Aristocrat (ALL) shares have traded in a tight range between $20 and $22 over the last five months. The stock has been consolidating after a strong run but I am firmly of the view that this short-term share price consolidation phase is an opportunity to increase holdings in ALL ahead of a further re-rating to new highs in the months and years ahead.
The AIM Global High Conviction Fund has used this period of share price consolidation to increase our exposure to ALL, now making it one of our very biggest portfolio holdings. As a global fund we will buy an Australian stock if we believe it is the best in its sector in the world and looks cheap versus global peer multiples. ALL fits both those descriptions.
We are of the view that ALL’s FY17 results on November 30 will be better than their own guidance and better than current analyst consensus. This will lead to upgrades to FY18 consensus estimates and should concurrently drive a re-rating of the stock.
To put this in context, we believe ALL could report up to $550m of NPATA +38% yoy for FY17, around +3% ahead of consensus and around 6% ahead of ALL’s top end guidance of $518m (+30%) yoy. We feel guidance has been relatively conservative the whole way through the year and we feel it isn’t a big hurdle to jump judging by our feedback from the global and domestic gaming industry re usage of ALL products.
We also believe FY18 consensus would lift on the back of a FY17 beat. We can see FY18 consensus EPS rising to 105c, which would represent year-on-year growth of +23%. The question then becomes what will the market pay of another year of 20%+ eps growth from ALL and further improvement in all returns?? Our answer is more than the current 21x earnings, which has been the P/E pretty much the whole way through the last few years.
While ALL shares are up +255% of the last few years, the company’s earnings are up +255%. There has been NO P/E re-rating to reflect a genuine transformation of this company from a manufacturer to a platform. This company should be looked at and priced more like a “software as a service” or “gaming platform” company, rather than the historic pricing of a poker machine cabinet manufacturer whose growth is priced from unit sales. In our view, that multiple is +5 to 10 P/E points higher than the current multiple and will come through time to ALL as the market starts to understand the 44% return on equity (ROE) and 100% cash conversion is sustainable.
We are not the only people thinking about ALL’s potential P/E re-rating. To quote directly from a recent Macquarie Research report on ALL: “Business has transformed but the stock has not re-rated. In recent years Aristocrat has reduced its reliance on volatile and lumpy outright sales market through growth in higher quality recurring earnings segments including participation and digital (more than 60% of revenue from FY18+). This transformation has also significantly improved cash flow with cash conversion averaging 100%, compared to 82% during FY06 -13. The 255% increase in the share price over the past three years has been driven by earnings growth which we see continuing”.
Our view is another +20% year of EPS growth will most likely drive ALL share price gains, yet we think this year the market will have to start adding P/E which could easily add another +20% on top of that to ALL’s share price. We can see scenarios where the market in 12 months’ time is paying 25x earnings for ALL’s 105c of FY18 EPS, which equates to an ALL share price target of $26.25. We don’t think this is a big stretch and is likely if ALL can keep the fundamental market share gain momentum in key markets.
Those key markets do have very good momentum and recent industry events confirm that.
The major industry event of the year is the G2E Conference in Las Vegas that just occurred. The feedback from gaming sector analysts who attended the conference is universally bullish regarding Aristocrat’s product suite and market share gain potential in North America. There continues to be a multi-year pathway of growth ahead for ALL in North America driven by three different segments.
Class III video participation is the biggest sectorial driver of growth with analysts forming the view that ALL will be the North American market leader by 2020. Macquarie Research forecasts ALL’s market share to increase by +10% to 36% by FY20 implying +7000 net installs, or +47% growth. Those forecasts are underpinned by proprietary data from the Queensland market (monitored monthly) which indicates that Dragon Link has had no impact on Lightening Links installed base or performance. Macquarie consider IGT’s “Wheel of Fortune” installed base to be most at risk to market share losses to ALL’s Dragon Link.
Class II video participation is forecast to grow market share by +10% by FY20. ALL can now address a 30,000 machine installed base, which is expanding. It is already licensed in most tribal states and its eventual 200 game portfolio will operate on the successful Helix+ and Arc cabinets. Forecasts are for an installed base of 3,500 by FY20.
Class III stepper outright is also growing market share, with estimates ALL can achieve 10% ship share , or 1,500 outright sales in FY18 and beyond.
Digital is also growing strongly. While ALL is currently a small operator in the social casino segment with 7% market share, we believe that’s about to change. With the ability to leverage its deep catalogue of land based content, Macquarie Research forecasts +15% average revenue growth to FY20. This compares with broader market growth of +10% implying further market share gains. The Plarium transaction is expected to close by 31 December 2017 (US$845m acquisition including earn outs). This business opens new opportunities for ALL in the US$22B market segment where it only has 1% market share currently. Combined, the forecasts are for +40% average segment growth to FY20 lifting the digital segment contribution to around 25% of ALL earnings by FY20 from the current 13%. Obviously, digital earnings streams and their higher sustaining able ROE will drive a higher P/E for ALL overall.
What this strong growth and cash conversion is leading to, despite paying US$845M cash for Plarium, is that analysts forecast ALL will be debt free by FY21. Clearly, the company can carry some gearing and it wouldn’t be out of the question to expect large scale capital management from ALL in the years ahead to restore an appropriate level of gearing.
The earnings forecast and investment arithmetic matrix is strong for ALL: based of $22.00 share price.
Overall profit margins are also growing to around 50%, which means ALL ticks every box we look for in an investment.
The final attraction is the 65% of earnings which are coming in US dollars. If the Australian dollar has peaked versus the US dollar at around 80 US cents, then any further weakness in the Aussie Dollar is an earnings translation positive for ALL.
After 5 months of being range bound we are of the view ALL is breaking out of that range and will make new highs as the market comes around to our view that this transformed company deserves a higher P/E rating as the world leader in its industry.
On a FY18 Price to Growth ratio (PEG) of less than 1x the stock remains solid stand-alone investing irrespective of whether the re-rating comes.
We are of the view that ALL will be one of the star performers on the ASX this year in a domestic market that is broadly struggling for growth.
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