TAH is a collection of two businesses in the same industry but with very different outlooks 1) The lotteries business which benefits from a long term track record of delivering annuity style revenue growth while requiring a low level of incremental capital to generate additional returns; and 2) the rest is dominated by a wagering business facing structural headwinds but does possess unique competitive advantages relative to corporate bookmakers that should (at some point) arrest it’s declining market share.
Lotteries has a long track record of consistent growth and there are a number of attractive features relating to the business model:
- Has delivered a 40 year track record of steady turnover growth (as per the chart below) which supports a higher multiple as an annuity style revenue growth business – roughly in line with GDP.
- Operates an effective monopoly in the states and territories which is operates with 98% market share. There is limited near term threat to this as licenses in most jurisdictions (ex Victoria) extend beyond 2050.
- Lotteries will benefit from margin expansion as acquisition channels shift to online and fewer commissions will need to be paid to newsagents.
- Operates a capital light business model which requires minimal ongoing maintenance expenditure and underpins the ability to generate significant free cashflow in the future.
- Lotteries benefit from a negative working capital cycle as cash is received upfront from customers which helps to manage cashflow and minimize the working capital drag on FCFF.
Wagering has been a troubled business in the last few years although there are a number of factors which should support an improvement in industry profitability.
- Overall industry growth remains positive (+4.2%) which should partially mitigate losses in market share as corporate bookmakers continue to grow via digital channels.
- Consolidation amongst corporate bookmakers sets a solid foundation for rationalizing competitive behaviour due to the improved market structure. This should ultimately translate to less aggressive generosities and marketing, ultimately supporting higher yields and margins for the industry as a whole.
- TAH does have some competitive advantages over corporate bookmakers including totalizer licenses and a significant bricks and mortar presence.
- TAH is still in the midst of realizing synergies from the merger with Tatts which should provide an additional ~$50mn boost to EBITDA according to company announcements.
Valuation – I have used a DCF to reflect the long term growth potential of the lotteries businessand better capture long dated cashflows. I arrive at an equity valuation of $7.445bn which represents ~15% upside from the current price (2/6.)
Lotteries & Keno
Lotteries has a long track record of consistent turnover growth which makes it an attractive business for investors. There are a number of characteristics which ensure it is well suited to continue to grow over the long term and as a result, this segment underpins the majority of my valuation.
1) Consistent underlying growth trends – over the past ten years, lotteries turnover in Australia has grown at approximately 2.5% p.a. with lotto growing at an average rate of 3.3% per annum (not including 2019 which saw an abnormal jackpot spike) while instant lottery, charitable and other lotteries and sports pools have experienced an average decline in annual growth of 1.7%, 6.4% and 2.9% respectively. Since 1992, Tatts turnover has grown at an annualized rate of 3.7% and 4.9% since 2010. This growth has been relatively consistent in spite of economic downturns and is the foundation for my long dated revenue growth assumptions.
2) Favourable market structure – TAH benefits from 98% market share across the states and territories that it operates in (everywhere in Aus ex WA.) The market is controlled by exclusive government licenses which ensure that there is minimal competition for volumes outside of slightly alternate products such as betting on lottery outcomes (Lottoland.) The bulk of these licenses (when measured by volume of turnover) won’t expire in the next 30 years which provides a strong foundation for modelling out a long term, 25 year forecast horizon in a DCF.
3) Operating leverage – The lotteries business has benefitted from steady margin expansion driven by a continued migration to online channels (currently sitting at 23.5%.) This enables TAH to bypass the ~9% commission that they have historically paid to newsagents. Additionally, TAH benefits from economies of scale related to overheads (people, PPE etc) which should provide the business with operating leverage as it continues to grow. A good indicator of this is the lotteries extremely high turnover in 2019 as a result of an abnormal jackpot cycle which delivered 170bps of margin expansion vs. the prior year. This highlights that as volumes grow, a reasonable percentage of their costs are fixed and therefore, margins can continue to expand.
