Betting on Aristocrat

They say ‘Content is king' and Aristocrat Leisure's latest half-year result certainly makes the case. The company's results presentation was a sea of upward-pointing green arrows.

Revenue was up 47% to $1.0bn for the six months to 31 March and underlying net profit rose 66% to $183m thanks to increasing market share, particularly in the USA, and strong growth in digital sales.

The star of the show was Aristocrat's Digital business, which doubled revenue to $119m due to the growing popularity of the Heart of Vegas app on iOS and Android.

We're big fans of the Digital division for a couple of reasons. Aristocrat's older business – selling slot machines to casinos – is often a matter of feast or famine and is exposed to swings in the economy. Revenue from online games, however, is stickier as players come back day after day. 

This, along with the 2014 acquisition of VGT – which leases gaming machines rather than selling them outright – has caused a big change in Aristocrat's business model. Some 50% of revenue is now considered ‘recurring', compared to just 13% in 2013, which makes for more predictable cash flow.

The other good thing about Aristocrat's Digital business is that it has significant operating leverage, which supercharges profit growth.

Developing an app is a large, upfront fixed cost – but a little more of each additional sale falls straight to Aristocrat's bottom line. This period is a case in point: the large jump in revenue, combined with a lesser rise in expenses, led to an increase in the Digital division's operating margin from 31% to 39%.  

Design and development

Making attractive content is the cornerstone – some might say the only stone – of the gaming industry and requires lots of spending on design and development (D&D).

D&D spending increased 19% to $108m after removing the effect of currency fluctuations and accounts for a third of operating expenses. Management aims to keep D&D spending as a proportion of revenue in the ‘low to mid teens', but it fell from 12.3% to 10.7% this half due to the rapid sales growth.

D&D spending can be quite volatile, so to see whether it has been money well spent we need to add back D&D expenses to Aristocrat's earnings before interest and tax (EBIT). This figure too, though, jumps around due to the cyclical nature of the industry, so we'll smooth out the bumps by taking a three-year average.

Before we pull out the calculator, though, make no mistake – D&D is a crucial expense, and a very real one. If Aristocrat were to cut design and development, it would temporarily improve profits but would quickly erode the company's competitive position against the likes of Ainsworth Game Technology, which similarly spends around 10% of revenue on D&D.

The earnings figure itself doesn't mean much but the margin is useful to see changes in underlying profitability. And indeed it has changed – Aristocrat's pre-D&D operating margin has gradually risen from 31% for the three years to 2013 to 35% more recently (see chart 1). When talented content developers meet a business with operating leverage the mix can be powerful.

With this in mind, we were more than happy to see the $23m uptick in D&D spending this half, and to hear that management expects it to increase further in the second half – both in dollar terms, and as a proportion of revenue.

North America

Outright machine sales in North America – Aristocrat's largest market – grew 26% to US$420m thanks to more units being sold and a higher average selling price. This was all the more impressive because the overall market was flat, and speaks to the popularity of Aristocrat's games such as Lightning Link, Game of Thrones and a new Britney Spears game. Increasing market share has been the norm for several results now.

This was echoed in Australia and New Zealand, where revenue rose 64% to $213m thanks to higher unit sales and a 10% increase in the average selling price. Management expects sales of its Arc and Helix cabinets to continue to grow due to soon-to-be-released games such as Big Bang Theory and The Walking Dead II.

Free cash flow more than doubled from $86m to $180m due to a reduction in working capital and faster payments from customers, which itself is thanks to the growing Digital business and VGT acquisition. The company used the deluge of cash to reduce net debt from $1.5bn to $1.2bn.

Raising price guide

Management expects the business to achieve similar profitability in the second half of the financial year, implying underlying earnings per share of around 58 cents, and putting the stock on a forward price-earnings ratio of 22.

There's no doubt we have significantly underestimated Aristocrat's turnaround over the past few years. The VGT acquisition has been far more successful than we, and the company's management, expected. The Digital segment, too, has beaten forecasts. 

The stock is up more than five-fold since we most recently upgraded it on 2 Jul 12 (Long term buy – $2.45), but we pulled the trigger too early when we recommended you Sell on 17 Oct 14 (Sell – $6.03). We've been playing catch up ever since.

We're increasing our recommended Buy price from $5 to $8 and our Sell price from $10 to $16 to reflect the fast-growing business. A share price of $16 would put the stock on a forward PER of around 28. That's steep for most stocks, but for a company that has more than doubled revenue in two years and shows no sign of losing momentum it may still not reflect Aristocrat's potential. We'll cross that bridge when we come to it.

Still, it's important to be mindful of the company's shortcomings. Aristocrat's large debt pile has always been a concern, though we're pleased to see management paying it off. There's also the risk of unfavourable regulatory changes, as the distinction between Class II and Class III games is becoming redundant (see Odell bets his reputation). Nonetheless, Aristocrat has operating leverage, outstanding content and a growing stream of recurring revenues. HOLD.

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