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Morningstar | Aristocrat FVE Rises to AUD 21.50 on Currency Tailwinds; Remains Overvalued. See Updated Analyst Note from 25 Sep 2018

We have lifted our fair value estimate for narrow-moat-rated Aristocrat Leisure by 5% to AUD 21.50 per share, following a revision of our forward currency assumptions. As most of the company's earnings are generated in U.S. dollars, we expect the lower Australian dollar to translate to a 3% EPS uplift on average during fiscal 2018-2021, and we forecast average annual EPS growth of around 20% during this period (assuming an AUD/USD of 0.74).

Despite shares in Aristocrat falling by 15% during the past couple of months, we continue to believe the stock overvalued, relative to revised fair value estimate. The recent derating sees the stock trading at 25 times fiscal 2018 earnings, which we believe is a stretch given the inherent cyclicality of outright machine sales (which still account for over one third of group earnings), the intensity of the competitive environment, and potential fickleness of the digital gaming space.

One of the company's strengths is its balance sheet, with net debt at less than 2 times fiscal 2018 EBITDA (and likely to continue falling in the coming years), which is less than half of its key rivals IGT and Scientific games. While its rivals are heavily indebted, Aristocrat is free to continue heavily investing in design and development. The high debt levels are likely to limit the rivals' ability to aggressively ramp up design and development expenditure, preventing a material change in competitive intensity in the near to medium term, however, longer term we think this is a potential risk.

Accordingly, we do not expect the company to continue growing at the current rate of knots beyond the next five years, especially outright machine sales in both Australia and North America. In North America, sales were soft in the first half of fiscal 2018, which is consistent with our thesis market share in this space is approaching its peak. We project a modest increase in North American ship share (share of outright machine sales) peaking at 22% by fiscal 2022, up from current 20%. Australia, on the other hand, has already peaked (unit sales volume declined by 4% in the first half of fiscal 2018) and we forecast local ship-share to decline to around 60% over the next five years, down from the approximately 65% currently. Both regions, however, are likely to maintain strong average selling prices, given the high quality and superior game performance. It is worth noting for the most part, the industry offers very little growth, and gains will typically come at the expense of a competitor. Consequently, competition from rival firms will remain high, hence, our reluctance to extrapolate recent market share gains too far into the future.

Class III participation (leased machines) is likely to remain a key earnings growth driver for the foreseeable future. In the North American market, we expect the company to increase penetration of the highly successful Lightning Link range, and given the strong initial customer feedback, a similar trajectory for the recently launched Dragon Link is highly likely. We expect this winning recipe to drive the firm's market share in North American Class III participation (leased machines) to 40%, up from around 30% currently. This should smooth out group earnings volatility, and over the long term is supportive of margins. Notwithstanding, in a similar fashion to the outright sales category, we continue to believe competition will not stay dormant forever, and as the competitors' financial position improves, we believe this participation market will be an obvious target.