You don’t find many $6.3bn market cap companies with dominant market shares in oligopolistic businesses trading at an 8x PE multiple, net of cash on the balance sheet. And, in this case, if you dig, you’ll find that cash represents 30% of the market value of the equity providing a heaping measure of downside protection.  And, when you discover that the security trades $100mm per day in volume, you can’t do anything else, but back up the truck.  (For the rest of this report, I'll use Yen and the Japanese ticker since that is where the trading volume is - Yen share price is about 3,000).

 

Sega Sammy is relatively newly listed share on the Japanese Market (6460 JP) that was formed through the combination of the old Sega (yes, Sonic the hedgehog SEGA!) and a company called Sammy that manufactures pachislot and pachinko gambling machines for the Japanese pachinko parlor market.  English translation:  Sammy makes slot machines (without levers, just buttons) and stand-up pinball gambling machines which award prizes that can be exchanged for cash in the Japanese gambling industry.

 

Sega Sammy has four business lines:  (1) Pachislot/Pachinko machines, (2) amusement centers, (3) amusement machines, and (4) consumer games.   The business lines contribute to the company as follows (all figures in billions of Yen for fiscal year ending 3/06):

 

                                                Revenue                       Operating Profit

Group                                      553.2                           111.9

Pachislot/Pachinko                    265.6                             99.8

Amusement Centers                  106.2                               9.2

Amusement Machines                 71.2                             12.2  

Consumer Games                       90.4                               2.0

Others                                        19.5                              (1.7) 

 

It is readily apparent that what you are paying for is the Pachislot/Pachinko business and you get some other businesses with lest robust returns on capital (but interesting growth/restructuring call options) thrown in. 

 

This is a government regulated gambling business with mandated payouts and machine specifications very similar to the slot machine industry.  Unlike, IGT which I believe makes a recurring profit share, Sega Sammy makes all its money off of machine sales.  This is OK since these games are highly designed and typically have a pretty short lifespan until the next hit comes out (which is OK since there are only a handful of companies with the R&D, distribution, and servicing capability to compete).

 

Sega Sammy is dominant in the Pachislot market with about a 35% share and is trying to make inroads into the Pachinko market with only about a 6% share.  For those who really want to understand industry trends, the annual report is comprehensive and in English so I’ll refer you there.  In brief, one of the key reasons for this opportunity is a regulatory shift in the relative payout mandate for Pachislot and Pachinko machines which has spooked the market into believing that Pachislot usage and purchases by parlor owners will drop as players and owners gravitate back toward Pachinko (where Sega Sammy is much weaker).  I make no claim to be able to forecast the ultimate equilibrium of the Japanese parlor gaming public, but I do assert that you are buying the stock at a 11x multiple of earnings assuming the bear case comes to pass with lots of possibilities both in this business line and others to own a company at 7x growing earnings two years out.

 

The Pachislot/Pachinko business never loses money.  For those who want more proof than  the last two years of public data from Sega Sammy, I refer you to 6417 JP (Sankyo), a pure-play Pachinko manufacturer with about 15 years of data readily accessible on Bloomberg.

 

I’ll lump these two together since the reason to run the centers revolves in large part around selling the games.  This business is not really economically cyclical, but it is cyclical in the sense that hit games drive traffic.  FY 2007 (ending in March ’07) was a slow year in this business for Sega Sammy off of huge growth in FY 2006.  I don’t know whether FY 2008 or FY 2009 will be a “good year,” but this company has shown a core competence in design and product development and that good year is not far off.  And, this business won’t lose money this year either.

 

FY 2007 was also a slow year in the consumer games side with the market waiting for PS3, the new game cube and the new X-box.  FY 2008 promises to be a much better year here since those machines are finally out.

 

Sega Sammy is launching a Chinese multi-user online gaming portal (I forget the acronym, but think Everquest, Ultima, etc.) that it has high hopes for.  They also have land that they are holding for the development of Japan’s first real Casino that may see the light of day under the new government.

 

Bloomberg doesn’t have either of these numbers right, so casual due diligence overstates share count (and market cap) and understates cash.  The correct share count is 252 million vs. Bloomberg’s 283 million (Bloomberg counts treasury shares) and the cash, short term investments and long term investments now total $180bn Yen versus Bloomberg’s 110.5bn Yen.

 

For the Bear Case, I refer you to the Goldman Sachs 11/16/2006 analyst report (low man in the world).  The gist of this report is that the analyst believes in the long-term structural shift away from Pachislot and hits the company for declining sales volumes and unit pricing (if the parlor owners can’t get play out of the games, they won’t pay as much for them).  He holds the Arcade division profitability constant and drops profits in the consumer division by about 10%.  This all occurs in FY09 because he is generous enough to grant that FY08 (calendar 2007) will be a good year since parlor will have to buy “new-spec” Pachislot machines to replace old Pachislot machines that will no longer comply with the regulations after June 2007.  His net profit for FY2009 forward is 200Yen/share.  With cash on the balance sheet at the end of FY2008 (march 2008) of  $225bn Yen and debt of about $22bn Yen, he’s showing net cash of over 800 Yen per share (assuming no share buy backs).  So, in the bear case you pay 2,200 Yen per share for 200 Yen/share in EPS.  The funny thing about this report is that he slapped a 3,000 Yen/share price target on the stock even after stating that the DCF on his numbers was 3,750 Yen – I guess he thinks people will worry about FY2009 until after it happens.

 

Since I can’t forecast the Japanese gaming market, I’ll refer you to a myriad of analyst estimates between 240 – 270 yen per share in FY 2009 about flat from the FY 2008 numbers (where the GS analyst clocks in at a respectable 260 yen per share) and the FY 2007 run rate of 250 yen per share.

 

Even if the Pachislot/Pachinko business is flat, this management has proven capable of building the other businesses and has shown a willingness to buy back stock (though I’d love it if one of you activists convinced them to do a massive repurchase and take on net debt since this business could handle it).  So, if they can take 250 yen per share in EPS and get it back on a 5% growth curve I see no reason why this company couldn’t trade at 15x EPS + cash or 4,750 per share for a 60% gain.

 

What’s not to like in a non-cyclical business with plenty of growth opportunities priced with 15% downside potential (I really don’t think could even stay there long) and 60% upside.

 

For those who want even less downside (with less upside), take a look at Sankyo (6417 JP)…It has over 50% of its market cap in cash.