Aristocrat Leisure Beats High Expectations

This story features ARISTOCRAT LEISURE LIMITED. For more info SHARE ANALYSIS: ALL

Brokers welcome the strong first half results from gaming machine business, Aristocrat Leisure, as the company continues to deliver on its growth initiatives by developing titles for both land and digital platforms.

-Debate centres on re-rating based on stronger earnings, less volatility and higher margins in recurring business
-Guidance potentially conservative given time of year and the company's track record
-Balance-sheet capacity could cope with a $1.5bn acquisition
 

By Eva Brocklehurst

Brokers welcome the strong first half results from Aristocrat Leisure ((ALL)) as the company continues to deliver on its growth initiatives by developing titles for both land and digital platforms. Further opportunities are expected to be sought from Asian mobile penetration and key product releases.

The company posted a 49% increase in net profit after amortisation of $272.9m, supported by a large increase in market share. The interim dividend of $0.14 per share was 25% franked.

North American earnings were up 29%, digital earnings were up 48% and Australasian earnings up 1%. Digital daily active users are expected to reach 1.8m in 2018, comprising 15% of the company's profit and 2017 guidance for net profit after amortisation growth is in the 20-30% range.

The increase in the dividend was lower than Deutsche Bank expected while the maintenance of full-year guidance was disappointing. Yet, the broker acknowledges this should be seen in the context of a new CEO and the company's usual conservatism at this point of the year.

Strong operating leverage resulted in group earnings (EBIT) growing 32% from 27% previously. This is a positive step change which UBS believes will continue in the second half and is a key driver behind the broker's upgrades to earnings per share. The shares may have outperformed by 33% over the year to date but UBS continues to envisage upside as the company remains under penetrated in the digital market and class III participation.

Competition is also at a cyclical low point in the product cycle and the company continues to search for accretive acquisitions. The broker's forecasts are yet to reflect the upside from adjacent market entries or an improvement in the US economy.

UBS observes debate in the market currently centres around a potential re-rating of the company's multiple, given a stronger set of earnings driven by less volatility and higher margins in recurring businesses which now make up 52% of revenue. Aristocrat has historically traded at a 35% premium to the ASX 200 over the past three years.

Given strong execution by management, a scarcity of earnings growth in the market and despite a decline in structural expenditure on slot machines, Ord Minnett believes the risk/reward is attractive. Capital management is also considered possible, as the company has the potential to outperform guidance.

Margins

The digital sales margin improved by 480 basis points to 43.6%. While Australasian earnings disappointed brokers, which Deutsche Bank attributes to the initial impact of the Access subscription-based pricing model, the margin is expected to benefit from the changes in subsequent periods.

Citi's upgrade to its estimates largely reflects upgrades to North American margin assumptions and digital growth forecasts. The broker also upgrades Australasian margin assumptions to reflect a ramp-up in the Access model sales.

Credit Suisse upgrades North American operating margin estimates, particularly the recurring revenue segment and digital, in the wake of the result and earnings per share by 11-14% across the forecast period.

Acquisitions?

The company maintains a strategy to invest in its core business and adjacent opportunities while also seeking acquisitions, returning capital to shareholders in the absence of these opportunities. Management has indicated it prefers to grow the company rather than make significant distributions in the near term and emphasised a focus on retaining sufficient liquidity to support current operations.

Credit Suisse notes the balance sheet has significant capacity and the company could handle a $1.5bn deal, although no particular target has been identified. First up the broker envisages solid growth in earnings per share out to FY20 on the back of Dragon Link rolling out in North America.

The digital business is less predictable but the broker believes, if Aristocrat can sustain Heart of Vegas revenues and launch new successful apps like Cashman Casino, then growth will occur out to FY20 in this area as well.

Although the company grew market share in Australasia, volume did not grow and this occurred despite the launch of Dragon Link in Queensland. This remains a key risk for the stock, in the broker's opinion. The company is attempting to mitigate the issue with an annuity pricing model but Credit Suisse notes other large apps in the social casino space have stopped growing, even though Heart of Vegas, surprisingly, outperformed.

Macquarie forecasts strong North American revenue growth of 14% and 12% in the second half and FY18 respectively, believing debt and liquidity metrics provide an opportunity for the company to grow both organically or via acquisitions. The lack of growth in Australasian revenue was the stand-out disappointment for the broker, envisaged as a reflection of a strong ship share that offset soft market conditions and the impact of cycling a strong first half in FY16.

FNArena's database shows five Buy ratings and one Hold (Credit Suisse). The consensus target is $24.33, signalling 12.9% upside to the last share price. This compares with $20.79 ahead of the results. Targets range from $23.00 (Ord Minnett) to $26.85 (Deutsche Bank).
 

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