Tatts: Interim result 2017

‘Reversion to the mean' is an important concept, but especially so for gaming company Tatts Group. There were 15 lottery jackpots above $15m in the six months to December, down from a record 24 in the previous corresponding period.

At first, that may seem like a good thing – Tatts is the one paying out the jackpots, after all. Unfortunately, though, without the chance to dream big, people are less inclined to buy lottery tickets, and this caused a 26% decline in revenue from the Powerball and Oz Lotto games for the six months to December. Excluding jackpot games, the rest of the division increased revenue 7%.

Overall, revenue for the Lotteries division – which accounts for 75% of operating earnings – fell 8% to $1.0bn, with earnings before interest, tax, depreciation and amortisation (EBITDA) down 11%. Most of Tatts' costs are fixed and that works wonders on margins when the business is growing, but it also means that losses tend to be supercharged, too.

Turning to the company's UBET wagering operation, fixed-odds racing and sports revenue was up 8% thanks to a 3% increase in turnover and a higher win-rate. The company has rebranded its 280 retail wagering outlets under the UBET brand and management said brand awareness among punters has doubled over the year.

This wasn't enough, however, to offset a sharp decline in tote betting. Overall, wagering turnover fell 5%, with revenue down 2.5% and EBITDA down 12% – again due to the large proportion of fixed costs. Management said it had changed its focus to revenue growth, rather than turnover growth, and an improved win-rate of 15.6% – up from 15.2% – suggests that shift is already having an effect.  

Not convinced

We have mixed feelings about the switch. On the one hand, a focus on margins over turnover can drive short-term revenue growth, as was the case this half. On the other hand, widening margins means less money in the hands of punters – either the company is offering worse odds or fewer promotional bonuses to customers.  

As we explained in Tabcorp: Result 2016, the wagering divisions of both Tatts and Tabcorp face an uphill battle against lower-cost online operators. The companies' biggest threat is Australia's largest online wagering outfit, Sportsbet – owned by UK-based Paddy Power Betfair.

Sportsbet already almost invariably offers better odds than Tatts due to its lower-cost operating structure, and customers have been flocking to online providers at the expense of traditional bookies. We can't see how Tatts offering even worse odds under a ‘win-rate optimisation' strategy is going to solve that problem. Indeed, Sportsbet grew turnover by 23% in the six months to December, suggesting Tatts is still losing market share to the company.

Net profit fell 17% to $123m due to that nasty base of fixed-cost retail outlets, as well as $10m of expenses related to the proposed merger with Tabcorp. Both companies' boards of directors support the merger but it still needs to pass various regulatory conditions, as well as get approval from the courts and the wagering and lottery regulators in each state. Tatts' management says it is happy with progress to date and the Australian Competition and Consumer Commission (ACCC) is expected to make a judgment on 9 March.

Raising price guide

Tatts has a monopoly position, long licences and is highly cash generative. The stock currently sports a forward price-earnings ratio of 23 based on consensus estimates for full-year earnings.

Under the proposed merger with Tabcorp, Tatts shareholders will receive 42.5 cents in cash plus 0.80 shares of Tabcorp, for a total implied value of $3.90 given Tabcorp's current share price (that's in addition to Tatts' 9.5 cent interim dividend). We think the deal undervalues Tatts, particularly given its more reliable Lotteries monopoly (though you wouldn't know it from this result). We aren't in favour of the deal and would rather see Tatts sell its ugly Wagering division to Tabcorp, leaving a standalone Lotteries operation.

Nonetheless, at least $130m of duplicate costs are expected to be cut from the combined businesses, which would add well over $1bn of value for shareholders. There was even a second deal on the table until the board knocked it back, so Tabcorp clearly isn't the only party interested. It isn't too late for a better offer to come in.

Although this was a poor result, we're raising our recommended Buy price to reflect the higher odds that a deal will go through. If the ACCC rejects the merger on 9 March, our valuation will decrease and we will again lower our price guide. For now, we're sticking with HOLD.  

Disclosure: The author owns shares in Paddy Power Betfair PLC.