Description

I am recommending selling short Shuffle Master, a gaming company making automatic card shufflers, proprietary table games, and other casino supplies. As a market leader in the popular gaming industry, the company is a Street darling (all 8 analysts who covered it recently rate it a “buy”) due to its predictable 25-30% EPS growth and the fact that the company has made or beaten its estimates in the last 12 quarters. However, this strong record is a façade. As growth has eased due to the increasing saturation of the market, SHFL has manufactured revenue and earnings growth by shifting from a lease-based model to a sales-based model that pulls revenue and earnings forward from future quarters. This change has helped mask the fact that growth is slowing for SHFL’s major products (a problem that has been exacerbated by the shift in the company’s business model) and the company’s new products will not be able to create similar results. These problems would have become apparent in Q2 and Q3 had the company not successfully papered over the insufficient results with accounting changes that allowed them to beat analyst expectations by $.01 in each quarter. As the growth continues to slow and the ability of the company to manufacture earnings diminishes, earnings growth should fall dramatically (possibly leading to declines in net income) and the hefty premium that the stock has enjoyed should disappear.

Short Positives
-Shift from lease-based to sales-based business model pulls forward future revenue to benefit current periods; Policy shift has hidden weakness in underlying businesses and overstated current period EPS growth at the expense of future results
-Business weakness became increasingly apparent in Q2 and Q3 2005
-Accounting shenanigans have allowed the company to remain a Street darling by continuing to exceed analyst earnings expectations; As continued accounting shenanigans become less possible, company will disappoint the Street
-Company remains extremely overvalued on various metrics
EV/S (TTM) 11.4x
EV/EBITDA (TTM) 22.1x
P/E (TTM) 38.3x
P/E (05 First Call) 35.2x
P/B (Q3 05) 46.7x

-Poor FCF generation combined with heavy options issuance and large share buybacks have led to significant debt position as the company attempts to support EPS growth by reducing number of shares
-Future products do not appear to provide a large avenue for growth

Short Risks
-Company retains leading market share in shufflers and table games
-Company quite adept at accounting shenanigans; Future accounting gimmickry certainly possible
-Larger than expected demand for new products could provide financial upside


Company Description
Shuffle Master makes automatic card shufflers, proprietary table games (3 card poker, pai gow etc.), chip sorters, and other casino gaming products. Based in Las Vegas, the company sells and leases its products to casino operators in the US and internationally (~15% of sales). SHFL has two main segments, Utility Products (shufflers, chip sorters etc., 33% of MRQ operating income) and Entertainment Products (table games, 67% of MRQ operating income).

Shift to Sales Based Model
Over the last few years, Shuffle Master has switched from mainly leasing its products to focusing on selling products.

2001 2002 2003 2004 9mos 05
% Revs from Sales (All) 25% 26% 32% 46% 55%
% Rev from Sales (Utility) 42% 43% 47% 53% 63%
% Rev from Sales (Entertainment) 1% 7% 15% 39% 43%



This business model switch is significant because it allows SHFL to recognize all of the revenue at the time of the sale, instead of being forced to recognize the revenue monthly.

SHFL’s Revenue Recognition Policy (from most recent 10Q)
Lease and Royalty Revenue- “… We recognize revenue monthly, based on a monthly fixed fee, generally through indefinite term operating leases….”
Sales and Service Revenue- “…Revenue from the sale of equipment is recorded upon shipment… Revenue from the sale of lifetime liscenses, under which we have no continuing obligations, is recorded on the effective date of the license agreement.”

The switch to a sales based model should be most problematic in the Entertainment segment (table games, 67% of Q3 operating income). Table games are a lower growth (organic growth in installed base in YoY 6.5%) business due to the desire of casinos to lower the amount of floor space devoted to table games due to their higher labor costs and lower profitability than slot machines. Thus, to increase table game sales, the company must rely on overall casino growth or the replacement of existing tables. However, many tables have an extremely long useful life suggesting that replacement of successful tables is not frequent. To combat this long lifecycle, most companies lease their tables, allowing them to reap a recurring revenue stream. Leasing arrangements are more profitable for gaming equipment suppliers as most leasing contracts allow the supplier a chance to share in the revenue generated by the tables. By selling tables, SHFL has frontloaded revenues and severely compromised the company’s ability to generate strong future revenues as it has removed the recurring revenue opportunity.
Not only do product sales pull revenues forward, they also carry significantly lower gross margins than product leases, lowering overall margins as the % of product sold has increased.

