Aristocrat Leisure: Interim result 2017

With Aristocrat Leisure's games now representing 64% and 54% of the top 50 games in New South Wales and Queensland, respectively, it's no surprise its latest interim result was a cracker (see Table 1).

By far the market leader in terms of poker machines already installed in hotels, clubs and casinos, Aristocrat also sells around 60% of the new machines sold each year. While this is a great achievement, it means that growth is likely to be limited here in Australia. 

We might already be seeing some signs of this. Aristocrat's recently-released Dragon Link series of games is proving as popular at this early stage as its Lightning Link series, but still Aristocrat sold around the same number of machines as in the first half of 2016.

With average selling prices falling by 6%, to $20,504, revenue inched down 1% but cost savings meant segment earnings before interest and tax (EBIT) rose slightly, by 1%, to $92m (all figures in constant currency).

Selling prices fell because Aristocrat has started rolling out its ACCESS subscription model, where casinos or clubs pay a discounted price for the machine upfront then lease the software and games over three years. Purchasers benefit from the lower initial capital outlay and ongoing support while Aristocrat's profit on each machine is higher over the life of the agreement. Early signs suggest this model could prove popular.

North America

Even so, Aristocrat has much better growth opportunities elsewhere, starting in the Americas, its largest segment (see Table 2).

Outright sales of Class III machines (see Shoptalk) rose 26% in the first half, to 6,760 – above the market growth of 18%. Aristocrat's Arc Single cabinet performed strongly due to popular games Buffalo Gold, Gold Stacks, Five Dragons Gold and Whales of Cash. Its Helix cabinet also sold well due to games such as Red Black, Wonder4, Pure Gold and Midnight Unicorn. As a result, the company was able to increase its average selling price by 4% to US$18,901.

Class III machines ‘on participation' – machines leased to casinos in return for a share of daily winnings – rose by an even more impressive 32%, to 15,320. The extremely popular Lightning Link and Buffalo Grand games, along with Sharknado and Game of Thrones, were the reason, and Aristocrat now has a 28% share in this section of the US market.

With Lightning Link continuing to be rolled out and Dragon Link following it shortly – both of which are only offered ‘on participation' (ie casinos can't buy machines that include these games) – Aristocrat is well placed to keep improving its share of the Class III participation market and hence revenue from recurring sources.

And, on an absolute basis, Aristocrat is fast narrowing the gap to its Class II machines on participation, which rose by a more sedate 4%, to around 22,000, as a result of new casino openings and expansions at existing casinos.

The Cashman cometh

In addition to the Americas, Aristocrat's Digital business is also going from strength to strength and will likely soon overtake Australia & New Zealand in terms of segment profit.

There are low barriers to entry to the online gaming market: anyone can develop an app and, if approved by Apple or Google, allow punters to download and play their games.

However, in practice, global slot machine manufacturers like Aristocrat, IGT and Scientific Games and their smaller competitors such as Ainsworth Game Technology possess competitive advantages in the form of their existing game libraries and expertise in developing new games that are popular with punters. (Something that Ainsworth has struggled with recently, admittedly).

Their ability to fund the acquisition of customers in onling gaming using the profits from their other businesses and the opportunity to spread their large design and development expense – Aristocrat spent $130m in the half – over both physical games and online games are further competitive advantages. This is why the global slot machine manufacturers also have strong positions in the online social gaming market.

So it's not surprising that Aristocrat's new Cashman Casino app – based on the popular Mr Cashman pokie game – has quickly been successful despite only being released on Android in December 2016.

Cashman Casino and Heart of Vegas – its other app – operate on a ‘freemium' model: punters can play various pokie games online for free then have the option of purchasing additional gold coins to keep playing.

As only around 5% of users actually choose to fork over real money, daily average users is an important metric. Combined, these two apps had 1.40m daily average users at the end of March 2017, up from 1.27m at 30 September 2016 and 1.26m at 31 March 2016.

On average, these users also spent more, with Aristocrat earning US$0.49 per daily average user compared to US$0.42 at 30 Sep 16. The operating leverage inherent in software businesses meant margins increased, from 39% to 44%, pumping up segment EBIT by 53%, to $77m (in constant currency). 

The company plans to release more apps in coming years. 

Elsewhere, new casino openings in Malaysia, The Philippines and South Africa meant that International Class III revenue more than doubled. Operating leverage again helped which, along with selling higher margin cabinets and games, meant segment EBIT more than tripled.

Recurring revenues

With more than half Aristocrat's revenue now ‘recurring' in nature – defined as the revenue received from both Class II and Class III machines on participation as well as digital revenue – this has helped reduce normalised working capital as a percentage of sales (from 11.9% to 7.9%). Along with the copious cash flows from its still growing business, net debt has fallen to just less than one times earnings before interest, tax, depreciation and amortisation, from almost two times in the prior corresponding period.

As a result, the company raised its interim dividend by a whopping 40% to 14.0 cents per share, 25% franked.

As we noted in Aristocrat switches jockeys, Aristocrat is a cyclical business but continued underlying growth in the Americas and Digital appears likely. Furthermore, the business is probably less cyclical than it used to be now that more than half its revenue comes from 'recurring' sources. 

To a degree, the company has been in the right place at the right time, but you make your own luck and it certainly did that with the acquisition of VGT in North America, as well the digital business Product Madness. It has also executed its plan almost flawlessly.

Clearly our Sell recommendation at $6.03 almost three years ago was premature, but there were significant risks at the time (not least from a large pile of debt) and if we're going to err, we'd prefer it to be on the side of caution. Anyway, that's the past and our focus is on the future; and given the company's improving fortunes we're raising our price guide again, with our Buy price increasing from $12 to $16 and our Sell price going from $20 to $26.

The reduced risks – largely from lower debt and increased recurring revenues, means we're also bumping up our recommended maximum weighting to 6% (from 5%). However, if your holding is close to or above this limit, we continue to suggest reducing it below that level. HOLD.