According to Jean-Baptiste Colbert, finance minister to Louis XIV, “the art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest amount of hissing”. Withholding tax from your pay neatly accomplishes this: there’d be far more hissing from citizens if they had to pay income tax in one big chunk at the end of the year like they used to.
Like paying taxes, no-one enjoys losing money gambling and the likes of Aristocrat Leisure and Ainsworth Game Technology have adopted similar tricks, including programming their machines to pay regular but small wins, to hide that players are destined to be heavily 'plucked' in the long run.
Intecq (FKA eBET) helps this process along through its cashless card-based or 'ticket-in, ticket-out’' technology and loyalty programmes, which all aim to encourage punters to keep playing the slot machines. The company was too small to be an official recommendation when discussed in a special report on small stocks but its shares have doubled since then and it’s time to take another look.
Strong market positions
Long term contracts and high switching costs
Half of revenue is recurring
In March 2015, Intecq discontinued its Gaming Machines division – which sold pokie machines manufactured by US-based WMS, owned by Scientific Games – and now has two divisions. Its Gaming Systems division sells systems that help pubs, clubs and casinos lower costs and increase the amount of money bet in their pokie machines.
These include its TRACE loyalty system, its cashless paper ‘ticket-in, ticket-out' technology and its card-based CARD-IT system, with the latter two enabling players to cash out of machines without requiring an attendant and also to transfer credits between machines. It also includes the Metropolis central monitoring and reporting system.
This division supports its Gaming Operations division, which provides hardware and software support and also earns technology licence fees. Gaming Operations also includes Odyssey Gaming, which provides central monitoring services, machine maintenance and service to its Queensland customers.
The company’s strategy involves selling a system such as Metropolis to a pub or club, then generating additional revenue over a number of years by supporting and maintaining this system through its Gaming Operations division. Once it has sold one of its systems, it's in an ideal position to sell additional products such as CARD-IT to the venue owner while also earning additional income from system upgrades.
The investment required to develop and continually improve its systems along with the stringent regulations set by gambling regulators mean the barriers to entry are fairly high. More importantly, however, Intecq’s systems form an integral part of a gaming establishment’s business, particularly if the customer has purchased multiple Intecq products. Along with the long term contracts that are typically the norm in its Gaming Operations division, this means customers face significant switching costs if they want to install a competitor's product.
All this means that once Intecq gains a customer, they tend to stay.
The place to be
Helped by its successful entry into the Victorian market in 2015 – its systems were in nearly 1/3 of the state’s pokie machines at 31 Dec 15 – Gaming Systems revenue has grown dramatically recently (see Table 1).
|Gaming Systems ($m)||12.0||24.3||13.8||14.0||9.4|
|Gaming Operations ($m)||14.3||25.7||21.6||21.0||20.2|
|Gaming Machines ($m)||-||0.9||4.7||7.4||11.9|
|Note: Gaming Machines discontinued March 2015, Other revenue excluded|
Gaming Operations revenue has also grown, albeit more sedately. We expect it to continue to grow as the number of pubs and clubs running Intecq’s systems expands, creating greater cross selling opportunities.
All things equal, the income from the Gaming Operations division – which is now more than half total revenue and also 'recurring' in nature – should be valued more highly than the potentially more variable revenue from its Gaming Systems division.
Nevertheless, a slowdown or even a reversal in its Gaming Systems division remains a risk. Slower growth is more likely now that the rollout in Victoria is ‘complete’, according to management, and the company already has large market shares in NSW, Queensland and Victoria, which combined account for 85% of Australia’s nearly 200,000 pokie machines. A growth runway, once large, has shrunk dramatically.
Perhaps this is why management revealed at the 2015 AGM that it was exploring opportunities to utilise its technology and intellectual property in adjacent sectors while also hoping to expand in Asia and pursue further acquisitions.
Intecq’s 7% free cash flow yield and PER of 12 appear attractive but we note that the company didn’t pay any income tax in 2015 due to accumulated tax losses (see Table 2). After adjusting 2015 NPAT for the large tax benefit and assuming a 30% tax rate, Intecq’s PER rises to 22.
|U'lying NPBT ($m)||6.1||3.6||2.9||2.4|
|U'lying NPAT ($m)||8.9||2.9||2.7||2.0|
|U'lying EPS (c)||0.51||0.19||0.18||0.13|
The company will also benefit from utilising tax losses in 2016 but its tax losses will soon be exhausted if it maintains current profitability. So taking the midpoint of management's guidance for net profit before tax of $7.7m-8.2m and applying a normal tax rate, its forward PER is 17.
Intecq is a fine business with strong market positions, a clean balance sheet, and, with more than half of its revenue recurring in nature, generates high returns on capital. With the operating leverage in its business, revenue growth could generate outsized earnings growth but revenue from its core gaming market is likely to slow. New growth will come from new markets, a risk that is not captured in the share price today.
It's not hard to make a sensible case for buying today but investors should show caution. Operating leverage works on the way down just as powerfully as on the way up and new markets will be harder to penetrate. We’d love to own Intecq but the possibility of a slowdown or even reversal in its Gaming Systems division gives us pause. For now, HOLD.