Q1 04 Q2 04 Q3 04 Q4 04 Q1 05 Q2 05 Q3 05
Sales GM 76% 75% 78% 77% 74% 71% 69%
Lease GM 83% 83% 83% 84% 80% 81% 80%
Total GM 81% 79% 81% 81% 77% 75% 74%

This decline in margins is another example of how the switch to a sales-based model harms the future of the company. Not only is the company losing a LT annuity stream of income from products, it is also accepting significantly lower margins when it sells the products instead of leasing them.

Q2, Q3 05 Business Weakness

The two most recent quarters have shown the deteriorating fundamentals in SHFL’s businesses. In the critical entertainment segment, Q2 05 revenue fell 18.5% Q/Q and 1%Y/Y and SHFL had a net negative placement of tables (70 tables sold, 78 tables lost from the lease base), suggesting both that SHFL had to strain to make numbers by converting leased tables to sold tables. Q3 05 was also a weak quarter for table games as organic unit growth was minimal (1.5% Q/Q) and entertainment revenue declined 3.4% Y/Y. For a company in a supposed high-growth business, these weak revenue numbers suggest significant problems. These difficulties in Q2 and Q3 suggest that SHFL is beginning to see the repercussions of switching to a sales-based model which frontloads revenues and robs them of a long-term stream of lease income.
Weakness in the utility segment (shufflers) also became apparent in the most recent quarter. Q3 05 shuffler revenues declined 4.9% Q/Q as opposed to Q3 04 when shuffler revenues increased 17% Q/Q. Weakness in their previously fast growing utility games segment supports the theory that the business model shift will be very damaging to their future prospects.
This business weakness was also apparent on the balance sheet where accounts receivable and inventories were both up sharply. In Q3, AR days were up 11.1% Q/Q and 23.6% Y/Y on top of a 29.1% Q/Q increase in AR days in Q2. Finished goods inventories were up 27.8% Q/Q and 23.1% Y/Y. This increase is working capital suggests that demand for SHFL’s products was weaker than expected.

Q2, Q3 05 Accounting Shenanigans

The weakness of the underlying business in Q2 and Q3 would have been apparent if the company had not employed several accounting shenanigans to beat Street EPS estimates. Q3 revenues actually missed Street estimates by 3.5% (27.1mn vs. 28.2mn) yet the company was able to beat EPS estimates through the use of the questionable accounting, the specifics of which are discussed below.

Q2 2005
Street Estimates $0.180
Reported EPS $0.185
Provision Changes ($0.010)
Tax Release ($0.014)
Recurring EPS $0.162

Q3 2005
Street Estimates $0.213
Reported EPS $0.222
Provision Changes ($0.013)
Tax Refund ($0.010)
Legal Reimbursement ($0.026)
Recurring EPS $0.172

“Provision changes” refers to declines in SHFL’s percentage allowances for bad debt related to investments in sales-type leases, bad debt related to accounts receivables, and provision for inventory obsolescence. These percentages have been declining for the past 4 quarters.

Q4 04 Q1 05 Q2 05 Q3 05
Bad Debt Expense (% of Account Rec) 6.2% 7.6% 4.6% 2.1%
Provision for Invent Obsol (% of Invent) 22.5% 20.0% 18.9% 16.9%
BD Exp(% of Invest in Sales Type Leases) 4.0% 3.5% 3.1% 3.1%

Furthermore, cash flow from operations suggests that the company is under-reserving for these accounts. While the company used to gain cash inflows from additions to their reserve accounts, these amounts have declined significantly in the last two quarters and have actually become cash outflows.

