Tabcorp: Interim result 2019

In the lead up to the acquisition of Tatts by Tabcorp, the merger was trumpeted as a cost-cutting story. Management pitched that it could use the combined company's scale to make marketing dollars go further and cut duplicate costs.

True to its word, Australia's largest wagering and lotteries group reduced administrative costs in the six months to December, and management increased its forecast savings for the full year from $80m to $95m. Management is now targeting as much as $145m in cost savings by 2021, up from $130m at the time of the merger.

Still, two numbers in the interim result worry us - probably the same numbers that caused the stock to fall 4% immediately after it was released.

The first is flat turnover in the company's Wagering division, which accounts for just under half of total revenue. Digital turnover grew 12% but this only just offset large declines in retail and call centre turnover. This led to a 5% decrease in Wagering revenue to $1.3bn. 

The other number of concern was the yield on TAB fixed odds Racing and Sports, which fell from 15.2% to 13.5%. These yields are 'post generosities'. In other words, the company is so aggressively chasing new punters with bonus bets and other financial incentives, that it's willing to forgo some of its profit margin. The strategy is working, though, with active customers for TAB rising 7%, but the new customers weren't big spenders and revenue for TAB still fell 4%.

The company's UBET business - the wagering operations previously belonging to Tatts - had an even worse year than TAB, with both turnover and revenue down 7%. Management attributed the poor result to UBET being rebranded under the TAB banner, causing disruption, and the discontinuation of some wagering offerings as it transitions to TAB's platform.

All this reinforces our view that the cost of acquiring new customers is rising and is likely to continue doing so. Marketing spending and financial incentives have increased dramatically over the past few years to defend against competition from online operators, so industry profitability is declining. Since 2009, Tabcorp's earnings before interest and tax (EBIT) margin of the combined wagering operations has fallen from around 17% to 13%.  

Lottery jackpots

Thankfully, the Lotteries division picked up much of the slack, with revenue up 20% to $1.3bn. Speaking to the strong economies of scale in this business, operating costs rose a modest 4%, which led to a 33% jump in EBIT. Management said that several big-ticket jackpots had attracted more punters, which contributed an extra $45m or so to revenue. While we're glad to see the revenue bonus from big-ticket jackpots, we can't count on them every year - they're lotteries after all - so it would be a mistake to assume this level of revenue and earnings continues. A slight decline next year wouldn't surprise us.

The Lotteries division had some further good news to report, with synthetic lottery products being prohibited nation-wide starting in mid-January. Synthetic lotteries - where a punter bets on the outcome of a lottery, without directly participating - are one of the few competitive risks to Tabcorp's monopoly over Australian lotteries. 

The stock trades on a forward price-earnings ratio of around 22 based on concensus estimates for 2019 earnings. Tabcorp's Lotteries division is a significant asset but we're mindful of the anaemic organic growth in the company's wagering business and its net debt of $3.3bn. HOLD.