Sankyo Co., Ltd. (6417): Pachinko and content creation at cash adjusted PE of 4.95x — a profitable combination.
Sankyo Co., Ltd. (6417): Pachinko and content creation at cash adjusted PE of 4.95x — a profitable combination.
Summary
The Pachinko/pachislot industry has weathered many challenges over the last two decades: shrinking population and the number of players, rising competitive forces within and outside of the industry (e.g., online games), and stricter regulations. Many weaker pachinko parlors and equipment makers were forced to close their doors. However, the remaining players have entered a new phase of growth, driven by the innovation of “smart pachinko” and “smart pachislot” machines, which offer more interactivity and variety to the players. For a more detailed discussion on why the industry is believed to be on the verge of a new resurgence, please refer to my pachinko industry report, “Pachinko in Japan: A Fading Trend or a Resurging Profit-Maker?”
Sankyo is well-positioned to benefit from the current industry development. Its long presence and large scale enable it to develop and market smart machines and collaborate with popular anime series and singers to create attractive and engaging games. In this report, the term “pachinko” refers to pachinko and pachislot, unless stated otherwise.
Who is Sankyo
Sankyo, a leading pachinko manufacturer, was founded in 1966 by Kunio Busujima, who passed away in 2016. The company’s growth was propelled by the launch of the “Fever” machines in 1976, which were a sensation in the pachinko market. Sankyo remains an entrepreneurial company, run by Busujima’s son Hideyuki and his siblings.
Sankyo produces both pachinko and pachislot machines, with pachinko machines making up about 80% of the total sales. Pachinko is the main source of income, as it has generated more than 100% of the operating profits for many years, compensating for the losses incurred by the other products.
1. Investment Thesis
1) The industry tailwinds
1-a) The industry has adapted to stricter regulations and other headwinds by introducing pachinko gaming content that emphasizes features similar to video games while downplaying the gambling aspects. Thus, the industry as a whole is at an early stage of growth resurgence.
1-b) Smart machines offer two main benefits. They allow players to enjoy the game without coins, reducing the risk of infection and cheating. Another possible benefit is that one smart machine can offer more variety and customization options for the players, such as different themes, animations, sound effects, and difficulty levels.
2) Branding power and deep relationships with other content creators.
Sankyo created the below three brands to offer a unique playing experience to wide groups of users and offer tie-up content most efficiently.
Sankyo: A full lineup
Bisty: Focus on “tie-up” models. Close relationships with Tsuburaya which is well known for its “Ultraman franchise”.
Joy Brain: Sankyo’s original contents with a focus on simplicity.
Tie-up models
The recent pachinko and slot machine market is dominated by tie-up models which are based on the world view of the gaming contents are developed in collaboration or partnership with gaming companies.
Tie-up Pachinko long-sellers” are Gundam (originally created by Bandai Namco) and Neon Gensis Evangelion which are based on popular Manga series. The ‘Gundam’ franchise has been a huge success for Bandai Namco, by making early $1 Billion in 2022. Sankyo was awarded two prestigious awards with these two product lines.
Fever Mobile Suit Gundam Unicorn — Pachinko Grand Prize 2021 (the highest award in the pachinko and Pachislot chosen by fans).
Neon Genesis Evangelion — Roar for Tomorrow -Received the Gold Prize (the highest award in the P-World Pachinko & Pachislot Awards 2022.
3) Competitive Edge
3-a) What sets Sankyo apart from its peer pachinko makers is its ability to add its own touch to these tie-up contents. Sankyo is known for its prowess in having machines with strong analog elements, such as “drum” for its 40-year-old “Fever” series. A drum is a part of some pachinko machines that display a slot reel on a large cylindrical screen. The drum rotates and stops to show different symbols, which can trigger various events and bonuses in the game.
3-b) The company’s liquid balance sheet is another differentiation factor. Backed up 65% equity ratio, Sankyo has been able to raise salaries to strengthen the sales team which includes non-pachinko players. This is a critical advantage in Japan which is suffering from a severe labor shortage.
4) Rebound from Brand mishaps
Despite Sankyo’s long history and built-up customer knowledgebase, the company faced some content challenges in the past. However, it learned from its mistakes in FY3/2016 and FY3/17 and recovered in FY3/22. I admire a company that can overcome difficulties and grow from them, rather than one that has never faced any problems. The latter may never rebound when faced with a challenge.
The below chart illustrates a decline in units sold in 2016 and 2017, due to the market share loss. A sharp decline in 2019 and 2020 was due to a COVID-related shutdown.
The below bar graph indicates Sankyo’s market share (in blue) was lower than that of Sanyo Bussan (a private company) in 2017 and 2019 and the gap widened in 2020. However, thanks to the success of the Gundam and Evangelion franchises, Sankyo regained the #1 position of around 25% in FY3/22.
(source: Statista: Number of pachinko units sold by Sankyo Co., Ltd, unit: 1,000)
(source: Yano Research Institute reported by Sankyo)
5) Brand power from a financial perspective
(source: company)
The above graph visualizes a steady decline in sales and gross profits in the pachinko/pachislot industry: the industry experienced a CAGR decline of 8.9% (sales) and 8.1% (gross profit) from 2014 through 2020. Notably, however, in 2019, Sankyo’s sales and operating profits increased from their 2018 level, vindicating the fact that the right content can win pachinko parlors’ interests.
6) Early signs of the adoption of Smart machines
FY3/24 and FY3/2025 should see the rapid adoption of Smart machines driven by popular content.
The company plans to accelerate the release of Smart pachislot titles. 90,000 pachislot unit sales are expected, an increase from 38,000 in FY3/23 During the first 6 months of FY3/24, the company sold 48,397, reaching 53.8% of the total 90,000 planned.
