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We thought they beat on revenues but we’ll take the margin beat

BYI delivered another solid quarter on the back of better than expected margins.  While revenues missed our estimate, they were in-line with consensus and strong gross margins pushed EPS above even our Street high estimate of 79 cents.  The market clearly liked what they saw, as the stock rallied another 2% after hours on top of being up 6% intraday.  At $49, the stock trades at 15x FY2014 earnings and throws off a 10% FCF yield, not bad in our opinion, especially given the price tag that SGMS was willing to pay for WMS, which we believe is an inferior business.  We have long thought BYI’s system business was way undervalued by investors.  With more predictable revenues and consistent growth, valuation of this segment should command its due premium.

So what did we like in the quarter?

  • Gaming equipment margins:  Excluding the 200bps benefit from a customer’s election to reduce costs, margins were still north of 50%
    • Even taking into account the higher mix of conversion kit sales in “other product sale revenues,” margins on box sales were still a little north of 50%.  Given that BYI isn’t introducing a new cabinet any time soon and their content remains solid, this should be sustainable.
    • Conversion kits are a big opportunity for BYI.  The vast majority of BYI’s sales comprise of Alpha 2 cabinets.  Currently, BYI’s makes a very small amount of revenues on conversion sales. However, we see no reason why this shouldn’t be a nice area of growth for them for the next few years.  As a point of reference, WMS sold $48MM of conversion kits in FY12 and $31MM in FY11.  FY14 should see strong growth in conversion kit demand which carries over 90% margins. 
  • Systems margins and growing maintenance revenue
    • Maintenance revenues of $23MM and growing.  Need we say more?  As BYI develops more content and continues to deploy more DMs and iVIEWs, the revenue earned per unit per day hooked up to their system should continue to grow.  Needless to say, the continued addition of units hooked up to BYI’s systems also grows this pie.  In our opinion, this is the highest quality and stickiest revenue stream at the company and deserves the highest multiple.  It’s much harder for a casino to replace a system than to replace a slot machine.  Once you have a system, you are going to pay maintenance fees to make sure you get continued updates and the latest products since the incremental cost is nominal. 
    • Margins on systems have averaged 74.4% over the last 10 quarters.  Between the high margins and the visibility on this business, what’s not to like?     

What wasn’t so hot?

  • It looks like replacements in the December quarter were likely softer than we anticipated for the market as a whole.  We now think that YoY replacements, excluding Canada, may have been flat to slightly down for the full calendar year of 2012.  With the trends we’re seeing in the regional markets right now, that doesn’t leave us feeling very encouraged on our 2013 outlook.
  • International segment continues to struggles with no real light at the end of the tunnel.  We expect this 800ish run rate to continue through year end.
  • Gaming operations saw some deceleration and was a little more seasonal than we thought
    • Roughly 50% of BYI’s gaming operation units pay variable fees and approximately 60% of their revenues are comprised from variable fees games
    • Seasonality, Sandy, and weak regional results weighed on the December quarter
    • The March quarter will be better seasonally but we don’t expect much growth in the WAP install base until the June Q