Sega Sammy Stock: A Profitable Gaming Stock With Surging Revenue And A Deep Discount

Editor’s note: Seeking Alpha is proud to welcome Laerthe da Silva Cortes as a new contributing analyst. You can become one too! Share your best investment idea by submitting your article for review to our editors. Get published, earn money, and unlock exclusive SA Premium access. Click here to find out more » tupungato/iStock Editorial via Getty Images Despite annual sales growth of 23% over the past three years, Sega Sammy (OTCPK:SGAMY, OTCPK:SGAMF) is still undervalued due to its unusual mix of assets and past management decisions. However, with the decision to sell the Phoenix Seagaia resort and the free cash flow generation of the Pachinko business, the company seems ready to focus on what it does best: games. At the current price, Sega Sammy shares are a great opportunity for investors seeking growth and value in the coveted gaming industry. Sega Sammy Holdings: An Overview Of The Integrated Business Sega Sammy Holdings currently operates in three business segments: Entertainment Content Business (ECB): This segment develops PC, console (and recently mobile) games, arcade machines, and produces/licenses toys and animations. Pachislot and Pachinko Business (Sammy/PCB): This segment focuses on the development and sale of Pachinko/Pachislot machines in Japan. Resort Business (RCB): This segment operates integrated resorts and, starting this year, develops casino software and gaming products. Three of Sega Sammy’s assets immediately stand out: the Sega and Atlus game studios, developers of several highly popular game franchises; and Sammy’s Pachinko/Pachislot business, a solid cash cow. Sega Sammy achieved a 23% increase in sales over the past three years, maintained a net cash position, and averaged a 13.6% ROIC during this period, driven by the strengths of its Japanese gaming studios and the recovery of Sammy Business. This ROIC number understates the returns of both the ECB and Sammy since the Resort business had negative numbers in two of these three years and only broke even in the last year. However, despite demonstrating excellent fundamentals and the recent news of the sale of Phoenix Gaia resort, the stock price remains at an EV/EBITDA of 7.13x, a P/BV of only 1.72, and an FCF Yield of 9.4%. This low valuation becomes even more pronounced when we compare Sega Sammy Holdings’ parts with equivalent businesses listed on the Japanese stock exchange. In my most conservative estimates, the stock is undervalued by at least 20%. In this article, I will show how I arrived at this number by evaluating the sum of the parts and discussing the potential risk of investing in Sega Sammy. An Overview Of The Entertainment Content Business Up until the last fiscal year, the Entertainment Content Business operates in three divisions: Consumer Gaming, Amusement Machines, and Animation/Toys. The data below shows the performance of these three divisions over the past three years. (Billion JPY) FY 2022/3 FY 2023/3 FY 2024/3 Yearly Sales 235.9 282.8 318 17.4% Consumer Gaming 158.3 187.9 222.6 20.3% Amusement Machine 49.7 64.9 61.2 11.6% Animation/Toy 25.6 29.3 33.5 15.4% Other/Elimination 2.3 0.7 0.7 — Operating Income 33.9 38.7 28.9 -7.4% Consumer Gaming 29.3 32.8 24.7 -7.8% Amusement Machine 2.5 2.9 2.9 8.0% Animation/Toy 3 4.5 4 16.7% Other/Elimination -0.9 -1.5 -2.7 — Click to enlarge As we can see, Consumer Gaming is a great business with high sales and growth prospects; Amusement Machines is a mediocre business, with a very low operating margin; and Animation/Toys is a small business, but with a decent operating margin of 13%. Sega Sammy ROIC Trend (Sega Sammy IR material) The combined ROIC of ECB was 18.6%, 19.8%, and 10.4% in the past three fiscal years (the FY 2024/3 number was impacted by an increase in investment capital in the acquisition of Rovio), resulting in an average of 16.26% annually. To set a price to the value of ECB, I suggest we try to understand the market value currently given to similar gaming companies in Japan. An Attempt To Estimate The Value Of The Entertainment Content Business Fortunately, the Japanese market has some companies that are exclusively focused on game production (except for Koei Tecmo, which has an insignificant stake in Real Estate): Square Enix (OTCPK:SQNXF, OTCPK:SQNNY), Koei Tecmo (OTC:TKHCF), and Capcom (OTCPK:CCOEY, OTCPK:CCOEF). (I am leaving Nintendo out because it is also in the console business.) (Billion JPY/USD) Market Cap JPY Market Cap USD EV/EBITDA Debt to Equity P/BV FCF Yield ROIC Sega Sammy 574.126 B 3.57 B — — — — 16.30%* Square Enix 591.705 B 3.68 B 10.64 0 1.82 7.06% 19.80% Koei Tecmo 478.77 B 2.98 B 16.95 0.28 2.85 7.27% 13.90% Capcom 1628.349 B 10.14 B 25.73 0.01 8.75 1.95% 36.70% * Sega Sammy’s ROIC corresponds only to the ECB.EV/EBITDA, Debt to Equity, P/TBV, and FCF Yield were calculated according to the latest annual reports. ROIC is from GuruFocus. Click to enlarge Of the companies above, Square Enix and Koei Tecmo have a similar Market Cap and ROIC to Sega Sammy Holdings, so I decided to exclude Capcom from the comparison. We can