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Morningstar | Ainsworth’s Domestic Suffering Continues Although 2H Outlook Is More Positive

Narrow-moat Ainsworth reported a weak start to fiscal 2019, with adjusted profit before tax, or PBT, of AUD 9 million, down 45% on the pcp, albeit marginally ahead of the AUD 8 million guidance. Unsurprisingly, the main challenge the company faced was intense competition in the Australian market, which led to an approximate halving of unit volume and revenue, along with margin compression. There were, however, a few positives in the result, the most noteworthy being: 1) strong international revenue growth which nearly doubled on the pcp and now accounts for 83% of group, up from 76%; 2) a 6% increase in units on participation (leased machines); and 3) a step up in design and development expenditure, or D&D, both in percentage and dollar terms. The board suspended the interim dividend, which is disappointing, but prudent given the recent lacklustre performance and should facilitate a higher level of reinvestment.

We still expect a stronger second half, but cut our fiscal 2019 PBT forecast to AUD 22 million from AUD 26 million, to reflect the weakness in the domestic market and higher D&D expenditure. Management guided to improved profitability in second-half fiscal 2019 (on a sequential basis), on the back of strong international momentum and new product releases in Australia. However, the language appears less optimistic than previous guidance for a minimum 75% PBT growth in the second half (compared with the first half). However, our midcycle earnings forecasts are broadly unchanged, as is our AUD 1.20 per share fair value estimate. At current levels, the shares are meaningfully undervalued. We are pleased with the company’s decision to increase game D&D both in dollar and percentage terms. Going forward, we expect D&D expenditure to be maintained at around 15% of the modestly growing sales base, compared with the five-year historic average of 11%. This should support a mid-single-digit recovery in revenue on average over the next five years.

Australia remains the most challenging market, with volume and revenue both halving, reflecting the intense competition. While we don’t expect a material change in the competitive landscape, we expect new product launches in the second half including "Loaded with Loot" and "Crazy Jackpot", and the additional D&D spend to support a domestic market share at around 8%. We project a 30% decline in fiscal 2019 volume, although beyond this, we expect Australian volume to improve at a modest pace. We forecast the segment’s EBIT margin to improve by around 3% to AUD 28% over the next five years, as revenue improve modestly and the firm benefits from high operating leverage.

North America performed reasonably well, with revenue and EBIT growing by 40% and 47%, respectively. This reflected strong outright sales of the "Quick Spin" product family on the A640 cabinet. Disappointingly, however, the gaming operations installed base shrunk by 23%, as customers opted to purchase top performing titles outright. Our preference would be to see the installed base growing strongly, as this revenue tends to be more resilient and higher margin. Although as the competition remains tough, Ainsworth had little choice but to meet the customer’s terms. We forecast mid-single-digit revenue growth in North America, which assumes a long-term ship-share of around 6% and incremental growth of the installed base.

Latin America’s earnings were flat on the pcp, although within the result, the game operations installed base grew by 37%, offset by a 10% decline in outright sales. On balance, we view this as a positive outcome, which should add to earnings stability. Margins improved slightly as well due to the higher-margin product mix and lower sales of refurbished units which impacted margins in the prior period.

Strong cash conversion helped keep the balance sheet in reasonable shape, despite the earnings weakness, with leverage (debt/EBITDA) at a modest 0.88 times. As earnings improve, we forecast leverage to fall towards 0.5 times within the next three years. Notwithstanding the healthy balance sheet, the board temporarily suspended dividends, although this is primarily to facilitate increased investment into D&D which is crucial to the long-term health of the business. On our estimates the firm can pay a AUD 1 cent per share final dividend, which represents 20% of underlying EPS, gradually increasing this to 40% by fiscal 2021, at the bottom of management’s target (40%-60%) payout range