The outlook for replacement demand is better than investor sentiment. We’ll tell you why.
The slow recovery of replacement slot demand is clearly frustrating investors. The fact is, replacement demand is getting better and we can see pass this perfect storm of impediments.
The replacement market discussion has dominated the price action of the suppliers for quite some time. On the upside, server based gaming (SBG) was supposed to spur a huge IGT-led replacement cycle in late 2006. More recently, fears of a permanent 50k annual replacement cycle has pressured the stocks. Well, 50k in annual replacement units would imply a 19 year cycle. Knowing that the age of the average North American slot floor is actually not old will go a long way to understanding that the cycle duration will probably normalize close to half that.
Before we can predict better replacement demand we have to understand why it was weak in the first place. So the slot floors aren’t that old. What else? First, the more permanent changes: a) the average life of a slot machine is longer than pre-TITO (ticket in/ticket out) since there is less wear and tear on the equipment and b) the ease of converting content on existing video slots is also extending the shelf life of slots. Second and less permanent (we hope) relates to the dynamics of the casino markets: a) economic malaise impacting casino patrons, b) overleveraged casino operator balance sheets, and c) little new casino competition the last 2 years.
The Current Replacement Market
The unit shipment trends we’ve been observing also suggest that replacements hit a bottom of 40k units in 2008 and crept up to 43.5k units in 2009. For 2010, we estimate units will grow modestly to 49k. However, the heightened competition in the slot space has masked some of this ‘modest recovery’ in replacements that’s already ongoing. The top 4 suppliers' share of NA shipments dropped from approximately 92% in 2007 to approximately 84% in 2009. This loss of ship-share by the public companies makes the overall market appear less healthy to the public investor who is only following the top 4.
Young Slot Floors Will Age Quickly
Over the last decade, equipment suppliers have shipped over a million new slots to North America. The total number of slot machines in North America has grown from 580,000 in 2000 to over 921,000 units at the end of 2009. We believe that an instructive way to look at replacements is as a % of the casino floor that’s been depreciated. Most casino operators depreciate their slots over 5 years. While the decision to replace slot machines isn’t solely based on age, operators are more likely to order a conversion kit for an underperforming ‘new’ game than replace it and lose their depreciation tax shield.
When we began this project we assumed – like most – that slot floors were old. We were wrong. At the end of 2009, 52% of slots in NA had been refreshed over the last 5 years and 80% had been refreshed over the last 7 years. Despite the fact that only 10% of the depreciated slot floor base was replaced last year, the average age of the floors in North America isn’t that old currently. However, if replacements persist at the current pace - 21 year replacement cycle or a 10 year cycle of replacing depreciated slots -, the slot floors will ‘get old’ very quickly. Assuming a replacement pace of 50,000 per year, by 2012, almost 60% of floors will be older than 5 years old and over 37% will be over 7 years old. This compares to over 67% of slot floors having refreshes within 5 years in 2005. We think that this scenario is highly unlikely.
Several factors negatively impacting the slot market should turn in the next 24 months:
- Given the low level of replacements, slot floors – while still young - are aging fast
- The economy isn’t booming but most operators would describe the environment as “stable”
- Many operators have recently refinanced with balance sheets and some are emerging from bankruptcy
- New competition is about to pick up with many new markets coming online: Illinois, Maryland, Ohio, and Kansas – so a lot of pressure building to refresh slot floors
Our Estimates Probably Exceed the “Whispers”
In our base case scenario, we assume that replacements grow to 60k in 2011 and 75k in 2012. In this scenario, by 2012, over 55% of slot floors will be fully depreciated and the implied replacement pace of depreciated units will be 7 years - 12 years for total units. In our bull case scenario, - 65k shipments in 2011 and 90k in 2012 - we assume that 18.5k units ship to Canada to fulfill orders of ongoing RFPs in several provinces. Even our bull case scenario suggests a 6 year replacement cycle for fully depreciated units (10 year replacement for total units) and implies approximately a third of slots floors will comprise of units more than 7 years old. These don’t seem aggressive to us.
We understand the investor pessimism, but we also think some are misinformed about the current age of the slot floor. We too would be much more pessimistic if we thought that the slot floors were old AND the casinos weren’t replacing machines. The takeaway here is that replacement demand is getting better and growth has the potential to be explosive. Demand should normalize significantly higher than current trough-like levels which implies the slot suppliers have significant built-in growth even before we consider the bull new market thesis.