Ainsworth to slot in as king of ker-ching

Australia loves a flutter - just ask those two waging a "he said, she said" war over at the Racing NSW stewards inquiry.

HAVING a flutter one year during my early teens, I stood for an hour after school each day at the local milkbar.

Leaning against the soft drink vending machine, I watched my friends pour 20c pieces into the pinball machine. Eventually the pinball gave way to PacMan, Space Invaders and Galaga. It was a complete waste of time and money but I enjoyed myself and, yes, it was addictive. I no longer play pinball machines nor do I gamble but I often wonder whether poker machines have the same appeal to others as pinball machines had for me all those decades ago?

Australia loves a flutter - just ask those two waging a "he said, she said" war over at the Racing NSW stewards inquiry. With 197,892 poker machines in pubs and clubs across the country, or one machine for every 111 people, Australia has the fifth-highest total number of gaming machines in the world and is ranked No 8 of international gambling hot spots.

For those willing to surmount the ethical issues, there are two paths to investing in this sector. One is to own listed gaming operators like Crown Entertainment (CWN), Echo Entertainment (EGP), Sky City Entertainment Group (SKC), Tatts Group Limited (TTS), Reef Casino Trust (RCT) and Tabcorp Holdings (TAH). For one reason or another we have avoided these. Another is to own those who supply these operators with their machines.

Over the years, operators cannot escape the fact that the machines they buy simply wear out or become unfashionable. With about 200,000 machines constantly ageing, pub, club and casino owners need to replace old floor stock with the latest and greatest machines.

Aristocrat Leisure (ALL) and Ainsworth (AGI) specifically target this market.

Ainsworth develops a range of poker machines and the games that are installed into each machine, servicing a market that replaces 40,000 machines annually.

Ainsworth's market share of this annual turnover is referred to as its "ship-share". Ainsworth has a 25 per cent ship-share, which equates to around 10,000 machine sales.

At about $20,000 each and aspirations to take its share to 35 per cent, one obtains a clear feel for the potential $280m revenue.

Our research also shows that although Aristocrat Leisure is the dominant player, we prefer the new kid on the block. The management team, with almost 20 years of research and development behind it, is backed by a solid balance sheet.

With these tailwinds and strengths, the company has been aggressively taking market share and few competitors have stood in its way following the release of the company's new A560 cabinet machines and suite of games.

Further, the company is one of a handful of manufacturers, both locally and internationally, that has invested heavily into product development when many others have been capital-constrained. This includes global competitors in the US, dominated by IGT (International Gaming Technology).

IGT is the dominant incumbent in North America with the lion's ship-share of about 50 per cent, followed by Bally at 15 per cent, WMS also at 15 per cent and others at 5-10 per cent including Konami.

Given 850,000 machines exist in the US and the replacement cycle is 60,000 a year, North America is an important addressable market for AGI and this is where the opportunity gets very exciting.

The replacement cycle is slower in the US than Australia due to the country's economic challenges, but again, if industry feedback is right, the potential addressable market could double on the back of an economic recovery and reach the historic average of 140,000 machines annually.

IGT's second-quarter financial results have provided us with anecdotal evidence that the North American slot machine replacement cycle is picking up from a cyclical low.

AGI's chief executive Daniel Gladstone relocated 12 months ago to specifically target the opportunity.

Thinking about IGT's recent results, including a 66 per cent surge in sales, if everything lines up and AGI captures 35 per cent share in Australia and our estimate of 10-15 per cent ship-share in the US, Ainsworth's revenue line could approach $600m over time.

On current 20 per cent profit margins, double those of Aristocrat Leisure, AGI could in the years ahead generate $120m NPAT.

On these numbers, a share price closer to $5 would not be completely unrealistic. Currently the share price is $3.80.

Ainsworth Game Technology (AGI) is not a business that will appeal to all investors. Problem gambling is a genuine condition for some but in owning the company shares we are also aware that many gamblers enjoy it as a form of entertainment, much as I enjoyed spending my pocket money on video games 20-something years ago.

Roger Montgomery is the founder of Montgomery Investment Management and the author of Value.able: How to Value the Best Stocks and Buy Them for Less Than They're Worth, available at www.rogermontgomery.com