Talk about expensive tastes. In 2010, a man flying with Ryanair to the UK played one of their in-flight instant scratchies and won €10,000. However, he was so upset to learn that the cash wasn’t ready for him on the plane, he decided to eat the winning ticket in protest.
There’s a lesson here that mothers have been preaching for generations: don’t cut off your nose to spite your face. In the investing world, though, many do just that.
There’s a never-ending supply of business gurus telling us how companies can, and must, be growing. Growth stocks, growth strategies, growth funds. If a company isn’t growing, we’re told, it must have know-nothing management or poor industry conditions. Either way, it certainly doesn’t deserve your investment.
Wagering rebound is likely to be temporary
Lotteries in excellent shape
Margin improvement and steady growth
Yet the biggest problem when it comes to investing is not too little growth; rather, it’s paying too much for it. Lotteries operator Tatts Group won’t be found on the BRW Fast 100 list any time soon. But, here, we want to make the case that this is still a great company going for a reasonable price.
First, the bad news
No review of Tatts would be complete without mentioning the company’s problem child – its Wagering division, which covers tote and fixed odds betting on horses, greyhounds and the like.
There’s a war going on in the wagering industry and Tatts is losing ground to online competitors, such as Sportsbet (owned by Paddy Power Betfair), which has a lower-cost business model and can therefore charge lower commissions (see Tatts: The lottery that always pays?).
Recently, though, Tatts rebranded its wagering operations to UBET and, at least on the face of it, the strategy seems to be working. Wagering turnover increased 3% in the six months to June, compared to a 1% fall in 2015. Still, Sportsbet grew turnover 30% over that period so the division will need to do much better if it wants to keep up.
Unfortunately, with Sportsbet almost invariably offering better odds than UBET due to its lower cost structure, we’ll put the latter's recent resurgence down to the temporary triumph of marketing over logic. Operating earnings for the division are still 10% below where they were in 2009.
Reason for hope
Lower growth assumptions for the wagering business are a major part of why the stock is down almost 20% since the high watermark etched in January.
But there’s reason for optimism. Firstly, Tatts’ wagering operations account for only 23% of earnings before interest and tax (EBIT). It’s a sideshow compared to the big breadwinner – Lotteries – which we’ll get to in a moment.
What’s more, punters tend to have their rituals and habits. As Tatts’ latest result shows, getting the best odds isn’t always what customers are after – a speedy betting platform, loyalty programs, and a pleasant experience in the bricks-and-mortar TAB outlets are also important. With this in mind, we doubt there will be a sudden rush for the exits, just a slow migration of punters from high-cost bookies to cheaper, online and mobile alternatives.
Better still, Tatts may choose to offload the division entirely. A sale of the wagering business to larger competitor Tabcorp would open up several new markets for Tabcorp due to Tatts’ exclusive licences to operate in Queensland, South Australia, Tasmania and the Northern Territory.
In a February interview with Fairfax Media, Tatts’ chief executive Robbie Cooke said that a merger with Tabcorp would result in around $100m of cost-cutting synergies – most of which we assume would come from wagering, where there's the most business overlap. That level of savings will be hard to pass up if competition intensifies further. Potential merger talks have surfaced on at least three occasions over the past 10 years, but they have always ended over price rather than a lack of strategic merit, which gives us hope that a deal will one day be struck.
Don't eat the scratchie
The simplest way to gauge what the division might be worth if sold separately is to look at what investors are willing to pay for Tabcorp itself, because the company is as close as you get to a ‘pure-play’ wagering business.
But here’s where things get whacky. Tabcorp’s enterprise value (EV – the sum of its market cap and net debt) is 15 times underlying EBIT – which is on a par with Tatts' own EV/EBIT multiple.
To us at least, that doesn’t make sense, even after taking into account that Tabcorp’s wagering business is arguably in better shape than UBET and in more lucrative markets.
Around 73% of Tabcorp’s EBIT is from wagering – which faces increasing competition, shrinking margins and a loss of market share to online operators – whereas 76% of Tatts’ EBIT is from lotteries, which is the next best thing to owning the Royal Australian Mint. Investors seem to be throwing this rather big baby out with the bathwater.
Growth and margins
As we've explained previously, Tatts’ lottery business couldn’t be more different from its gambling cousin, Tabcorp. Tatts operates all the lotteries in Australia (outside of Western Australia), rebranded recently under the national monicker 'The Lott'. And 80% of EBIT from the Lotteries division is earned on exclusive licences with over 34 years to expiry. It's a regulated monopoly.
Growth has also been remarkably consistent, albeit slow. Lottery turnover has grown at around 4% a year over the past 20 years, and with relatively little volatility. Even during the financial crisis, turnover only fell 10%, but then quickly made up the losses – and then some – in 2011 through 2013.
There’s also a good chance earnings will grow faster than revenue. A large portion of Tatts’ costs are fixed so additional lottery sales fall quickly to the bottom line.
Margins should get a further boost from a shift to online ticket sales. Tatts’ digital lottery sales grew 32% in 2016, though they still represent only 14% of total sales. The good thing about online sales through Tatts.com is that the company is able to bypass the commission paid to middlemen retailers, such as your local newsagent, which is typically around 9%.
Indeed, thanks to more online sales and Tatts’ fixed cost base, the Lotteries segment’s operating margin has increased from 6% in 2007 to 16% today (see Chart 2). For the 2016 full-year result, an 8% increase in revenue led to an 11% lift in EBIT from lotteries, though we expect more modest growth in the mid-single digits over the long term.
Great company, fair price
All up, the quality of Tatts’ Lotteries division outweighs the risks associated with Wagering – so long as we can buy the stock at a reasonable price.
So what’s a fair price to pay for a business with reliable earnings, steady growth, long-dated operating licences, a clean balance sheet and plenty of free cash flow?
The company generated revenue of $2.9bn in the year to 30 June and an underlying net profit of $263m, or 18 cents per share, with underlying free cash flow being roughly the same. That puts the stock on a price-earnings ratio of 20 and a free cash flow yield of 4.9%. Tatts has a long-standing policy to pay out at least 90% of net profit, so the stock also sports a fully franked dividend yield of 4.8%.
Assuming annual growth of 4% or so over the long term – with slightly higher growth from Lotteries being offset by a decline in Wagering – total annual returns could be around 8–9% a year. And if the Wagering division’s turnaround is the real deal, that could add an extra percentage point or two.
So while Tatts isn't going to be the next REA Group, if you’re after reasonable growth and a steady yield, there’s still a lot to like. Tatts is currently a Buy up to $3.50, with a recommended maximum portfolio weighting of 5%. We’re very close to upgrading the stock and will hopefully get our chance soon. HOLD.
Disclosure: The author owns shares in Paddy Power Betfair PLC.