Shares in Aristocrat Leisure (ASX:ALL) have largely traded in a tight range for the majority of the year. While the land-based business has been performing strongly, there have been market concerns about the digital business. Accordingly, we recently researched the Company in The Dynamic Investor, with a focus on the digital business. Given improving trends for the digital business, are the shares about to re-rate?

About Aristocrat Leisure

Aristocrat Leisure is a slot machine manufacturer with operations in ANZ, the Americas, and International Class III segments. The Company’s digital gaming operations, rebranded Pixel United in November 2021, has a leading presence in the US market.

Key Fundamental Drivers

Is the Digital Business Facing a Structural Slowdown?

The key disappointment from the recent result was ALL’s digital division, Pixel United. Pixel United accounts for around 30% of group segment profit, having grown materially in the recent years. The growth has been supported by several factors. These include Merger & Acquisitions, successful products within Social Casino and outperformance relative to industry growth.

More recently, there has been a slowdown, with bookings tracking backwards. In addition, higher costs are impacting profitability. Notably, Pixel United’s margin declined for the six months to 31 March 2023 (1H23). This was underpinned by both softer-than-expected revenue growth as well as higher operating costs.

There is a risk of a structurally lower margin within Pixel United in light of:

• Ceasing operating games in Russia in March 2022, which was a higher-margin market.
• Reduced bookings in higher-margin legacy products, noting that around 93% of bookings come from ten titles. While the Company is typically active in terms of game launches, not all products reach a scaled launch. In context, outside of RAID: Shadow Legends, other recent launches have not seen the same success as legacy products mature. Having said that, the Company is hopeful that at least three new products will be launched in the next two years. In particular, ALL is confident in the scaling of the recently-launched Merge Gardens.

Proposed Acquisition of NeoGames a Potential Game Changer

On 15 May 2023, ALL announced the proposed acquisition of 100% of NeoGames. NeoGames is a global leader in content and technology solutions for the ~US$81b online Real Money Gaming (RMG) industry. Their full-service suite includes content, proprietary technology platforms and a range of value-added services across iLottery, iGaming and Online Sports Betting. The acquisition is expected to complete in May 2024.

Within the growing ~US$81b online RMG segment, North American iGaming revenues are on track to reach US$8b in 2023. There is potential for the revenue to reach US$28b in 2030. A key factor underpinning this growth is expected legislative approval of iGaming at US state level.

The success of the iGaming segment is dependent on further legalisation for iGaming in US states. At the time of the acquisition announcement, around 20% of the US population have access to iLottery and 10% have access to iGaming. Accordingly, the upside to earnings (which is significant with NeoGames) will be dependent on future legislative decisions.

Balance Sheet Optionality Remains Post NeoGames Acquisition

As at 31 March 2023, the balance sheet was in a net cash position of $440m. Following the acquisition of NeoGames, ALL will retain a strong balance sheet, with pro-forma gearing (on a net debt/EBITDA basis) of approximately 0.7x as at 30 September 2022. Importantly, this is below the Company’s medium-term gearing guidance of 1.0-2.0x. In turn, this provides scope for further investment in growth or more potential for capital returns via ongoing share buybacks out to FY25.

Assuming gearing rises to 1.5x by FY25 (i.e, the midpoint of the medium-term guidance range), there would be additional optionality of ~$1.5b.

Fundamental View

Aristocrat is currently trading on a 1-year forward P/E multiple of ~20x, which is at the lower end of the recent trading range and average multiple post COVID. While the current multiple is not demanding in the context of an EPS growth profile of ~11.5% over FY22-25 on a CAGR basis, we take a cautious view.

On the one hand, the strength in the land-based businesses and the improved growth outlook for ALL following the proposed acquisition of NeoGames are the key fundamental attractions. Having said that, NeoGames is a medium-to-long-term story, with the more immediate market concern being: i) The declining revenue trends for the digital business and ii) Structurally lower margin for the digital business. We contend that these two factors are likely to limit scope for a re-rating.

Charting View

Since May, ALL had been trading in a sideways range. There was resistance near $39.50 but it recently broke above that resistance line to trend higher again.It is now hitting the next line of resistance near $42 so we expect the shares to consolidate here. Support is back near $39.50 so a fall under that would be a negative.

 

Michael Gable is managing director of Fairmont Equities.

 

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