4) Capital light business model – The outlook for the lotteries business to deliver significant free cashflows to shareholders is strong, underpinned by a low level of capital intensity. Capex has historically been within the range of 5-10% of EBITDA prior to the merger. There does appear to be increased capital allocated to the segment post 2017 however, it has remained within the band of 1-3% of sales or 5-15% of EBITDA in this period. Note that a significant component of this has been capex related to restructuring and I am forecasting capital expenditure to return to ~10% of EBIT in a steady state.
5) Substantial negative working capital cycle – Revenue is generated primarily in cash or via cash payments systems while a significant proportion of payments are made over longer timeframes (e.g. product payments, wagering taxes, major lottery prizes). This results in TAH receiving cash payments upfront and not needing to distribute cash until winnings are paid. This is further supportive of TAH’s high cash conversion and underpins TAH’s ability to generate free cashflow.
Building out Lotteries & Keno assumptions
Some of the major assumptions I have made to derive my lotteries valuation below –
- Revenue: In the short term I assume revenue growth of -12.5% in FY21 as TAH cycles a very strong run of jackpots followed by a return to consistent growth of 3.25% (well below long term trends and slightly below trends over the past decade to retain a margin of safety.) I forecast Keno revenue to grow at 2% which is below the 10 year average of 4% as I adjust for structural changes earlier in the decade that allowed increased penetration in NSW and SA.
- EBIT margins: TAH is likely to benefit from two majors sources of margin uplift over my forecast horizon. TAH’s 2019 Lotteries margins were 16.1% which I forecast to expand to 22% by 2045 by expanding 30bps per year.
- Ongoing operating leverage as TAH’s overhead cost base is spread over large volumes. From 2014 to 2019 TAH generated 270bps of margin expansion, of which 61% I attribute to the increase in the digital channel leading to lower commissions to newsagents. The remaining 39% is due to operating leverage as volumes have grown. This accounted for 17.5bps of margin expansion per year while digital penetration accounted for 27.5bps per year.
- Continued penetration of the digital channel (currently 23.5%) which will enable TAH to recover more of the ~9% of margin that it currently pays as commission to newsagents. The sensitivities surrounding margin upside can be found below.
- I assume Keno’s margins to remain at 2018 levels which were the lowest in 7 years. In reality, Keno will likely benefit from some form of operating leverage too however, this is not part of my base case.
- Capex: Lotteries capex is focused on the distribution network and fluctuates depending on projects being rolled out. Given that terminals are essentially nationally rolled out already, the online technology platform is developed and the acquisition is bedded down after FY21, the requirements for capex should be limited to maintenance which as previously discussed is minimal. Keno has historically been more capital intensive (25-30% of EBITDA) but is much smaller from an overall revenue contribution standpoint. I forecast combined Lotteries & Keno capex to return to its 5 year average (prior to the merger) of 6% of EBITDA as it gives a better indication of BAU capex than the last two years.
- Depreciation: has remained relatively steady at $82mn, $84mn and $84mn in the past 3 years post-merger so I have flat-lined this number.
- Other Assumptions: I have assumed no change to the regulatory environment or tax environment which admittedly poses a risk when licenses are renewed (e.g. Victoria in 2028 and 2038 during my forecast period.) I have allowed for payment for this license in my FCFF projections for these years.
Wagering & Media
The Wagering business of both Tatts and Tabcorp has a more checkered growth track record than Lotteries. I will preface this section by saying any sort of a recovery or reversion of the recent trend is not part of my base case. Regardless, I do believe there are a number of factors which should drive an improvement in the competitive landscape for wagering and subsequently, somewhat arrest the declines the segment has been experiencing:
1) Industry growth trends remain positive – Although racing turnover has stagnated for certain periods, it is clear that the trend continues to remain positive. This is likely driven by the social normalization of betting beyond hardcore gambling audiences and cross selling available from increasing penetration of sports betting. Much of this can be accounted for through the digital channel however, it does highlight that overall volume trends can at least partially compensate for market share losses to corporate bookmakers. Wagering has grown at a 4.2% CAGR over the past 20 years primarily by sports however, racing wagering (TAH’s main exposure) continues to grow positively.
