Firstly, thank you to those of you who sent nice comments about my mother’s investing prowess. I have attempted to learn from Mum, and one of her key strategies was when she was on a winner to stick with it.
Aristocrat (ALL) appears to have finally taken out long-standing technical resistance around $24.00 and has broken into a new higher trading range. I believe the new trading range is $25.00 to $30.00, with the upper end of that range to be tested later this calendar year.
The best in the world
Aristocrat has been a core holding of the AIM Global High Conviction Fund since we started investing around 2.5 years ago. We said we would only own an Australian stock in the portfolio if we believed it was the best in the world in its sector and met our investment arithmetic criteria. Aristocrat clearly fits that description. It has delivered strong returns and contributed to the fund’s outperformance of global and domestic equity benchmarks.
We do get many questions about Aristocrat and whether “it has done enough.” Of course, the natural temptation in investing is to take profits in stocks that have performed well, yet the real trick to long-term outperformance is to let your structural winners run and cut your losers. Our fund has increased its holding further in Aristocrat in recent weeks, as technical resistance was taken out and broker earnings upgrades commenced. I think that answers the question.
Regulatory risk
While Aristocrat operates in a sector where there’s a clear chance of “populist political risk”, from analysing the policies and statements of domestic and international politicians, it appears that regulatory risk is falling, not rising in the gaming software sector. This is the complete opposite of many Australian sectors, where regulatory risk and regulatory intervention are rising. This is another clear reason why the S&P/ASX 200 continues to underperform the world: rising regulatory risk.
Aristocrat is entering a seasonally-strong period of share price performance, and that is another reason we have increased our holding.
Sell side and buy side analysts typically make two trips each year to Las Vegas. One in March (shortly after the February reporting season) and one in September, ahead of the G2E gaming conference.
Every March and September, the street meets with all the casinos and comes home appreciating just how strong Aristocrat ‘s market position is. The buy side adds to their positions and sell side upgrades numbers.
The monthly performance table below is for the last 5 years (source UBS). Note the most recent year was slightly out, given the G2E conference was held in October, not September (so performance came that month +12%). We believe this points to evidence of seasonality.
A cheap structural growth stock
Aristocrat is a cheap structural growth stock in our view, with multiple drivers of that structural growth. Trading on a PEG ratio of less than 1x, there’s every chance that multiple expands over the next year. Below we go through why.
Aristocrat has multiple growth drivers (all at high incremental margins)
- US Class III Gaming Ops: Increasing Nth American share, thanks to strong game performance (28% of installed base/21% ship share vs. 60% ship share in AusNZ).
- Dragon Link Rollout: Annualizing 6,000 rollouts in Nth America vs. 3,900 total rollouts (all products). Implies ~4% upgrade to EPS, assuming it holds.
- New Pricing Model: Premium lease style pricing model (i.e. what’s offered for DragonLink in US) drives material margin improvement.
- New Markets: Rolling out product into multiple new Nth American markets. Class II video showing enormous promise (positive early signs from California).
- US Consumer Leverage: US economy showing signs of life. GGR been broadly flat for 10 years. 1% increase = 1% to Group EPS (see below).
- Margin Expansion: Given significant fixed R&D cost base, majority of Aristocrat’s growth strategies deliver very high incremental margins.
Aristocrat is materially leveraged to US economic improvement
- 1/3 of EBIT now exposed to US consumer via Class II and III participation (as casino revenues increase, Aristocrat benefits via its leased pricing model).
- 1% increase in US GGR = 1% increase in Group EPS.
- US GGR grew at ~6.6% p.a. in the 10 years preceding the GFC. The past 10 years have seen an average of 0.5% p.a. In the Dec Qtr, GGR picked up to +2.1%.
- 45% of Aristocrat’s US participation revenue comes from Oklahoma where growth has been >3% over the past three months
The market is underappreciating Aristocrat’s recent Digital acquisitions
- Plarium and Big Fish should add US$150 million EBIT in FY19 (a 17% increase on FY17 Group EBIT).
- Industry data suggests online social casino market grew 52% Y/Y in the December Quarter. Big Fish was 22% Y/Y.
- Big Fish Casino ARPDAU (Average Revenue Per Daily Active User) sits at US$1.04 vs. global peers US$0.41 and Product Madness US$0.53 (see chart below).
- Aristocrat’s two most recent acquisitions were screamers (Product Madness + VGT). I think it’s fair to back the Board’s capital allocation framework.
Higher quality revenue vs. last cycle
- Aristocrat talk about ~65% of their revenue coming from “recurring” sources (i.e. participation machines + Digital gaming).
- It’s higher quality revenue than the traditional “one off” machine sales.
- We are comforted by the fact that SciGames and IGT’s game performance over the past few years has been poor, yet the share declines in their participation business have been gradual (see below).
Offering a 5% equity free cash flow yield
- Nothing eye watering but this is a significant number for a business growing earnings >30%.
- Healthy balance sheet at 1.7x Net debt to EBITDA ratio and de-gearing ~0.5x p.a.
You can see below that Aristocrat’s EPS forecasts are in a structural uptrend. The chart overlays consensus FY18 forecasts for Aristocrat and the Aristocrat share price. You can see they are joined at the hip.
However, this earnings upgrade cycle is far from over as we suggest in the points above and I expect Aristocrat to benefit from both consensus EPS upgrades and investors paying a higher P/E for those earnings upgrades as they get more comfortable with the recent acquisitions.
I continue to believe Aristocrat will be one of the best performing large cap stocks on the ASX over the next five years. .
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.