Tatts and Tabcorp get green light

As far as analysts go, I don't have a typical background. I began my career working for a professional gambling syndicate and I've bet on a good 20,000 horse races over the years. Without getting too side-tracked about the surprising overlap with value investing, one company was at the heart of my daily life: Tabcorp.

Not only was the syndicate Tabcorp's largest customer, but we also worked from the top floor of Tabcorp's Sydney headquarters. This gave me a birds-eye-view of a rapidly changing industry and I walked away in 2010 with one glaring conclusion: I'd much rather be a Tabcorp customer than one of its shareholders.

The company's operating profits have halved since 2010 – in fact, you need to go back to 1999 before you find a figure lower than that for the year to December 2016. What could be worse? Perhaps realising that the number of shares outstanding is up 37% since 2010 and has almost tripled since the eve of the millennium. The company's intrinsic value per share has been on a steady decline for more than a decade.

The reason for this value bleeding is simple: rising competition. Online bookmakers – the largest of which is Paddy Power Betfair, owner of Sportsbet – have a significant cost advantage over Tabcorp and smaller competitor Tatts Group because they don't have to maintain expensive retail outlets.

The differences add up: Sportsbet's business model means that punters only lose around 10% in commissions, compared to the 15–20% takeout at a typical TAB. Betfair does even better, with a takeout of only 5% or so. If you're off to the races this Saturday, these companies almost invariably offer better odds than those you would receive on the track or at a physical Tabcorp or Tatts outlet (trust me, I've shopped around).

Paddy Power Betfair has been chipping away at the two incumbents' market share and it now accounts for 12% of all Australian sports betting and a quarter of the online market. Given that Tabcorp and Tatts started with a cozy oligopoly and enormous economies of scale, it's an impressive feat.  

All systems go

The question now is whether strapping two tortoises together is enough to beat a hare. The Australian Competition Tribunal (ACT) has given a green light to the $11bn merger of Tabcorp and Tatts – despite opposition from the Australian Competition and Consumer Commission (ACCC).

‘The tribunal is satisfied that the proposed merger is likely to result in substantial public benefits,' said ACT president Justice John Middleton, ‘and the public detriments identified by the ACCC and the interveners are unlikely to either arise or are not of significance, the tribunal is satisfied in all the circumstances that the proposed merger would result, or would be likely to result, in such a benefit to the public that the acquisition should be allowed to occur'.

The wording is intricate because the ACCC and ACT apply different tests: the ACCC is tasked to ensure the merger doesn't substantially lessen competition, while the ACT reviews whether the merger is in the public interest.

The ACCC had several concerns when it released its preliminary view in March, so Tabcorp withdrew its application for informal clearance by the ACCC and sought authorisation from the ACT, hoping it would balance public benefits against a less competitive industry.  

The disagreement between the ACT and the ACCC is telling and implies that competition within the industry will be reduced – no surprise there – but that the merger is still a good thing for punters and taxpayers.

Winners and losers

The wagering industry has lots of fixed costs, such as IT infrastructure, compliance and shopfronts. Scale really matters, which is why the merger – at least from the perspective of Tabcorp shareholders – makes perfect sense. On completion, the combined business will have revenue of more than $5bn and earnings before interest, tax, depreciation and amortisation (EBITDA) of more than $1bn. More importantly, around $130m in duplicate expenses are expected to be cut.

Unfortunately, the companies cannot simultaneously eat their cake and keep it. If Tabcorp and Tatts want to stem the migration of customers towards lower-cost alternatives, they will need to pass on the savings as better odds and offerings to punters.

As the cost cuts flow through, we expect betting turnover to pick up – the national pooling of parimutuel wagering might even give tote turnover its first uptick in years – but widening margins is a dream. Overall, we think the deal is good for customer retention, and will probably lead to some revenue growth, but we aren't holding our breath for a big impact on long-term profits. Most of the spoils will go to the public.   

Approval by the ACT was arguably the merger's biggest hurdle, but there are still a few other bits of paperwork that need signing. An independent expert must conclude the proposed transaction is in the best interest of Tatts' shareholders; a few other regulatory and government approvals are in the works; and the Federal Court needs to give its nod too.

Tabcorp has the most to gain, but we think Tatts shareholders are getting a poor deal. The company's lottery division is a regulated monopoly and offers a stable, growing income, while earning extremely high returns on tangible capital. Lotteries currently account for 70% of Tatts' EBITDA, but the merger will reduce that to just a third for the combined business – with the rest coming from the struggling wagering divisions. As Charlie Munger put it, ‘when you mix raisins and turds, you've still got turds'.

With a forward price-earnings ratio of around 27, Tatts' current share price is below our estimate of intrinsic value. However, the share price is slightly above the implied offer price of $4.11 under the Tabcorp proposal (0.80 Tabcorp shares and 42.5 cents in cash for each Tatts share held). This suggests investors still expect a better offer to come through from a third party, which could sway the board's support for the deal. HOLD.

Tabcorp shareholders are one step closer to getting a stronger company, added scale and one of Australia's best businesses – Tatts' lotteries monopoly – for a reasonable price. With a forward price-earnings ratio of around 21, we continue to recommend you HOLD.

Disclosure: The author owns shares in Paddy Power Betfair.