2) Industry consolidation – the flurry of corporate bookmakers establishing a presence in Australia in the past 5-10 years led to significant marketing campaigns and generosities which weighed on wagering yields and margins. However, there has been considerable consolidation in the market. Looking at a market share chart from 18 months ago…
- Sportsbet and Beteasy have merged which will substantially reduce promotions as these are two of the more competitive players
- Ladbrokes acquired Neds in 2018 for $95mn
- Bet365 have significantly reduced generosities since entering the market in 2015 and are a far more rational player.
- The US sportbetting opportunity looms as large for the likes of Flutter (owner of Sportsbet), PBH and Bet365. In my view, it would be prudent to manage yields in order to use more established markets as funding to launch aggressive US campaigns for market share. However, my forecasts do not assume any improvement in the competitive landscape.
Yields have trended lower consistently over time however, are approaching a floor if the UK market is a good representation.
3) Inflated current cost base – As a result of the merger, there are still ~$50m of EBITDA synergies that can be achieved bringing total synergies to TAH’s target range of $130mn – $145mn. This involves both revenue and cost synergies through migrating UBET customers across to the TAB platform. I do not assume any further margin uplift in my forecasts.
4) Benefits of Incumbency – TAH hold licenses to operate totalizator and fixed odds wagering on racing and sporting events through the TAB branded retail network of around 2,800 agencies and licensed venues. This business also includes TAH’s Sky Racing and Radio media business which broadcast approx. 120,000 live throughbred, greyhound and harness races per annum to 2.8mn homes and 5,400 commercial outlets. This enables TAH’s online customers to have digital access to all Australia racing vision live through TAB digital platforms which is unique currently among wagering operators. Although this omni channel approach is more costly and lower margin than the corporate bookmaker’s business model, there are still competitive advantages associated with the product offering.
Wagering & Media assumptions
Some of the major assumptions I have made regarding Wagering & Media to arrive at my valuation –
- Revenue: The track record over the past two years has been sub-par (averaging -3%) although revenue has largely stood still for the combined wagering divisions since 2013. I do believe that there is merit in TAH’s offline presence and at some point, market share losses will subside. Regardless, and to be conservative, I have assumed revenue growth of -3% every year until 2045 resulting in end revenue of $1.08bn vs. current revenue of $2.3bn.
- EBIT: I have assumed margin contraction of 30bps every year as the business suffers from operating de-leverage, leaving 2045 EBIT at $57mn vs. current $272mn.
- Capex: I have assumed capex as a % of sales to be 6.4% which is lower than the average of the past two years of 7.2%. This is driven by a reduction in merger related expenditure and a more normalized operating environment. For reference, the average capital expenditure (as a % of sales) of the two groups combined from 2013 to 2016 was 3.4% so once again, I feel as though there is a sufficient margin of safety in these projections.
Note: This is an area where Bear’s will disagree with me and penalize TAH by implementing huge capex bills… I have heard valuations of -3x EBITDA for the wagering business due to the perceived capex requirements which will weigh on FCFF. For all the reasons outlined previously I think this is overly punitive and my earnings projections have captured the downside for the wagering business.
The Gaming Services segment is not a material component of my valuation and as a result I have flat-lined the revenue, EBIT, D&A and capex resulting from this division from FY19 onwards. There is significant uncertainty regarding the operating profile of this business going forward and I do not feel as though I can add much value speculating on the outcome of the strategic review. It is worth noting that the business generated $66.5mn of EBIT and required $91.5mn of capex in all of my forecast years. There is significant depreciation & amortization charges in this segment and as a result, it is $28mn FCF positive (on a post-tax basis) in each year of my valuation as it was in 2019. This was the worst year this segment has had in 5+ years.
All up, this contributes ~$330mn to the valuation and is not a material driver. If anything, there may be scope to sell the business, reduce its capital intensity or improve margins which may increase its value.
Using the above assumptions, I arrive at an EV of $10.745bn and after subtracting net debt ($3.3bn), an equity value of $7.445bn. This represents 15% upside from the current market cap of $6.5bn. I believe that I have been conservative in a number of areas:
- Wagering – Effectively assumed that earnings fall drastically over the next 20 years however, in reality there will likely be some benefits of incumbency and some advantage stemming from TAH’s licenses and bricks & mortar channels.
