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Morningstar | Weak but Well-Flagged Fiscal 2018 for Ainsworth, but we see Meaningful Upside from Current Levels

Fiscal 2018 was a challenging year for narrow-moat-rated Ainsworth. Underlying profit before tax declined by 32% to AUD 39 million, although this weakness had been previously flagged, and the result was broadly in line with our expectations. Accordingly, our AUD 1.70 per share fair value estimate is unchanged. The main contributors to the earnings pressure were continued market share losses in the domestic market and rest of the world, along with lower margins in North America. On a more positive note, the board declared a final dividend of AUD 2.5 cents per share, which exceeded our expectations, taking the total for the year to AUD 4 cents per share (fully franked) equivalent to a 46% payout ratio. Management reaffirmed a target dividend payout ratio between 40% and 60% of underlying earnings, which signals confidence in the earnings outlook and balance sheet.

We continue to believe the stock is undervalued at the current price. While the negatives overshadowed during the year, several positives worth highlighting were: (1) early signs of ship-share improvement in the domestic market, following new game title releases; (2) a strong 10% increase in group participation machines (double over the last five years) particularly in Latin America, which should increase earnings stability; (3) R&D expenditure increased by 1% to 13% of revenue. While management expects to maintain R&D at around 13% of sales going forward, it is expected to be higher in absolute dollar terms which implies stronger revenue in fiscal 2019. This level of R&D is considerably higher than the 11% long-term average, which is pleasing as future sales are highly dependent on innovation and game development, both areas in which we believe the company has dropped the ball in recent years; and (4) the balance sheet is also in healthy shape, with net debt steady at around 0.5 times EBITDA, providing the company a buffer to weather the cyclical down periods.

At the group level, we project mid-single-digit revenue growth on average during the next five years, which assumes stabilisation of Australian market share, a resumption of growth in North American outright sales, albeit at a very modest pace, and increasing penetration of the Latin American participation market. We forecast EBIT to grow faster, at around 10% on average, given the high degree of operating leverage within the business, and a faster-than-expected revenue improvement could deliver substantial margin upside from our current estimates.

The outlook for the domestic market is encouraging. We believe the main competitor Aristocrat's domestic market share has become unsustainably high and we expect Ainsworth's ship-share to recover modestly from fiscal 2019 onwards. Management flagged June's ship-share in NSW (one of the most competitive markets in the world) was 15%, which is double the average in fiscal 2018. This is encouraging and reflects new product launches, including the new EVO cabinet, Golden Cash, and PacMan. The customer feedback on the new games has been positive, and the new cabinet along with 15 new game titles should help stabilise the Australian performance. We expect the renewed commitment to R&D to help Australian ship-share recover by a modest 100 basis points in total during the next five years, to around 12%, albeit less than half of prior highs.

We expect the strong growth in the Latin America installed base to continue, supporting high-single-digit revenue growth in the region, on average, during the coming years. The company's new games have been well received and should take meaningful share in Mexico on the back of new licences. Outright unit sales were also strong, growing by 4%, although increased demand for used machines and lower-priced machines weighed on average selling price and saw EBIT margin fall to 39% in fiscal 2018 from 48% a year ago. The company has already received strong preorders for the latest version of the Raging Roosters game, which had huge success previously in Latin America.

North American volumes were steady, including the completion of a major order from Churchill Downs, although strong pricing and average daily fees drove a 4% increase in revenue. However, this was offset by the higher componentry cost of the A600 machines, which drove North American EBIT margins down 500 basis points to 39%. The company is undertaking cost reductions which should improve margins, and given the high degree of operating leverage, we expect margins to improve significantly on the back of growing revenue. We forecast North American EBIT margins to add around 200 basis points during the next five years, reaching 41% by fiscal 2023. North America is among the largest markets in the world, and with an estimated 5% ship-share in the region, we believe Ainsworth is under-represented, which presents a huge opportunity. Despite being highly competitive, we believe this market will remain a key focus, and expect the firm to add at least another 100 basis points to its ship share within the next five years, following the ramp up in R&D.