see that the ECB has a higher ROIC than Koei Tecmo, but lower than Square Enix. We need to keep in mind that the ECB’s ROIC in 2023 (FY 2024/3) was impacted by the capital invested in the purchase of Rovio and by the restructuring of European businesses. In 2022, both the ECB and Square Enix had a similar ROIC (19.8% and 19.4% respectively), so the advantage of Square Enix is smaller than it seems. Now let’s compare the revenue and operating income numbers of ECB with the two selected companies: (Billion JPY) 2021 2022 2023 Yearly Sales Sega Sammy (ECB only) 235.9 282.8 318 17.4% Square Enix 332.5 365.3 343.3 1.6% Koei Tecmo (Excl. Real Estate) 71.6 77.3 83.4 8.2% Operating Income Sega Sammy (ECB only) 33.9 38.7 28.9 -7.4% Square Enix 47.2 59.3 44.3 -3.1% Koei Tecmo (Excl. Real Estate) 34.1 39.1 29.0 -7.5% 1. 2021/2022/2023 is equivalent to the last three fiscal years of these companies. In the case of Sega Sammy that would be FY 2022/3, FY 2023/3, and FY 2024/3. 2. ECB’s sales numbers in 2023 include an additional 10.6 billion from the acquisition of Rovio. 3. The drop in ECB’s Operating Income in 2023 was impacted by a 6.6 billion yen restructuring of gaming studios in Europe.) Click to enlarge As we can see, ECB enjoyed a much larger sales increase than both Square Enix and Koei Tecmo (even after subtracting the Rovio acquisition revenue in 2023), and the sales gap between ECB and Square Enix has been narrowing. The reason Koei Tecmo has a much higher operating income margin is that Sega Sammy has been investing heavily in its gaming division to lay the groundwork for future revenue growth. In 2022 (I couldn’t find the 2023 numbers on Koei Tecmo’s IR page), for example, Sega Sammy spent 66 billion JPY on ECB R&D compared to just 7 billion for the entire Koei Tecmo. In 2023, the ECB alone spent 31.6 billion JPY on Advertising compared to just 5.65 billion JPY for Koei Tecmo. Square Enix spent 25.1 JPY billion. So one could argue that the difference in market value lies in the quality of Koei Tecmo or Square Enix’s gaming franchises. That is not the case with Koei Tecmo. Their only established franchise with considerable sales power is the Warriors series. They have been launching new franchises (like Nioh and Rise of the Ronin), but it is still early to say if these will turn into popular franchises, and these games compete in highly competitive niches. Square Enix, on the other hand, is overly dependent on the success of Final Fantasy. I find it hard to believe their IPs currently enjoy the diversity and momentum of Sega Sammy’s titles, and I think the ECB’s surging revenues can prove that. With Sega Sammy Holdings having a current market cap of 3.57 billion (574.1 billion JPY), which is slightly less than Square Enix’s $3.68 billion (592 billion JPY), we can safely say that ECB alone is worth at least the current market cap of Sega Sammy Holdings. In this case, I would assign a value of $3.70 per ADR (since there is a ratio of 4:1) or 2380 JPY per share for the Entertainment Content Business. So, at the current price, you are getting the rest of Sega Sammy’s assets for free. Next, I will show you why this is something good. An Overview Of The Pachinko/Pachislot Business The Pachinko/Pachislot market has faced enormous challenges in recent years, especially due to strict regulation. It is a declining market, but it still has considerable size, being worth $91 billion (14.6 trillion JPY) in 2022. The good news is that companies like Sammy are trying to adapt to the new market conditions by innovating. The first smart Pachislot from Sammy, the Smart Pachislot Hokuto No Ken, released in April 2023, was a great success. While it is unlikely that these companies will return to enjoying a growing market, they are highly profitable and boast a very high ROIC and FCF generation. In the last fiscal year, Sammy had a higher operating income than Koei Tecmo and ECB itself. Its ROIC was 14.8%, 37.4%, and a staggering 81.6% in FY 2022/3, FY 2023/3, and FY 2024/3 respectively, for an annual average of 44.6%. Therefore, as long as the business remains highly profitable, I see no problem in the market decline trends, because, unlike pure Pachinko stocks, Sega Sammy has the additional option to allocate this cash stream to ECB or other promising businesses. An Attempt to Estimate the Value of the Pachinko/Pachislot Business To better understand the value of Sammy, I suggest we try to understand the value that the market is currently giving to similar gaming companies in Japan. The leader in Market Share in the Pachinko/Pachislot market is Sankyo (OTCPK:SKXJF), with a 30% market share in 2023, while Sammy vies for the third position with a market share of around 10%. (Billion JPY) 2021 2022 2023 Yearly Sales Sammy 75.8 94.2 135.9 39.6% Sankyo Co 58.1 157.3 199.1 121.3% Operating Income Sammy 9.3 20 41.2 171.5% Sankyo Co 6.6 58.5 72.5 500.3% 1. 