Weakness in The Lottery Corporation (ASX:TLC) shares since the release of FY23 results in August prompted us to recently research TLC in The Dynamic Investor. Are the factors that led to a weaker-than-expected result likely to recur? If not, are the shares an opportunity at current levels?

About the Lottery Corporation

The Lottery Corporation is the leading lottery and Keno game operator in Australia. The Company’s shares commenced trading on the ASX on 24 May 2022, following its demerger from Tabcorp Holdings (ASX:TAH). TLC holds long-dated licences to operate lotteries in all Australian states and territories excluding Western Australia. As synthetic lotteries are prohibited in Australia, TLC holds a monopoly position in the states and territories in which it operates. The Company has two operating divisions:

i. Lotteries (85% EBITDA): This division consists of traditional draw-based games, such as Powerball & Oz Lotto.
ii. Keno (15% EBITDA): Keno is a number game in which 20 numbers between 1 & 80 are randomly drawn, with instant cash prizes as well as multi-million-dollar jackpots.

Key Fundamental Drivers

Lotteries Impacted by Bad Luck but Structural Growth Drivers Remain

Unfavourable jackpot outcomes had a meaningful impact on turnover for the Lotteries division. Powerball tracked close to the statistical model. However, Oz Lotto experienced a highly unfavourable 1-in-20-year jackpot run.

Notwithstanding these impacts, there are several factors likely to support revenue growth for the Lotteries division over the short-to-medium term:

i. Normalising revenue (~4% turnover lost from unfavourable jackpots).
ii. Full year impacts of the price increase for Powerball games in May 2023. The price increase is designed to generate more frequent and larger jackpots.
iii. Increases to retail commissions.
iv. Following changes to Monday & Wednesday lotto, the Company is currently working on expanding the Monday & Wednesday product to Fridays.

Are Offshore Lottery Providers a Competitive Threat?

Offshore lottery providers provide local consumers with access to offshore lotteries that have significantly higher jackpots than Australian lotteries. To date, TLC has yet to see any adverse impact on sales from the step-up in market activity from offshore lottery providers, such as The Lottery Office. The threat to TLC is that any growth in the number of offshore lottery providers has the potential to cannibalise TLC’s products. However, this would also present a risk to government revenue. As such, it is likely that both industry participants and regulators would take proactive steps to ensure the viability of its existing licenses.

Margin Expansion Still Expected

Operating expenses are expected to step-up in FY24. This is mainly due to wage inflation and higher marketing costs to support anticipated higher jackpots. Despite the expectations for higher costs, EBITDA margin expansion at a group level is still expected in FY24/25 from two avenues: i) An earnings boost from increased retailer commissions and ii) the resumption of digital penetration.

Capital Management to Resume as Gearing Expected to Fall

Gearing (on a net debt to EBITDA basis) as at 30 June 2023 was 3.1x. Gearing increased from 2.6x as at 31 December 2022 and remains within the lower end of the revised target gearing range of 3.0-4.0x.

In context, the increase in gearing is not a major concern. TLC is a highly cash generative business, underpinned by the long-run and generally exclusive licences within Australia across lotteries and Keno. In addition, CAPEX requirements are low (as a % of revenue). With a minimal ongoing CAPEX requirement, the Company is likely to maintain a fully franked dividend. At the same time, debt is expected to progressively reduce. This is likely to push gearing below the low end of the revised target range. As such, further capital management (such as special dividends) are expected in the foreseeable future.

Fundamental View

At current levels, the shares are trading on a 1-year forward P/E multiple of ~26x. This multiple is at the lower end of the trading range since listing. However, the current multiple is not demanding in the context of an EPS growth profile of +11% over FY23-26 on a CAGR basis.

Investor sentiment has been impacted by weaker-than-expected growth in the Lotteries division in FY23. This sentiment is likely to reverse as the market begins to look through the FY23 result and instead focus on several strong fundamental drivers. These include the normalisation of the jackpot cycle in FY24 and the potential for margin expansion.

Charting View

TLC recently fell back towards support near $4.60. It became oversold on the RSI before rebounding solidly and providing us with a buy signal. It therefore seems that we have a significant low for now. TLC therefore looks like a buy at current levels. Investors can look to place an initial stop under last week’s low near $4.56.

 

Michael Gable is managing director of Fairmont Equities.

 

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