Aristocrat Leisure Hits Digital Jackpot

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

Most brokers were surprised at the strength of Aristocrat Leisure's first half results, welcoming the strongly positive contributions from Plarium and Big Fish.

-Recurring revenue providing increased certainty regarding growth
-Morgan Stanley raises question of strong digital acquisitions versus weak cash flow
-North America still considered under-penetrated amid adjacent opportunities
 

By Eva Brocklehurst

Aristocrat Leisure ((ALL)) turned on the bright lights in its first half result, posting a significant beat to broker forecasts and causing substantial upgrades to estimates and targets.

Most brokers were surprised at the strength of the result and welcomed the confirmation of strongly positive contributions from the Plarium and Big Fish acquisitions, which grew operating earnings by 60% and 34% respectively.

Despite the businesses not being the largest in the group, the highlight for UBS was the more detailed disclosure and a reduction in near-term downside risk, therefore removing an overhang from the stock. Recurring revenue is providing increased certainty regarding growth.

Digital revenue and operating earnings (EBITDA) beat CLSA's estimates by 9% and 28% respectively. Class III net additions rebounded strongly from the prior half, thanks to product releases, and the broker suggests this bodes well for the rest of the year, given the strength that is typical for Aristocrat in the second half.

Morgans agrees that the performance of the digital division should help alleviate investor concerns regarding the acquisitions. The broker continues to envisage upside for both outright machine sales and gaming operations because of the strength of the company's library, and makes substantial upgrades to forecasts for FY18-20.

Aristocrat has increased its digital exposure to 26% of first-half earnings, up from 13% in FY17. Further digital growth and capital management opportunities are available, and Ord Minnett believes strong execution by management and a scarcity of earnings growth in the market signals the risk/reward ratio remains attractive.

The digital business and social gaming are becoming much more meaningful for the company, Macquarie agrees, as earnings diversify away from the traditional land-based business. Through FY19 the broker expects these newer businesses to account for more than 50% of segment profit.

Credit Suisse upgrades to Outperform from Neutral, taking the view that the performance in digital will attract new investors who would expect the company to scope out a much larger position in the US$50bn mobile digital games industry.

First half adjusted net profit was $361.5m, up 32.5% on the prior corresponding half. The focus on higher-quality daily average users assisted digital margins across the portfolio. Meanwhile, cross promotions and better monetisation are expected to support growth, although Ord Minnett notes lower-margin social gaming now comprises about half of total bookings.

Macquarie acknowledges growth into social gaming through Big Fish and Plarium will dilute digital business margins. That said, the medium-term margin outcome is based on user acquisition spending and scale benefits, so there should be some margin expansion as growth is delivered.

Cash Flow

Morgan Stanley is more cautious. The broker raises questions in trying to reconcile the strong contribution from digital acquisitions with a weak cash flow. Normalised cash conversion was 47% versus 81% in the prior corresponding half.

This can partially be explained by a rise in cash taxes paid and one-off factors related to acquisitions. Networking capital increased, driven by the timing of land-based product sales. Yet, as the broker points out, there was a substantial rise in current deferred revenues of $107m which should have led to strong cash flow. The broker will take up the issue with management.

Meanwhile, Morgan Stanley concedes solid earnings momentum and investors looking for offshore growth should provide support for the share price in the near term. While envisaging little risk to FY18 earnings, the broker believes the upside is priced in. The broker expects FY19 growth to slow to 15% and maintains an Equal-weight rating.

Credit Suisse envisages low risk to earnings in the near term, whether the step up in digital occurs or not. Debt is expected to be driven down rapidly by the cash being generated. Alternatively, digital games, particularly social casino, might offer revenue that is more sustainable than land-based casino games, where market share tends to shift over time.

Market Share

Furthermore, the broker considers the stock a market share story, rather than a structural growth story, that is exposed to the product cycle, and this needs to be considered with its valuation. While there is little risk for the near term, Credit Suisse acknowledges it struggles to envisage the premium multiple expanding further.

Macquarie is more confident, given the strong market share gains in North America and the digital businesses and considers North America still under-penetrated. Aristocrat has a market-leading product and attractive pipeline of game releases.

Adjacent market opportunities should also start to materialise through the second half. Hence, Macquarie suggests that the stock continues to look attractive, offering a 24% three-year compound growth rate.

CLSA, not one of the eight stockbrokers monitored daily on the FNArena database, envisages upside to the traditional US business through gains in market share. The broker points out that US tax changes should be positive at the margin.

Yet, given existing transfer pricing agreements and some US dollar earnings being repatriated to Australia this aspect will not be as positive as the headlines suggest. The broker increases its price target 15% to $34.50 and maintains an Outperform rating.

FNArena's database shows seven Buy ratings and one Hold (Morgan Stanley). The consensus target is $34.16, suggesting 9.0% upside to the last share price. This compares with $29.65 ahead of the result. Targets range from $29.00 (Morgan Stanley) to $38.75 (Deutsche Bank).

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms