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Morningstar | Ainsworth Continues to Struggle in Key Regions; Cutting FVE to AUD 1.20 From AUD 1.70

We cut our earnings estimates for narrow-moat Ainsworth in fiscal 2019, 2020, and 2021 by around 40% on average to AUD 6.0, 6.7, and 7.5 cents per share. Our fair value estimate falls to AUD 1.20 per share from AUD 1.70 on the back of our revised view of the company’s longer-term prospects. In a disappointing trading update, Ainsworth guided to fiscal 2019 first-half profit before tax of around AUD 8 million, a 30% drop on the previous corresponding period. Management expects second-half PBT to be at least 75% higher than the AUD 8 million in the first half. This implies full-year PBT of at least AUD 22 million, almost half of the AUD 42 million in fiscal 2018, considerably below our estimates and market expectations. The main drivers of the underperformance are weaker sales in North America and ongoing competitive pressure in the Australian market, only marginally offset by slight growth in Latin American. While the softer volume will weigh on revenue, the operating deleverage and EBIT margin will weigh on earnings for the foreseeable future.

Despite our fair value estimate cut, the stock looks undervalued. At the current share price, the market is pricing in no growth in any of Ainsworth’s key regions, a harsh assumption in our view. We maintain slot machines sales are highly cyclical, and following Ainsworth’s four consecutive years of underperformance, we continue to expect its performance will recover, albeit more modestly than we had forecast.

Additionally, we have raised our fair value uncertainty rating to very high from high. This reflects the unpredictability of game popularity, higher-than-expected sales volatility (as experienced during the past decade), and Ainsworth’s dominant exposure to outright machine sales. This contrasts with rival Aristocrat Leisure, which generates around two thirds of its earnings from leased machines, or digital gaming, which is much more stable and predictable than outright machine sales.

We’ve lowered our market share expectations in Ainsworth’s key regions, particularly Australia and North America. In order to support the stabilisation of Australia and modest improvement in North America, we believe design and development expenditure will be increased to around 14% of sales (from 13%), which will also affect EBIT margins. Despite the poor earnings performance in recent years, we expect the balance sheet to remain in relatively good shape. Net debt was around AUD 36 million as at fiscal 2018 year-end, and we expect Ainsworth to be in a net cash position from fiscal 2019 onwards, which gives us comfort the firm can ride out this cyclical trough.

Latin America has maintained its market position, and on our estimates, this surpasses North America as the group’s largest division, expected to generate approximately 40% of group earnings during fiscal 2019. Latin America has been the group’s strongest-performing region in recent years, reflecting above-average game performance. We forecast EBIT margins to improve around 300 basis points to 42% over the next few years, reflecting an improving sales mix. Last year margins suffered in this segment due to a higher portion of refurbished machine sales.

We have rebased our North American estimates, now excluding a repeat of a significant sale made in fiscal 2018, and consequently outright sales should decline by around 30% during fiscal 2019. North America benefited from a significant 900-unit (around one third of North American unit sales) order to Churchill Downs during fiscal 2018, and while we had previously expected the company to grow from this higher base, it now appears the transaction was more of a one-off. Management indicated revenue and profitability in the second half should grow on the pcp, excluding the sale to Churchill Downs, which occurred in the second half. Notwithstanding, we expect that over the next decade, the company can claw back some of this lost market share, returning to 5% ship-share, which is in line with the five-year historical average. This will be supported by higher reinvestment in game design and development, securing licenses in new jurisdictions including Nebraska and Virginia, along with further opportunities with Churchill Downs (although not enough to plug the sales gap). High operating leverage should help North American EBIT margins improve to almost 40% during this period from an estimated 35% in fiscal 2019.

Whilst we had previously forecast the Australian market had bottomed, it appears this is not the case and Ainsworth continues to disappoint in the domestic market. Despite flagging a strong increase in NSW ship-share during June and commentary guiding to a continuous recovery in fiscal 2019, the company indicated revenue and profit before tax in Australia are likely to be materially lower in the first half of fiscal 2019 compared to the pcp. While a portion of this is attributed to a 10% decline in industry demand (reflecting a slightly longer replacement cycle, which we believe will normalise), the firm blamed a continuation of highly competitive conditions. Accordingly, we expect Australian revenue to decline almost 20% in fiscal 2019, whereas EBIT should fall almost 30% due to operating deleverage. Management flagged a positive outlook for improvement in the second half, subject to new products gaining traction with customers. However, given the competitive intensity and the company’s failure to produce popular games, and the lack of evidence to suggest improving performance in the Australian market, we doubt the company can deliver significant improvement in ship-share over the long term. We believe the increased investment in design and development will help stabilise domestic ship-share at around 9% for the foreseeable future, compared with 11% in fiscal 2018.

We have retained our narrow economic moat rating, despite our expectations that the company will not earn returns above the cost of capital in the near to medium term. A large portion of the company’s woes are cyclical in nature, the consequence of weaker-than-average game performance, which we believe should improve over time. Accordingly, our projections assume the company resumes generating returns on invested capital above its cost of capital within the next decade, which is what we expect as a minimum hurdle for a narrow-moat-rated stock.