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Stock: Aristocrat Leisure

Stock code: ALL

Share Price: $2.60

P/E Ratio: 25.03 (Sector P/E 12.79)

Market Cap: $1,395,000,000

Broker Sell Recommendations:

Morningstar (30th May 2011, share price was $2.67 that day)

Intersuisse (23rd May 2011, share price was $2.65 that day)

Austock (10th May 2011, share price was $2.79 that day)

Shadforth Financial Group (4th April 2011, share price was $3.21 that day)

Novus Capital (14th March 2011, share price was $3.36 that day)

Company Investor Centre: Aristocrat Leisure

Company news: ALL

Chart

Chart: Share price over the year to 08/04/2011 versus ASX200 (XJO)

On April 10th we featured Aristocrat Leisure as our Bear of the Week and just two months later the share price has dropped 19% from $3.21 to $2.60. The outlook is no brighter since then, and the number of brokers lining up to place a sell on the stock should ring alarm bells for investors.

Even with it languishing at a yearly low many brokers continue to be bearish on this gaming stock, telling investors it’s simply too much of a gamble, that they should move on from ALL or pay the price. Five brokers who have a sell on ALL sum up the general sentiment toward the company: “no reason for investors to be in this stock”, “the stock will underperform”, “faces pressure from US competitors”, “we suggest investors sell or avoid”, “I expect the share price to retreat”. You get the picture.

In its former glory days, Aristocrat Leisure’s near-monopoly status in most clubs and casinos in Australia made it a solid bet – it was a high-revenue business that offered considerable upside. But times have changed and today Aristocrat Leisure is a much riskier proposition.

Regulatory risks in the gaming industry, a high Australian dollar, the need for fast-paced and constant product innovation, and the rising threat of internet gaming companies both locally and internationally, present significant challenges for the stock.

And investor and broker confidence in the stock remains low as new challenges appear on the horizon.

The Federal government is toughening up on the gambling industry. Julia Guillard’s gambling advisory committee, led by Andrew Wilkie and Nick Xenophon, is scheduled to publish measures to tackle problem gambling. The plan is to give clubs and punters a choice: they can either gamble on slower machines with slower jackpots, or gamble on faster machines fitted with new “pre-commitment” technology to limit the amount they can lose; the punter must first enter what they’re prepared to lose over a day or week, and once that amount is reached, they’re restricted from playing the faster machine for 24 hours.

Xenophon – who was elected on a “no-pokies” ticket – is not messing around when it comes to reform and PM Gillard last year promised independent Andrew Wilkie that if the States did not commit to gambling reforms then she would introduce legislation to seize control of poker machine regulation before the 2012 budget.

“If we can make a big difference to the 100,000 Australians who are hopelessly hooked on poker machines, losing an average of $21,000 a year each, to the other 280,000 people that are at risk of developing a full-blown addiction, if this will make a difference between people not losing their homes, people getting some control over their lives, then that’s a good thing,” said Wilkie in an ABC interview.

With the States not playing ball, it appears that Gillard will be forced to introduce legislation to take over poker machine regulation so as to retain the support of cross-bencher Wilkie in the hung parliament. But this won’t be an easy fight because as Xenophon says, the States “are completely addicted to the $4 billion a year in poker machine taxes they receive.”

Share Price Performance

Long-term shareholders in Aristocrat have not been rewarded for their loyalty to the gaming stock. Back on 1st Jan 2003, a share in ALL cost $4.68, or a 10,000 share holding was worth $46,800. Today, that holding is worth significantly less, at $26,000. Shares are down 27.9% for the year and down 6.7% over the past 10 years. It would seem that the odds on making money on ALL are about the same as winning on their poker machines.

The chart below compares the performance of ALL (in blue) to the ASX/S&P 200 index, or the index of the top 200 companies in Australia. As you can see over the previous 10 years, ALL has exhibited significantly more volatility than the underlying index, represented by higher peaks and lower troughs. Clearly, this stock is not for the more conservative punter, and if broker recommendations are anything to go by they’re not for anyone at all – unless they’re shorting.

Chart

Company Description

Aristocrat is a market leader in Australia and NZ when it comes to the gaming industry and earns revenue worldwide from the manufacture of electronic gaming machines – aka “pokies” – and gaming machine software. The US is a big market for ALL, and so was Japan until it all but collapsed, forcing ALL to create a design studio in Japan. This collapse in Japan, the problems faced with changing regulations and volatile gaming demand mean that earnings can easily disappoint.

In addition Aristocrat develops, manufactures and distributes gaming machines and systems in South Africa and Europe.

Aside from pokies, its products include casino management systems, cabinets for the games, lottery products, electronic poker tables and technical services for gaming machines and equipment.

Financials

Aristocrat reported a net operating profit of $54.6 million, which was a steep drop from $116.4 million in 2009. Revenue fell 25.1 per cent to $680.5 million.

Reported net profit was $77.2 million, compared to a loss of $157.8 million in the prior year – which included a $187.3 million one-off provision.

While sales in the US were off 8% in US dollar terms, Australian revenue was worse, down 34%. However the worst revenue performance came from Japan, its most difficult market, down almost 55% in Yen terms. The best performing market for ALL was Macau.

As Shadforth’s Elliott points out, ALL’s cash flow offers “little yield” and little hope for juicy dividends for shareholders. However the concern is whether the company has the balance sheet strength to ward off competitors with constant product innovation, a requirement for increasing market share.

In August 2008, ALL announced a 3-5 year strategy to double the group’s share of gaming operations market in North America and to better manage volatility in Japan.

2008A2009A
2010A
Sales Revenue ($m)
1,080909
681
EBITDA ($m)
253213
118
EBIT ($m)
213170
81
Adjusted NPAT($m) 140116 55
Reported NPAT ($m)
101 -158 77
Price/Earnings 23.1 17.7 37.2
Dividend Yield (%)
9.3 1.1 1.7
Net Profit Margin (%)
13.0 12.8 8.0
ROE (%)
72.8 75.2 28.7
ROA ($)
15.4 15.9 9.2
Net Debt/Equity (%)
195.6 48.9 152.1

 

Company Earnings Report: Aristocrat Leisure Full Year Earnings Report – June 30th, 2010

Analysts

Analysts continue to downgrade ALL, stressing to investors to get off the sinking ship.

Andrew Doherty from Morningstar said last week that the electronic gaming machine manufacturer and software provider is struggling in Australia, the US and Japan. “Products are out-dated, while changing regulations and volatile gaming demand add to business complexity,” says Doherty. He points out that Aristocrat has been a serial down-grader from brokers. “We see no reason for investors to be in this stock,” he adds.

Intersuisse’s Cameron Bell thinks that it’s likely that ALL will underperform given the challenges it’s facing in the US, Japan and Australia. On top of this, although it recently reiterated full year guidance “the guidance assumed an average Australian dollar to US dollar rate of $1 for the full calendar year…a 1 cent move in the exchange rate will impact NPAT (net profit after tax) by $1 million,” says Bell.

Michael Heffernan from Austock agrees that the company is struggling. “It faces pressure from US competitors entering the Australian gaming market on top of its struggling US and Japanese operations. In addition, its second largest major peer WMS (formerly Williams), recently downgraded its guidance due to soft gaming revenue conditions across its major US markets,” he says.

Chris Elliott, Shadforth Financial Group thinks that Aristocrat Leisure offers little yield and even less growth due to the fickle nature of the gaming industry. “A high Australian dollar and the Japanese disaster doesn’t help. Carrying a debt/equity ratio of about 160 per cent and slumping revenue – down 25 per cent in 2010 – we suggest investors sell or avoid,” said Elliott in early April.

Cleo Nanni, Novus Capital has had a sell on ALL for months. “Competition in the global poker machine market is fierce…this puts pressure on company revenue. In my view, the stock appears to be trading at a significant premium…I expect the share price to retreat in coming months,” he said.

Conclusion

The risky aspect of the gaming industry is that regulations both in Australia and internationally can change suddenly, either benefiting or disadvantaging companies like ALL.

A government can suddenly lift the tax rate on gaming revenue, reducing gaming demand in that jurisdiction. It can suddenly ban particular gaming machines in casinos and pubs, impose smoking bans, or permit or restrict particular companies from operating.

On top of this, gaming earnings are notoriously volatile as consumer demand ebbs and flows. International earnings are directly impacted by a high Aussie dollar (almost half of ALL’s revenue is sourced from the US).

But the biggest problem faced by ALL is an increase in competition from massive international players like International Gaming Technology, WMS Industries and Bally. All three of these companies are experiencing a drop in profits, and would be keen to cut into ALL’s territory.

Victoria’s decision several years ago to smash the duopoly held by Tabcorp and Tattersall’s certainly reduced expenditure by these two companies on new machines. This drop off in sales combined with a stricter tax regime and bans on smoking indoors all contributes to ALL’s losing streak.

These numerous uncertainties make Aristocrat a risky play, and certainly not a stock of choice for lower-risk investors.

>>Back to the newsletter to view other articles – June 5th 2011

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