We recently revisited the fundamentals for Aristocrat Leisure (ASX:ALL) to assess the outlook for each of the key operating divisions. This was taking into account recent performance in FY20 (ALL has a 30 September balance date), as well as the current trends in the Digital and ‘Gaming Operations’ businesses. Based on this, is ALL still a buy at current levels?
Key Fundamental Drivers
1. Strong Outlook for Gaming Operations to Offset Recovery in Outright Sales
Land-based revenue primarily comprises a mix of gaming operations and outright gaming machine sales. The former is 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. This has accounted for more than 65% of revenues during FY20 across Class II (28%) & Class III (37%)*. The revenue exposure to outright sales & conversions is around 25%.
The key factor underpinning the outlook for both the gaming operations and outright businesses is the timing/phasing of casino re-openings. As at 12 November, 92% of North American casinos were open and as at the end of October, 75% of Class III Premium and 90% of Class II gaming operations machines were operating. The number of outright sales boxes switched on has increased to 90% from 80% at the end of September 2020.
ALL is well placed to win incremental market share across both its gaming operations and outright sales segments in all markets in the medium-term. This is given that: i) Towards the end of FY21, a higher portion of the installed base is expected to become operational and ii) The combined Class II / Class III daily average yield improves back to pre-COVID-19 levels.
However, we expect outright sales volumes to slightly lag gaming operations. A full recovery in outright sales volumes not expected until FY22/23.
A key risk to this view is that increasing COVID-19 cases result in temporary casino closures. However, it is worth noting that ALL’s core markets (i.e. Oklahoma) are less likely to close. This is given that casinos on Native American lands (about 40‐50% of the market) would be performing better with fewer operating/capacity restrictions.
*Class II gaming machines are based on a bingo-style game, as opposed to standard gaming machines (known in America as Class III games), which are based on random number generators.
2. Margin Expansion in Digital Division Still Expected
Within the Digital division, ALL operates across three broad segments: 1) Social Casinos, which account for 51% of bookings (i.e. revenue) as at FY20, 2) Social Casual (16% of bookings) and 3) Strategy, RPG and Action (33% of bookings).
ALL expects revenue growth for the Digital division to moderate into FY21 (from the 32% reported in FY20) due to COVID‐19 playing habits reverting back to more normal patterns. Still, the Company expects to gain share of mobile gaming in FY21. Revenue growth is nonetheless expected to be solid, despite cycling “stay at home, play online” benefits. Social Casual growth underpinned by new game launches and the monetisation of RAID. This more than offsets a normalisation in social casino earnings post-COVID-19.
Margin for the Digital division (on an EBITA/sales basis) in FY20 was at 30.8% and slightly higher than FY19. This reflects higher revenue and operating leverage. Given that ALL is maintaining high levels of user acquisition investment, as well as game content in order to maintain the growth profile, margin is expected to remain at ~30% for FY21.
There is upside to margin, as the key RAID: Shadow Legends game (which accounts for nearly a quarter of digital booking) requires less investment and begins to generate more meaningful profit. A key risk to the expectation for higher margin is a greater-than-expected mix shift away from the higher-margin social casino games.
3. Balance Sheet Optionality Increases
ALL has manageable gearing levels, strong levels of free cashflow generation, and high levels of liquidity. These factors provide scope for a large-scale acquisition, which would accelerate group earnings growth. ALL remains on the lookout for complementary businesses and, as we have previously highlighted, potential acquisitions are likely to entail the Company expanding its digital offering by acquiring complementary gaming titles that are already strongly monetising.
In addition to opportunities in the Digital segment (which is highly fragmented), land-based acquisition opportunities may also become available given that COVID-19 has impacted ALL’s listed North American peers.
In the absence of acquisitions, gearing is expected to decline significantly in FY21, given: i) The earnings recovery, ii) Strong free cashflow even after taking into account investment in design & development and digital user acquisition spend and iii) A moderate dividend payout ratio of 40%.
Alternatively, the Company may undertake capital management initiatives (i.e. special dividends/share buybacks).
As growth in the core US land-based Class III segment begins to mature, ALL’s growth drivers are pivoting to adjacent US land-based opportunities and potential margin expansion in the Digital division (in particular through further monetisation of RAID). Redeploying balance sheet optionality could provide another leg of earnings growth through capital management and/or acquisitions.
Accordingly, we continue to rate ALL’s fundamentals highly.
In mid-January we saw ALL fall back and retest the November low. Since then, it has managed to bounce higher and the last couple of weeks has seen it outperform the market again. Congesting under the November high is a positive and ALL looks set to make a run back up the 2020 high. Current levels look like a buying opportunity.
Michael Gable is managing director of Fairmont Equities.
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