
• From expert checks I understand that initially a grace period of 3 years was intended for OEMs (like Sankyo) to gain compliance with the new restrictions, meaning 2021
• This was then delayed another year due to CV, meaning the OEMs had until 2022 to comply with the changes
• Voluntary restrictions
• As well as the formal regulatory requirements, the industry imposes voluntary restrictions on itself, which all OEMs typically adhere to
• These restrictions have actually been loosening over the past few years, particularly for Pachislot machines
• More specifically
• In June 2022, ‘model 6.5’ was introduced
• Lifting the upper limit of games played in the ‘advantageous section’ (bonus / high paying mode of the game) from 3000 to 4000
• From Nov 2022, the upper limit was abolished altogether for smart pachislot machines (more below)
• Smart machines
• Both Pachinko and Pachislot machines have been undergoing a digital upgrade, typically referred to as ‘smart machines’
• The smart machines differ in the following ways:
• Pachinko
• Player doesn’t touch or remove the ball bearings
• Instead they stay trapped inside the game, and the final winning score is printed on a ticket to exchange for prizes (or cash across the road) instead of taking the physical balls with you to the counter
• Pachislot
• Similarly, with smart pachislot the machine does away with physical tokens or coins, and instead gives the user a print out ticket of their winnings once they decide to stop playing
• While the smart pachislot transition has stimulated demand and prompted operators to replace and upgrade their machines, so far the smart pachinko impact has been comparatively sluggish
• Thought to be related to i) pachinko players being on avg ~20 yrs older than pachislot (typically 60s vs 40s) and thus less digitally savvy, ii) the rules governing smart pachinko in particular made the machines less entertaining
• In March 2024 the industry introduced the ‘lucky trigger’ system to pachinko machines, introducing a version of game play that leads to higher payouts or bonuses – essentially making the game more engaging and entertaining
• The hope will be that this lucky trigger stimulates demand and helps kick off an upgrade cycle similar to what we have seen with smart pachislot so far

Market share

• Market share over last 5 years by major OEM (from Sankyo FY Mar-24 investor presentation)
• Pachinko
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• Pachislot
• 
• Sankyo appears to have gained the mkt share for the following reasons
• Benefitting from major regulatory change (2022)
• Earlier I discussed the regulatory tightening that came into effect in 2022
• Expert checks have revealed Sankyo’s game development capability as a comparative strength vs peers
• Sankyo’s R&D team is the best funded
• Meanwhile Sankyo is full vertically integrated and designs all machines in house, meaning it is best placed to redesign the machine in the most efficient way to comply with new rules
• The message from speaking with pachinko parlours was Sankyo managed to best balance meeting the new regulation requirements while still keeping their new game(s) fun and entertaining, and stole a march over their peers
• Smart machine transition
• This has also absorbed development capabilities from the manufacturers as they design the new digital machines, again playing to Sankyo’s strengths
• A bit of luck creating a popular hit machine series (‘Neon Genesis Evangelion’)
• The year to year mkt shares between manufacturers do fluctuate widely depending on which machine happens to be a hit with players
• Sankyo have managed to produce a big hit with their ‘Evangelion’ title series… licensing the theme from the popular Evangelion anime
• Speaking with industry checks and other OEMs, which particular machines go on to enjoy break out popularity vs fall flat is quite hit and miss, so we should be cognisant of the randomness and luck that enters into this
• That said, once a machine is popular, the OEMs can then bring out follow up versions of the game that typically helps carry forward the popularity for a couple of years

History of recent share repurchases

• Busujima family ownership fallen from 41% in Jun-19 to ~7.5% today
• Initial Sep-19 repurchase of 100m shares (25% of outstanding) was bought from Chairman controlled ‘Marf’ corporation
• 
• Following this block repurchase, shareholders urged the company to consider further repurchases in the open market, which the company began in Dec-21
• Here’s the share repurchases since 2019
• 46% of shares bought back since Sep-19
• Chart including ASP of bbcks
• 
• Summary of 3 tranches

Mgmt medium term business plan: ambitious and shareholder friendly

• 3 yr plan FY25-FY28
• Announced 9^th May 2024
• Target RoE across the 3 yrs: 15%-20%
• Policy on return of profits to shareholders
• P.15 of plan: “Performance-linked dividends targeted at the consolidated payout ratio of 40% as our basic policy, we manage balance sheets appropriately in view of making additional shareholder returns through agile share buyback”

• Ie PoR: 40-50%, with the rest set aside for buybacks, which will be conducted based on share price and business outlook, exactly as we want them to behave
• Mgmt think they can hold onto their Pachinko mkt share gains…
• 
• …and grow their Pachislot share to boot:
• 
• With modestly expanding operating profit margin
• From 36% in FY24 to 40% in FY27
• For context the recent OPM low in FY21 was 11%

Key Financials

• P&L base case vs mgmt plan & street
• Pare back mgmt business plan assumptions, particularly on Pachinko market share
• Historical analysis of OEM mkt share shows how erratic it can be, and how difficult it has historically been for OEMs to hold onto high share
• Mgmt clearly have ambitions of doing just that, but we don’t need to underwrite mgmt’s plan for this to be a compelling buy, so why go there
• 
• Share repurchases
• Hard to know exactly how aggressive a pace the buybacks will continue
• Other than to note that the company has explicitly included ‘agile share buy backs’ in its capital return policy and is targeting a 15-20% RoE, which becomes tricky if they don’t deploy the excess cash over time
• Conservatively model base case ~JPY 40bn of repurchases per year (vs 90bn in Mar-24 FY)

Valuation

• Trading multiples
• Long term multiples vs street NTM figures (adjusting to remove treasury shares from mkt cap)
• With the exception of CV where enterprise value went negative, Sankyo is currently trading at all time low multiples, despite an extremely aggressive and transformational buyback policy
• 
• EV: attractive upside / downside skew
• Base case: +54%
• Even on subdued base case figures (Mar-26 OP -22% vs mgmt plan), a mere 6x EV/EBIT (~12x P/E) gets to ~50% upside
• Mgmt case: +120%
• Should mgmt hit their business plan, 6x EV/EBIT (~12x P/E) mgmt case gets to ~120% upside
• Bear case: -20%
• Slashing mkt share and taking OP down to JPY 22bn in Mar-26 (vs JPY72bn in FY24 and JPY22bn in FY19) ie similar to FY19 pre CV before the industry changes led to Sankyo market share explosion…
• 5x on this with no buybacks gets to ‘only’ -20%
• 

Catalyst

Resumption of share buy backs

Holding pachinko mkt share

Expanding pachislot mkt share