Q4 04 Q1 05 Q2 05 Q3 05
Provision for bad debts 117 182 (60) 45
Provision for inventory obsolescence 730 100 (150) (115)

In Q2, “Tax Release” refers to the company’s decision to release prepaid tax assets from 1999-2001 from the balance sheet through interest income. Company admits that this is a one-time occurrence yet it accounted for the transaction as a part interest income (where it blended in on the income statement) instead of as extraordinary income or other income.

In Q3,”Tax Refund” refers to a temporary “true-up” lowering from the normalized tax rate of 34.5% to 31.3%, mainly due to differences between actual and estimated Federal and State taxes. During the Q3 conference call, the company reiterated that its normal tax rate is 34.5%.

In Q3, “Legal Reimbursement” refers to a $1.46mn of the $10.5mn payment SHFL that received for selling an interest in RFID patents to IGT. For this transaction, $9.04mn of the payment was recorded in Cash Flow from Investing Activities as “Net proceeds from patent sale”. However, according to the Q3 05 10Q, the company recorded the remainder of the payment as a, “a reduction of legal fees.” Thus, SHFL used a payment it received for the divestment of an asset to reduce operating expenses, improving operating margins by 5% and improving EPS by almost $.03. This transaction is certainly not a recurring, normal business transaction and should not be considered a reduction of operating expenses. The accounting treatment for this one-time transaction allowed the company to help offset weak revenues and reported inflated operating and net income figures and beat Street estimates.

Other Products
Some bullish analysts suggest that new SHFL products like the Intelligent Table (RFID chips allowing for bettor tracking and loyalty program mgmt), TableMaster (virtual table games), EasyChipper and ShuffleUpProductions (production company to televise table game tournaments) will drive future growth.
As far as the RFID opportunity, conversations with a casino company executive suggest that SHFL’s RFID product needs modification as the chip is currently very easy to reprogram (use a cellphone to make the computer think a $1 chip is a $100 chip and rack up loyalty points). Furthermore, SHFL sold a 50% interest in the project to IGT for $15.4mn (10.5 now, 4.9 performance based), a valuation that suggests that even SHFL doesn’t believe their remaining 50% interest in the division will be a major driver of earnings going forward.
TableMaster, a virtual table game program, and EasyChipper, a roulette sorting program have proven to be reasonably popular so far but it remains to be seen how the product can support the weakening utility and entertainment divisions. In FY05, TableMaster has only generated $2mn worth of revenue and an installed base of 65 units. With table games creating revenue of over $30mn and having an installed base of 3,576 units, it is difficult to see how TableMaster could support the division as table games weakens. EasyChipper has generated sales of just over $1mn with an installed base of 45 units during 2005, versus $47mn of revenue and an installed base of 17,833 units for shufflers. Again, while there have been some successes for these products, they remain far too small to be significant growth engines for Shuffle Master.
I do not believe ShuffleUpProductions, a marketer of table-games tournaments, provides a strong opportunity for the company. As a product company, Shuffle Master does not have experience in tournament promotion. Furthermore, one must question the size of the market for television tournaments about table games like Let It Ride and 3 Card Poker. Unlike regular poker which has a large casual following around the nation, these table games are only played in casinos and are not nearly as popular among the general population. Conversations with Turning Stone Resort (1st tournament venue) suggest that overall turnout for Three Card Poker tournaments will be weak. Only about 250 players showed up for the Turning Stone tournament (one of 9 regionals for the 3 Card Poker Championship), below the expectations of the casino management. The tournament generated less than $50,000 in entrance fees, suggesting an extremely limited financial impact. While SHFL has suggested that this segment can generate up to $.10 of EPS for the company through tournament fees and a possible TV deal for the finals, this level of earnings seems seriously unlikely given the limited appeal of the product and low level of absolute revenues so far.

