Aristocrat: Interim result 2015

After Aristocrat Leisure completed its acquisition of Video Gaming Technologies (VGT) on 20 Oct 14, investors got their first glimpse of the combined group's performance with the release of its 2015 first-half results this week (the company has a September year end). Comparisons with 2014 are difficult due to VGT's inclusion (see Table 1) but based on the subsequent 6% increase in the company's share price, investors were suitably impressed.

As we noted in Odell bets his reputation on 14 Jul 14 (Hold — $5.40), Aristocrat is expecting the primarily debt-funded VGT acquisition to transform its prospects. VGT leases 20,000 Class II machines to tribal casinos in Oklahoma and other states in return for a share of the machines' daily revenue. These machines are different to the Class III slot machines that Aristocrat sells or leases in the United States, Australia and elsewhere.

Casinos prefer leasing machines to purchasing them outright because of the lower cost and the lower risk of purchasing an unprofitable machine. Slot machine makers like Aristocrat and Ainsworth Game Technology also prefer leasing their machines as it can lead to higher margins while also reducing the variability of their revenue. This is because casinos' purchases of new or replacement machines tend to be lumpy and heavily influenced by economic conditions and the amounts gambled by their customers. 

America the profitable

Combined with the 12% increase in Class III machines leased by Aristocrat, the company's 'installed base' of leased machines is now around 30,000. Even better, the average revenue per day earned on its Class II and Class III machines increased by 11% and 16% respectively, helping the company generate 47% of its revenue from recurring sources in the first half of 2015. This is more than double the 22% earned in the first half of 2014 so in that sense the VGT acquisition has certainly been transformational.

By contrast, the North American market for outright sales of slot machines contracted by 25% in the half. Aristocrat continues to gain market share, however, with its sales declining by only 15% due to the popularity of its Helix cabinet. Along with the 6% increase in the machines' average selling price, to US$16,462, this suggests that recent consolidation in the industry has not yet had a major impact on prices. There's every chance of this in future, however, particularly if highly indebted competitors Scientific Games and International Game Technology attempt to gain market share to repay their debt.

Aristocrat's North American revenue increased 75% to US$333m, with the improved margins as a result of the inclusion of VGT's leased machines helping segment profit rise by 118% to $158m.

Antipodes & digital strong

Aristocrat's other major segment, Australia and New Zealand, also had a fine first-half performance, with profit increasing 37% to $46m in constant currency terms. Although the slot machine market only rose 12%, Aristocrat's sales increased 54% with the release of the Players Choice Sapphire and Diamond editions along with the Lightning Link family of games.

These games helped make the company's Helix cabinet the best-performing cabinet in NSW and Queensland and helped it increase the average selling price by 23% to $19,797. Aristocrat expects to maintain its share of games sold but we'd expect strong competition from other manufacturers including Ainsworth as they release new games upon receiving approvals in various jurisdictions.

Aristocrat's fastest growing segment is Digital, where segment profit more than doubled to $16m as the company's Heart of Vegas application was released on the iPad and iPhone. We think Digital profits will continue to rise quickly as Aristocrat expands the distribution of its content – Heart of Vegas will likely be released on Android later this year – and as various jurisdictions continue to relax laws against online gambling.

The company's International Class III segment was the only part of its continuing business to decline, with sales of slots to new casinos in Macau offset by weak conditions in Europe and South Africa. Aristocrat also recently decided to exit the Japanese pachislot business. 

Dividend steady

The VGT acquisition also transformed Aristocrat's debt position, although here too the early signs are positive. The improved results in North America, Australia and New Zealand, and Digital, pulled gearing (net debt / EBITDA or earnings before interest, tax, depreciation and amortisation) down to 2.9x, from 3.6x at the time of the acquisition (before taking into account funds raised from the Ainsworth family offering and share purchase plan as part of the VGT acquisition). 

As previously flagged, the company maintained its interim dividend at 8c per share (unfranked) to help pay down debt. The company continues to expect a short period where dividends don't increase as the funds are allocated to debt repayments but the Board will continue to monitor its capacity to increase dividends should results continue to improve.

Even though nearly half of Aristocrat's revenue now comes from recurring sources and it pays only 5% interest on its debt, we'd still like to see it reduced as quickly as possible. Revenue from both recurring sources and outright sales will likely be affected should the American economy enter a recession or Aristocrat's games become less popular.

Updated price guide

The sum of all this is that Aristocrat now looks to be in its best shape ever, despite risks from its high debt burden and from increased competition in North America and Australia. Unfortunately, as can happen with value investing, it appears we sold too soon on 17 Oct 14 (Sell — $6.03) – and we must reflect the company's transformation by transforming our price guide.

Assuming Aristocrat's second-half profit (adjusted to remove amortisation of intangibles) is similar to its first half as indicated by management, it should earn around 34 cents per share in 2015, putting it on a forward PER of 24. Given the risks we'd be looking for something in the mid-teens to make a purchase, suggesting a Buy price of around $5. If you ignored our Sell recommendation, though, then we'd suggest hanging on a little longer to see how much further the company's transformation can take it, and we're raising our Sell price to $10 accordingly. The result of these moves is that our recommendation moves back to HOLD.