Sunday, June 11, 2006

ShuffleMaster: Master of Its Domain?

Shares of gaming supply company Shufflemaster (SHFL) took a haircut on Friday after the firm reported a loss of $12.7 million due to acquisition-related and R&D charges that the top line could not cover. Excluding one time items, the company would have earned 18 cents per share, missing Wall Street's consensus estimate of 22 cents per share. Note that quarterly revenue was up 60 percent at $44 million. The Street, often myopically short term, brutalized the stock. On any more weakness, we'd take a closer look at the stock -- here's why.

Description SHFL specializes in providing its casino and other gaming customers with automatic card shufflers and chip sorting devices to improve their profitability, productivity and security, as well as entertainment products, including poker, blackjack, baccarat and pai gow poker-based table games. The company, whose 320 employees were responsible for $120M in sales last year, owns roughly 20,000 shufflers and 4,000 table games.

Positive Considerations ShuffleMaster is an unequivocal play on the Macau casino boom. Anything casino-related is enjoying massive penetration rates there because of the explosive demand for a wide array of services (Macau is the fastest growing casino market in the world). With 90% market share, enviable intellectual property, a stellar portfolio of gaming titles, and first mover advantage (SHFL has done business in Macau for over 10 years), Shufflemaster presents a compelling play on casino growth abroad. For years, table games' share of the U.S. casino market contracted, giving way to more space for slot machines. Today, we're seeing the reverse: tables are making a comeback, especially overseas, where tables hold more weight than slot machines. Fortunately for SHFL, this is particularly the case in Macau. Hence, SHFL is in the right place at the right time.

The company developed the first automatic card shuffler in 1991 and now owns 90% of the worldwide market. More than 20% of the company's revenue comes from outside the United States, which we like, because the US space is arguably saturated. Gross margins are white hot (75%+) while cap ex is perennially low. Shuffle Master is a small firm in a large category, but its market dominance is impressive. Besides International Gaming Tech (IGT), we can't think of a better way to bet on the internationally-driven gaming explosion. SHFL's revenue has climbed at a 24% CAGR over the past five years and we think replacement demand should keep the stock afloat for the forseeable future, although a couple of more analyst downgrades could be on their way (see the risks section below).

Risks International markets lead to a whole array of legal, currency, and regulatory risks. Additionally, although SHFL is a first mover, a better-capitalized player could decide to enter the card shuffler category anytime and effectively take Shufflemaster for a wild ride. That said, it's unlikely a behemoth will be able to serve customers with the same level of drive and zeal that Shufflemaster has. SHFL, which now holds a $1.2B market cap, has made a fair number of acquisitions, too. Analysts think a few of those targets were taken out at inflated prices, resulting in a questionable balance sheet, in which we see that intangibles account for roughly 1/4 of assets. Serial acquirers who miss quarters get beat up hard, so know what you're getting yourself into. With a 19% short interest, a great deal of pessimism has been priced into the stock.

Valuation We think the stock has to come down a bit more before investors pull the trigger. On a trailing 12 month basis, SHFL still trades at 40 x EPS, which is twice the amount the industry changes hands for; on a price/sales basis, the stock is going for 10 x revenues, which should make anyone hesitant, especially in today's violent market. Our current rating is HOLD, but that could change relatively soon (for better or worse) depending on the next few quarters, which we'll be watching like a hawk.

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