Options and Share Buybacks
SHFL has a generous option and restricted stock compensation program. Over the TTM period, options compensation expense would have been, on average, 27% of operating expenses and 38% of net income and company currently has 3.6mn options outstanding. To both combat the dilution caused by the company’s option issuance and to lower shares outstanding to help support EPS growth, the company has a large buyback program. While share buybacks are generally noble goals for management looking to effectively use cash, SHFL does not generate nearly enough FCF to fund its share repurchase plans, and has instead funded the buybacks by increasing debt levels. Since the start of FY04 (7 qtrs), here is an overview of SHFL’s cash inflows and outflows:

Free Cash Flow 35,785
Share Buybacks -119,933
Debt Increase 162,000

To promote earnings growth and prevent dilution from options issuance, the company has bought back stock at a level far higher than what could be supported given the free cash flow they have generated. The company has become heavily indebted (MRQ debt/capital 88%) which suggests that there may be a limit to how much more debt the company can take on to fund further share buybacks to support EPS growth.

Valuation
SHFL currently trades at over 34x 2005 EPS estimates and at over 11x TTM EV/sales and 22x TTM EV/EBITDA. To justify these valuations, Street analysts note SHFL’s 12 consecutive quarters of exceeding Street expectations (shockingly, by a penny most times; See above for comment on quarterly earnings manipulation) and the company’s continuing ability to grow EPS @ 30+% a year. However, this strong growth has been manufactured by the previously discussed shift from a lease-based to a sales based model, which has pulled both revenue and income forward into earlier quarters. Had SHFL kept its sales/lease mix constant, EPS growth would have been much lower.

For example, assuming that SHFL kept the same sales/ lease ratio in this TTM period (Q3 04  Q4 04) as in the previous 12 mos (Q3 04 Q4 03), EPS growth would have been 14.8% Y/Y instead of the 27.6% actually recorded. See the following example for an illustration of the effect of this switch in the sales model. The input differences between the pro-forma income statement and the TTM income statement are the % of product sold and leased, the resulting revenue, and the gross margin (as leasing carries a higher GM).

Inputs Assumptions
TTM % Shuffler Sold 64% Proforma % Shuffler Sold 55%
TTM % Shuffler Leased 36% Proforma % Shuffler Leased 45%
TTM % Table Sold 42% Proforma % Table Sold 37%
TTM % Table Leased 58% Proforma % Table Leased 63%
Sales GM 71% Table Lifecycle (yrs) 7
Lease GM 80% *Dep Life 3-15 yrs
Tax Rate 35% Shuffler Lifecycle (yrs) 4 *Dep Life 3-5


TTM Income Statement Pro Forma Income Statement
Revenues 105,705 Revenues 98,362
Gross Profit 79,086 Gross Profit 74,913
Margin 74.8% Margin 76.2%
Operating Expenses 36,322 Operating Expenses 36,322
% of Sales 34.4% % of Sales 36.9%
EBIT 42,764 EBIT 38,591
Margin 40.5% Margin 39.2%
Other Income (1,079) Other Income (1,079)
Net Income 27,095 Net Income 24,383
EPS 0.75 EPS 0.67

Growth Pro Forma Valuation at P/E of
TTM EPS Growth (Y/Y) 27.55% 16x $10.74
Pro Forma EPS Growth (Y/Y) 14.78% 18x $12.09
20x $13.43
22x $14.77
24x $16.11


Conclusion
Overall, SHFL’s sales strategy mortgages higher-margin future revenues to meet current Street expectations for high growth. The effects of this strategy on the business model are starting to become more visible, especially in the table games segment which has begun to show significant weakness. The company’s efforts to beat Street estimates through accounting gimmicks were quite apparent in the last 2 quarters and also support the theory that SHFL’s core business is struggling. SHFL has garnered an expensive valuation based on a track record that has been artificially inflated. As the business continues to weaken and the company’s effort to promote the illusion of high-growth run out of steam, SHFL should begin to disappoint investors and the Street and should see its share price return to a level more in line with the actual value of the business.

*********DISCLAIMER: The author and/or his affiliates may hold a position in the following company and may change that position at any time and are under no obligation to inform anyone of our actions. Please do your own due diligence before making any investment decision.**************



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Catalyst

-Business model shift leads to revenue and EPS growth disappointments as company is less able to paper over weakening business with questionable accounting practices.