We recently researched Aristocrat Leisure (ASX:ALL) as the shares appeared to be oversold. The key factors that contributed to the weakness in the share price were the lower growth trajectory for the digital business, a de-rating of ALL’s digital peers and market concerns about the defensiveness of ALL’s earnings in the context of a weaker US consumer environment.
With the shares having recovered from its recent lows, are current levels still an attractive entry point?
Aristocrat Leisure is a slot machine manufacturer with operations in ANZ, the Americas, and International Class III segments, as well as a fast-growing Digital segment. The Company’s digital gaming operations, rebranded Pixel United in November 2021, has a leading presence and encompasses the large-scale acquisitions of Plarium, Big Fish and Product Madness.
Land-based revenue primarily comprises a mix of gaming operations and outright gaming machine sales, with the former based on a daily fee model and the latter requiring operators to expend capital to purchase product.
Over the past five years, Aristocrat’s product mix has significantly shifted towards gaming operations, which accounted for ~ 65% of revenue for the first half of financial year 2022 (1H22).
The Company has a 30 September balance date.
Key Fundamental Drivers
North American Business Continues to Perform Strongly
ALL’s land-based games have maintained excellent performance over the June 2022 quarter, averaging 2.6x the floor average. This strong performance drives its premium-leased market share of 33%, up slightly over the past few quarters . Aristocrat holds five of the top 10 games in the premium-leased segment by installed base. These include Aristocrat’s relatively new Cash Express Luxury Line and Dollar Storm titles.
In a meeting held with investors in late September 2022, ALL noted that there has been no material impact from the expected softening in consumer spend. Visitations in Las Vegas have been at record highs and the Company also noted that gaming has remained resilient during past downturns (typically recording declines of around low single digits).
For the June 2022 quarter, ALL’s competitors reported varying gains and losses, which led to a slight decline in their collective installed base. Importantly, ALL has typically outperformed these competitors historically and as such, the growth rate in the installed base over 2H22 is expected to be at the top end of the peer group range.
Margin Expected to Recover
While industry revenue data for the June 2022 quarter was very strong, higher supply-chain costs are impacting ALL’s competitors’ EBITDA margins. EBITDA margins for a peer group declined due to a combination of higher fuel prices and freight rates as well as shift in the sales mix towards lower-margin outright sales. For the June 2022 quarter, competitors have reported EBITDA declines ranging from 3-9%, while one has reported 7% growth.
ALL’s Americas segment has historically generated profit margin above its peers. The expansion in profit margin for 1H22 (+7.1% to 57.9%) was driven by a combination of factors including: i) Mix benefits given the higher margin generated within gaming operations vs. outright sales, ii) Operating leverage relating to the increase in outright volumes to record levels, and iii) increased inventory to mitigate impacts from supply chain disruptions.
While the Company was able to mitigate to mitigate additional costs from supply chain disruptions in 1H22 through a strong inventory position, ALL commented at the 1H22 results release that it is facing increased supply chain and logistics costs in 2H22. There has been no subsequent commentary from ALL in this regard, however the Company is clearly not immune to the pressures of higher fuel prices and freight rates experienced by its competitors, although commentary from peers pointed to some signs that these pressures were easing.
Opportunities & Challenges For Digital Segment
Within the Digital segment, ALL operates across three broad segments: 1) Social Casinos, which account for 51% of bookings (i.e. revenue) as at 1H22, 2) Social Casual (14% of bookings) and 3) Strategy, Role Playing Game (RPG) and Action (35% of bookings).
The digital industry has seen a slowdown since COVID. ALL’s bookings for the Social Casino portfolio declined by -7% (on a year-on-year basis), while bookings for the Social Casino genre in general declined by -15%.
However, ALL is continuing to take market share in social casino driven by live operations and has also seen strong momentum from a big launch in RAID from earlier in the month. MechArena was launched in August 2021 (and is seeing improved bookings) and Merge Gardens is expected to be launched imminently. There are two key launches planned in FY23: MagicWars and a new slot game. There are also ten titles in active development for launches over the next few years.
Balance Sheet Provides Scope For Further Capital Management & Acquisitions
As at 31 March 2022, ALL had a net cash position of $523.5m, which has been boosted (from a prior net debt position) following a $1.3b capital raising for the unsuccessful Playtech acquisition. With strong cash generation and partial completion of a $500m share buyback by the end of FY22, the net cash position as at 30 September 2022 is likely to expand to +$600m.
Over the period from 1H18 to 2H20, the gearing level (on a net debt to EBITDA basis) progressively declined from 2.0x to 1.4x. Assuming that the balance sheet is able to support a gearing level of ~1.5x, then the Company would have substantial balance sheet capacity (i.e. >$3b) that would support further capital management (including a new share buyback program) as well as further Merger & Acquisition opportunities.
At the time of our research report (in The Dynamic Investor on 4 October 2022), the shares were trading on a 1-year forward P/E multiple that was below the lower end of the long-term range (18-25x). While the recent recovery in the shares now see the multiple above the lower end of the long-term range, we consider that there remains a number of positive catalysts for the shares:
i. A stronger-than-expected performance in the land-based business. In particular, the ongoing strength in the US casino industry, the strong performance of existing games and a faster growth rate for newer games than competing titles in the US are strong indicators that the Company is well positioned to navigate a weaker US consumer environment.
ii. Balance sheet capacity has increased and the utilisation of the increased balance sheet capacity could provide another leg of earnings growth through capital management and/or acquisitions.
iii. The likelihood that margin pressure from higher supply chain costs is likely to be temporary and be managed well by ALL.
Overall, it appears as though ALL was in a downtrend until a few months ago. It then broke that downtrend and it is now forming a base here. When we last looked at the ALL chart in mid-August, we noted that it was slowly making some higher highs and lows. Like the rest of the market though, it is back at the June lows. However, the one positive about the ALL chart is that the stock bottomed a month before the rest of the market. There is good support here near $32 and we expect ALL to track sideways for a while longer. Current levels are an opportunistic buying opportunity for those willing to run a tight stop under the May low.
Michael Gable is managing director of Fairmont Equities.
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