Smart Pachinko title releases are more gradual than that of Smart pachislot, but the company has sold 167,818 units of pachinko machines for 1H of FY3/24, reaching 58.3% of a total 287,800 units planned for FY3/24.
7) Product development
Sankyo has been on top of developing industry-leading technology. Its “Fever Valvrave the Liberator” was introduced in 8/2018 and is the first model compliant with new regulations. Its “Pachislot Valvrave the Liberator), the industry ‘s first Smart Pachislot, was launched in 11/22.
8) New dividend policy
At the earnings release for 2Q of FY3/24, the company announced its new performance-linked dividends policy with a target of a 40% payout ratio. The minimum annual dividend per share is set at ¥100 which was the lowest dividend in its recent history, to ensure stable dividends. The current dividend yield is high at 3.6%.
9) Margin of safety
The company generated net income even in FY3/17 when it lost market share to its competitors and went through adjustments to stricter regulations. Its ample operating cash was able to finance investment activities and the company ended its year-end cash position at ¥251,818 MM which was higher by ¥16,912MM.
The next challenge came in FYE3/21 as a form of COVID-induced shutdown of many public places including pachinko parlors. Nonetheless, Sankyo again generated net income of ¥5,749MM and ¥10,563MM in cash flow from operations. Its FCF of around ¥9,016 MM was able to cover ¥9,176 MM dividend payments.
10) Attractive Valuations
P/E multiples
Even with ~70% appreciation for the past 12 months, Sankyo is trading at 3/24 expected PE at around 11.2x. However, cash and marketable securities (¥174,999 in short-term marketable securities + cash ¥92,610MM as of 3/23) accounted for about half of the Market cap ~¥500Bn, yielding cash adjusted P/E of 4.95x. The dividend yield is already high at 3.6%. With no interest-bearing debt and ¥263Bn net cash on the balance sheet as of FY3/23, the company has many options available to fund its content growth and equipment investment while raising dividend payout.
Intrinsic value:
Absolute worst case: If the industry takes a nosedive under a perfect storm scenario which is unlikely, after 20 years of dealing with multiple headwinds, the company stops growing and pays minimum dividends of ¥100. This assumption against the current stock price of ¥9,000 (8,779 to be exact) yields a 1% return.
Reasonable case: The company maintains a 10% increase in dividends when the smart machines reach saturation. This scenario will give a 20% return.
Aggressive case: The company has the potential to be valued as a video game company and emulate Sega Sammy’s diversified business model of pachislot and game machines. Then, Sankyo company could achieve a P/E ratio of 14–15x similar to Sega’s. This would imply a stock price of ¥13,000, a 40% upside. If Japan Company Handbook’s higher EPS estimate for FY3/24 is used the price will be ¥14,000, ~a 50% upside.
11. Solid Business Model
The company’s business model of a smooth integration of product initiation, design, testing, production, sales, and reusing under one roof sets it apart from its smaller peers. Its products manufactured at its fully automated factories are sold by 300 salespeople located at 9 nationwide branches and 14 sales offices.
12. Sustainable profitability
Financial Results from FYE3/2014 through FYE3/23
(source: Company)
The above table reveals its sustainably profitable corporate structure, as it generated net income in FY3/17 (market share loss) and in FY3/21 (Covid). For 3/24, the company guided to achieve sales increase (+11%) and operating profits (+1.7%). Net income is expected to be slightly lower than that of FY3/23 when sales of non-core fixed assets and marketable securities were recorded. The company is expected to achieve this rather conservative guidance, driven by the robust equipment sales of the Evangelion franchise (287,000 units vs. 267,000 in FY3/23). Pachislot machine sales are expected to reach 90,000 vs. 51,000 in FY3/23.
13. Upside in Total Addressable Markets (TAM)
(Source: Statista — Leisure market size in Japan 2022, by segment, as of 1/9/24)
The leisure market in Japan was valued at ¥28.41 trillion in 2022, of which the pachinko market accounted for ¥14.6 trillion, representing about half of the entire amusement industry. As the line between pachinko and video game machines becomes more blurred, the pachinko industry may have the potential to appeal to younger players. Despite the declining population, the pachinko industry may be able to gain customers from other entertainment sectors.
2. Weaknesses/Risks
1. Unknown risks may emerge.
The risks surrounding the pachinko industry are abound but known to a large degree. The industry has survived a decline in player population, regulations, and even a pandemic. This does not mean the industry will not face another unforeseen challenge, but Sankyo will likely offset headwinds with appealing content.
2. A Stalled growth of smart machines.
Adoption of smart machines, especially smart pachislot, has been encouraging. However, the players’ tastes can change without warning. Sankyo is no stranger to title flops and has learned to recover, recoup, and rebound. With its established tie-up relationship with anime and other content providers, Sankyo is likely to develop the next hits.
[Disclaimer]
The opinions expressed above should not be constructed as investment advice. This commentary is not tailored to specific investment objectives. Reliance on this information for the purpose of buying the securities to which this information relates may expose a person to significant risk. The information contained in this article is not intended to make any offer, inducement, invitation or commitment to purchase, subscribe to, provide or sell any securities, service or product or to provide any recommendations on which one should rely for financial securities, investment or other advice or to take any decision. Readers are encouraged to seek individual advice from their personal, financial, legal and other advisers before making any investment or financial decisions or purchasing any financial, securities or investment related service or product. Information provided, whether charts or any other statements regarding market, real estate or other financial information, is obtained from sources which we and our suppliers believe reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future performance.