2021/2022/2023 is equivalent to the last three fiscal years of these companies. In the case of Sega Sammy that would be FY 2022/3, FY 2023/3, and FY 2024/3. Click to enlarge It is easy to see that Sankyo enjoys much higher sales than Sammy, and over twice the Operating Income. Its average ROIC was 52.48% over the past three years, compared to Sammy’s 44.6%. Sankyo currently has a market value of $2.76 billion (443.2 billion JPY). If we assume that Sammy could be worth 1/4 to 1/3 of Sankyo’s value, we would have a Market Cap of $692 to $921 million (111 to 148 billion JPY) for Sammy. Sammy’s EBITDA in the last fiscal year was 43.8 billion JPY. This means that its approximate EV/EBITDA (conservatively disregarding Sammy’s cash reserves, which would lower this value) would be between 2.53 in the lower range and 3.38 in the higher range. This seems like a good estimate to me, since the leader Sankyo Co is currently trading at an EV/EBITDA of 4.21. This would mean a value of $0.72 to $0.95 per ADR (since there is a ratio of 4:1) or 460 to 613 JPY per share for the Pachinko/Pachislo Business. The Resort/Casino Business And The “Diworsification” Risk If the mix of the high-growth gaming division and the free cash flow generation of the Pachinko/Pachislot had been paying dividends to Sega Sammy Holdings, the same cannot be said of the Resort business. In 2012, Sega Sammy bought the Phoenix Seagaia Resort and surprisingly entered the resort business, where it had no expertise. This division has never been profitable, except for a tiny profit in the latest fiscal year. During this period, Sega Sammy spent $485 million (78 billion JPY) in investments and loans in the Resort business. This is the equivalent of 13.5% of Sega Sammy’s current market cap. IR material from Sega Sammy The ROIC of RCB over the past three years was -16.2%, -7.6%, and 0% in FY 2022/3, FY 2023/3, and FY 2024/3, likely influencing the valuation of the other businesses. The good news is that last month, Sega Sammy decided to sell Phoenix Seagaia Resort to the Fortress Investment Group. The share transfer will result in an extraordinary gain of $53 million (or 8.5 billion JPY) for Sega Sammy’s current fiscal year. After the share transfer, Sega Sammy will only hold 20% of the newly issued shares. With this, Sega Sammy will have a minority stake in Phoenix Seagaia Resort (operated by Fortress) and in Paradise City (operated by the Korean Paradise Group). Starting this year, Sega Sammy intends to make this division a third pillar with the addition of slot machine sales and gaming products for casinos, through the acquisition of Gan Limited for approximately $107.6 million. The acquisition is expected to be completed by the end of 2024/early 2025. Sega Sammy expects to invest $6.4 million (1.1 billion JPY) in this business segment in the next year and forecasts a negative operating income of $9.3 million (1.5 billion JPY). Therefore, at least in the short term, this third pillar will continue to affect Sega Sammy’s ROIC. As a shareholder, I would prefer the company to focus solely on ECB and Sammy or to keep buying back shares instead of attempting to over-diversify the business. However, there are signs that management has learned its lesson and will avoid capital intensive businesses from now on. In 2021, the company revealed its intention to join a proposed casino in Yokohama, but ultimately abandoned the idea and decided to invest its resources in the company’s more profitable divisions. The numbers seem to point in this direction, as Sega Sammy cut its Capex by over 49% in the last five years while ramping up R&D expenses in Consumer Gaming. For valuation purposes, I will ignore RCB (since its assets have no earning power so far) and Sega Sammy’s stakes in Integrated Resorts, assigning them a value of zero. Conclusion When summing the parts in the most conservative manner possible, we have a market cap share value of $4.27 billion (685.1 billion JPY), which would represent a share price by ADR of $4.42 (or 3140 JPY per share), a minimum upside of approximately 19% compared to the current stock price. This would imply an EV/EBITDA of 8.71 (clearly lower than Square Enix and half that of Koei Tecmo, and very low for a mix of two non-capital intensive businesses), a P/BV of 2.06, and an FCF of 8% (still higher than both Square Enix and Koei Tecmo). These are very low numbers. If we assume that ECB should have the same value as Square Enix and use the upper range of Sammy’s value estimate (neither of these assumptions is too aggressive), then we would have a share price by ADR of $4.77 (or 3068 JPY per share) and an upside of 29%. With a net cash position and strong momentum in its main businesses, the only risk for Sega Sammy shareholders is that management allocates capital to poor businesses, as it did in the past by acquiring the Phoenix Seagaia Resort. So, it is worthwhile to keep an eye on management’s future capital allocation decisions. Nonetheless, the current share price offers a compelling margin of safety for investors. Sega Sammy is attractively priced both in absolute terms and relative to competitors, benefiting from the protective moat of its distinctive Japanese gaming franchises and its consistent generation of high levels of free cash flow. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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