Aristocrat (ALL) has been a core long position in the AIM Global High Conviction Fund since our inception two and half years ago. Last week Aristocrat announced FY17 profits and also announced a $1.3 billion acquisition. While all analysts, including ourselves, believed the results were better than expected, the stock fell 7% on the day of the result because of fears around the large-scale acquisition of Big Fish, Aristocrat’s second large-scale acquisition in 3 months.

Long-term investment opportunity

While the stock has paid its annual dividend, and started to recover in the week since the result and acquisition, I remain of the view this kneejerk share price pullback is an opportunity for short, medium and long-term investors. The AIM Global High Conviction Fund increased its holding in Aristocrat over the last week under $23.00.

Aristocrat is the $14.5 billion market cap world leader of the global gaming machine and gaming software industry. In recent months, they have sensibly diversified their business towards social gaming and online casinos, which I think, through time, will lead to a higher P/E being applied to Aristocrat shares to reflect the faster growth and higher margins of those digital sectors. I also believe Aristocrat’s increasing percentage of recurring earnings will drive P/E expansion. This is becoming a platform company and platform companies attract higher P/E’s due to their structurally higher ROE’s.

Interestingly, up until now, Aristocrat has seen no P/E expansion. The strong share price gains of the last 5 years have all been driven by earnings growth. The chart below overlays the consensus FY18 Aristocrat EPS estimate and the Aristocrat share price.

Aristocrat’s FY17 results beat consensus expectations at every level across the board. Revenue beat consensus by +4%, EBITDA +5% and NPATA +5%. The operating cashflow number of $800 million was significantly ahead of analyst forecasts and a key positive from the result.

All things being equal, that should have been more than enough to drive Aristocrat’s share price through all-time highs, but the $1.3 billion acquisition of Big Fish completely overshadowed the excellent FY17 results and associated upgrades to FY18 consensus. The share price reaction was about institutional investors selling Aristocrat shares on the view that the Big Fish acquisition was “too much too soon” coming after the recent $500 million Plarium acquisition. Clearly some institutional investors believed the risk profile of the company had risen due to the spate of large scale acquisitions by Aristocrat.

Same, same but different

However, it’s worth keeping in mind the same short-term share price reaction, driven by institutional sellers, occurred when Aristocrat announced the company making Video Gaming Technologies (VGT) acquisition around three years ago. Back then the market was sceptical of the debt funded acquisition, which was then Aristocrat’s largest acquisition. But within three years the debt has been all but paid off by the cashflow from the acquisition. It was a brilliant piece of M&A that at the time, due to investor scepticism, provided an excellent short, medium and long-term buying opportunity in Aristocrat.

No doubt Big Fish is a “big bite” for Aristocrat. It is their biggest acquisition to date and the price paid at 12x EBITDA is full. As a debt funded deal it takes Aristocrat’s gearing up a notch in the short-term to a Net Debt to EBITDA ratio of 2.2x. However, as I said above, Aristocrat has very strong cashflow and can handle a short-term lift in gearing to fund a growth acquisition that will drive future earnings and dividend growth.

The beef or the fish?

On Monday of this week Citi hosted Aristocrat management for an investor lunch. Below I quote directly from Citi on the feedback from that management presentation.

• Citi hosted Aristocrat management for the FY17 result lunch here yesterday – it was all about the Digital strategy. Big Fish was one of 20 opportunities management looked at and what they have acquired here is the capability to build digital content at a faster pace alongside the Meta-game technology which they can use across their entire digital portfolio. Aristocrat have a clear vision around the near-term improvements they can make to the Social Casino which will lift performance from the get-go.
• Management noted that Metagame IP has been a clear driver of recent growth in the Social Casino segment. This acquisition will help Aristocrat to leverage the Metagame capability across the broader portfolio, they described Big Fish as the bridge between their traditional participation business and the Plarium business. Importantly, this looks to be it for a while on the acquisition front for Aristocrat as they now look to focus on the operating of both recent deals.

It seems that Aristocrat management lunch at Citi brought stability to Aristocrat shares and some fresh buying. It did seem to clear the air a little and bring in some buying form the sidelines.

Because Aristocrat are expensing the costs of the Big Fish acquisition, which is a conservative approach, the real EPS uplift is in the FY20 year when EBITDA lifts +5%. This is before taking into account any benefit from US corporate tax cuts where Aristocrat earns 60% of its revenue.

Aristocrat earnings forecasts have increased to EPS of $1.00 in the current FY18 year. I think the market, as it gets comfortable with the Big Fish acquisition, will pay 25x for that $1.00 of earnings, equating to a $25.00 price target over the next 10 months. After that, EPS should rise by another 20% in FY19 to around $1.20. Again, I think the market will pay 25x for that $1.20 of earnings over the next two years, setting a November 2019 price target on Aristocrat of $30.00. I think $30.00 is highly achievable for Aristocrat over the next two years and particularly in an environment of large cap Australian equities offering very little obvious earnings growth.

Aristocrat is also a potential beneficiary of any weakness in the AUD/USD cross rate over that period due to its high percentage of US dollar earnings. We assume 75 US cents average for the next two years but that could easily be too optimistic considering US/AUS interest rate differentials are moving strongly in favour of the US.

Aristocrat remains a high conviction investment for us with a clear pathway to being a $30.00 stock. We like both the Plarium and Big Fish acquisitions and their very cheap debt funding (no equity dilution to Aristocrat shareholders). While we don’t doubt the headline acquisition numbers are big, we think the online diversification strategy is the right one and will lead to higher earnings and a higher multiple being paid for those higher earnings through time.

Right now, due to investor scepticism, those structurally higher Aristocrat earnings are commanding a lower P/E than two weeks ago. That is an opportunity in our eyes and we think it’s time to do a little “fishing” in Aristocrat shares while they remain discounted due to uncertainty around the M&A.

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