- Gaming Services – no assumption of a recovery to the earnings base of the past 5 years and heavy ongoing capex requirements which weighs on FCF.
- Keno – halving the revenue growth rate to 2% vs. 4% over the past 10 years and assuming there is no margin expansion in this business despite current margins being at a 5 year low.
The stock has a number of potential catalysts upcoming that may prompt a revaluation of the stock. There is a lot of negative sentiment amongst investors towards TAH however; I believe that current valuations offer a sufficient margin of safety with potential upside if a number of the following catalysts eventuate.
- Strategic review of gaming services may lead to opex savings, reduced capex requirements or a sale of this business
- Potential for rationalization of competition following consolidation in the wagering industry
- Management change: The current team are particularly lowly regarded by the market and any changes to the management structure would likely be viewed as a positive
- Delivering on synergy targets will reduce restructuring opex and capex in addition to lowering run rate of cost base.
Regardless, even if these do not eventuate, I believe there is sufficient upside from the lotteries business alone given current valuations to validate Buying TAH now. I have not assumed any benefits from the above catalysts and still retain 15% upside from the current share price.
Appendix: Other Key Issues
1) Capital structure
The level of gearing is a pertinent issue with net debt ~$3.3bn and the fact that TAH will likely exceed covenants of 3.5x this half. The annuity style cashflows of the lotteries business supports a relatively highly geared capital structure in the future however, given the current business mix; gearing is unequivocally too high to be comfortable. As a result I have reserved $50mn in free cashflows in each of the next 4 years to pay down debt until Net debt/ EBITDA sits comfortably below 3.0x.
To support its capital position, TAH has recently announced the suspension of its 2020 dividend and a waiver of leverage & interest coverage covenants until next calendar year.
2) General DCF assumptions
Weighted average cost of capital: I have used a 7% WACC given TAH remains a relatively defensive business model (particular in the outer years where lotteries are a significant component of earnings.) For reference, TAH’s average interest rate over the past 3 years is 5.8%
Terminal Growth: I have used a terminal growth estimate of 3% which implies a terminal EBIT multiple of 17.9x. This is warranted given the significant earnings mix skew towards lotteries (91% of EBIT) and the fact that a number of material lotteries licenses are decades away from being re-negotiated (even in 2045.) For context, French comp FDJ currently trades on 20x FY2 EBIT.
3) Working capital requirements
The two largest businesses (Lotteries and Wagering) both operate with a negative working capital cycle. The track record over the past 7 years suggests that working capital required to run the business has decreased on average each year as payables (related to winnings) have increased. I have not assumed any free cashflow benefit arising from this trend in working capital in order to remain conservative.
I have not accounted for a number of factors.
- 11.5% stake in Jumbo Interactive currently valued at $82mn. I have left this out given the recent volatility of JIN’s share price and the dependence on JIN’s agreement with TAH which is up for renewal in 2024. If included, it would naturally be positive for my valuation.
- Vic Wagering License. Despite having paid $410mn for it in 2012, it is often raised by management as an upcoming positive catalyst in 2022 given the structural decline of the tote. I have not speculated as to the new cost but it is worth noting that should the cost come down and the ongoing amortization requirements for this license in subsequent years will also decline. Therefore, the valuation impact from including the cost for this capitalised license in my valuation is ambiguous.
 I have accounted for the Victorian license renewal in 2028 and 2038 by recording a payment made out of FCF in those years. This involved extrapolating the 2018 license cost at a rate of growth equivelant to Lotteries revenue growth (3.3%.)
 If anything, the merger has weighed on margin uplift as Tatts included significant lotteries overheads in corporate costs which inflated margins in the segment whereas the merged entity attributes more corporate costs to each segment.
 I calculate this by assuming a cost of 9% of revenue paid to news agents as commissions & a linear improvement in margins as digital penetration improves. I.e. 50% digital penetration equals 4.5% margin improvement.
 Note that 45bps of margin expansion per year is elevated given the significant Jackpot run in 2019.