Cash machines lie idle as Aristocrat, Ainsworth face covid crisis

Few things kill the urge for a flutter on the pokies like an economic downturn—especially one that bars you from even stepping foot near the machines.

But in the case of Aristocrat Leisure (ASX: ALL), the gaming machine powerhouse founded by Len Ainsworth, the covid19 crisis has been a different experience to the loss it suffered when the GFC roiled markets in 2008.

Aristocrat suffered heavily in the global financial crisis. Between 2007 and 2010 its earnings per share fell by about 80 per cent. The crisis was largely to blame, emptying the wallets of its pokie players, but so too was management: it borrowed heavily to fund share repurchases and was overly generous with dividends.

A decade on, Aristocrat (market cap: $17 billion) and its little brother Ainsworth Game Technology (ASX: AGI, market cap: $154 million) face a global crisis of a different kind. The coronavirus restrictions have forced them to shut their door to customers and throw out guidance statements.

The short-term hit prompted by the worldwide shutdown is inevitable, says Morningstar director Mathew Hodge. But he sees no change to the longer-term picture for Aristocrat and AGI. Both are narrow moat stocks, which implies a competitive advantage of ten years. Hodge has kept his fair value estimates and his long-term earnings forecasts intact.

“We lowered our near-term forecasts, and both firms have withdrawn their fiscal 2020 guidance,” Hodge says.

“Aristocrat and Ainsworth face a material decline in outright machine sales, as well as ordinarily recurring revenue from leased machines because of the closure of venues limits.

“Our fiscal 2020 underlying net profit after tax forecast for Aristocrat drops to $774 million, down 13 per cent from fiscal 2019 levels, compared with previous guidance for continued net profit growth.

“We also expect the near-term situation to be challenging for its smaller Australian competitor Ainsworth, and now forecast the firm making a net loss of $2 million in fiscal 2020, compared with previous guidance of a return to profit.”

As Aristocrat prepares to report on Thursday, it has a strong balance sheet—with more than $1 billion in liquidity and no near-term debt—and the interim suspension of its fiscal 2020 dividend shows it has rethought its dividend largesse. It’s had to cut jobs but it’s also cut exec pay.

Aristocrat Leisure, Ainsworth Game Technology - YTD

Source: Morningstar

Collect: Aristocrat reaches fair value

Since the lockdown of 23 March, Aristocrat’s share price has risen by more than 70 per cent versus a rise of about 20 per cent for the broader market.

It’s currently trading more or less in line with Hodge’s fair value estimate of $27.50. Much like its pokie-playing clientele, the company’s share price has had its highs and lows as suggested by the 52-week range of $14.18-$38.28.

Ainsworth, also a narrow-moat stock, is trading at a 60 per cent discount, according to Hodge, and since the 23 March lockdown it has climbed 30 per cent.

Aristocrat’s licence for longevity

What does the future hold? Well, there’s good reason Hodge assigns Aristocrat, which was founded in 1953, a narrow moat rating. The question is: can it go beyond that? Hodge isn’t so sure. But first the bullish points.

The key to success in the gaming world is the intangible asset of a licence and the more tangible asset of machines themselves. On the first score, Aristocrat has done pretty well: it’s got a strong foothold in NSW, which Hodge calls perhaps the most “hardcore” gaming market in the world, and it is also expanding its imprint in the US.

“Aristocrat has accumulated licences in every US state that allows gaming,” Hodge says, “and operates in almost every major country in the world. It is this intangible asset that creates significant barriers to entry and ultimately underpins the narrow moat rating.”

But note the key word here: “narrow”. The covid-19 restrictions on movement have laid bare the effect of shutting down facilities and at the same highlighted the shift to online gaming, which, in the case of Aristocrat, now accounts for 40 per cent of group revenues.

But with that comes consolidation and competition. New rivals have emerged such as multinational giant IGT and Las Vegas-based games and systems provider Scientific Games.

The growth in online gaming, and the ageing population—Aristocrat’s core demographic—are two reasons why Hodge sees the company’s competitive advantage as narrow rather than wide, and he’s not confident in the sustainability of excess returns beyond the next decade.

Aristocrat has a PE ratio of 17, and Hodge forecasts revenue growth of 6 per cent for the next five years. Driving this is growth in digital gaming and market share gains in North America, which Hodge tips to rise from 25 per cent today to 30 per cent in five years’ time.

“Our fiscal 2020 underlying net profit after tax forecast for Aristocrat drops to $774 million, down 13 per cent from fiscal 2019 levels, compared with previous guidance for continued net profit growth.

“We also expect the near-term situation to be challenging for its smaller Australian competitor Ainsworth, and now forecast the firm making a net loss of $2 million in fiscal 2020, compared with previous guidance of a return to profit.”

Len Ainsworth: skin in the game

It’s only fitting Len Ainsworth, at 96 Australia’s oldest billionaire and one of its canniest businessmen, put his name to his other pokie house.

AGI began gaming machine development in 1999 and listed on the ASX in 2001. It turned profitable in the latter part of fiscal 2010 and has enjoyed strong earnings growth, thanks to the development and marketing prowess of the senior management team.

“AGI has a good record and its products are generally regarded as above average in terms of their performance and patron acceptance,” Hodge says.

And like Aristocrat, its offshore expansion, which accounts for 80 per cent of group revenue is paying dividends.

“The company has ramped up its North American efforts by establishing a Las Vegas-based game design facility, investing heavily in innovation staff, and working with third-party game designers to develop offerings specifically for the North American market.”

It also has greater access to the previously impenetrable European market through Austrian gaming giant Novomatic, which bought a controlling stake in the company late last year.

“The new ownership brings significant potential benefits including access to the Novomatic games library, distribution of products via Novomatic channels, sourcing, and scale benefits,” Hodge says.

“Having a major shareholder like Novomatic, which spent more than five times’ the amount spent by Ainsworth on research and development in 2015, also puts the company in a better position to compete, further insulating its moat.”

Hodge’s fair value estimate for AGI is $1.10 per share. This implies a fiscal 2021 P/E ratio of 57, a fiscal 2020 enterprise value/EBITDA of 13, and free cash flow yield of 6 per cent.

In the longer term, Hodge’s top-line growth assumption is about 5 per cent a year, and the EBITDA margin is estimated to be 27 per cent, reflecting stabilisation of Australia and steady improvement in the international operations.

It began paying dividends in 2013 and has a target payout ratio of 40 to 60 per cent of net profit.

All Aristocrat and AGI need now is for the restrictions to be lifted and for punters to return to the machines with their spirits up and their pockets full. No small ask in this climate but there is a glimmer of hope that the Australian labour market might have passed its lowest point.

Consumer confidence has risen for the seventh consecutive week, according to ANZ research, and the total wages bill rose in the past two weeks, based on ABS data.

That may give Australia’s pokies powerhouses some hope but perhaps the true test will come around the end of the September when the government’s stimulus measures expire.