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Morningstar | Lower Tax Rate and Stronger Growth in Recurring Revenue Drive Aristocrat FVE to AUD 23.50 Per Share. See Updated Analyst Note from 29 Nov 2018

Narrow-moat rated Aristocrat Leisure delivered strong earnings growth during fiscal 2018, after receiving a boost from the recently acquired digital game firms Plarium and Big Fish. Normalised net profit after tax (pre-amortisation of acquired intangibles) rose by 34% on last year, to AUD 730 million, albeit in line with our expectations. The digital segment did a lot of the heavy lifting, and if excluded we estimate earnings would’ve grown by approximately 13%. The board declared a final dividend of AUD 27 cents per share, taking the full-year total to AUD 46 cents per share (40% payout ratio), a 35% increase on the pcp, consistent with our forecast. Our fair value estimate increases by 9% to AUD 23.50 per share after incorporating a higher sustainable earnings base. At the current price, shares in Aristocrat are broadly fairly valued, relative to our revised estimate.

We’ve increased our earnings forecasts by around 7% on average, and we project average EPS growth of approximately 12% per year for the next five years. This follows a guided 100-150 basis point tax rate reduction during fiscal 2019 that we expect will fall further during the coming years as an increasing portion of the firm’s earnings are generated in North America. Additionally, the firm grew its North American installed base by almost 30% (ahead of our expectations), and this revenue is much more sustainable than the volatilities outright sales, supporting our earnings revision.

We forecast Aristocrat’s North American ship-share (share of outright machine sales) to reach 25% within the next five years, up from the current estimated 21%. These gains will be incremental in nature, compared with the accelerated growth during the past three years, and will be supported by expansion into adjacent segments, which should help grow the addressable market. The North American class III premium gaming operations installed base (recurring revenue) will also continue growing strongly for the next few years. We believe the firm can comfortably increase its market share to over 45% by fiscal 2022, compared with the current 33%, driven by further penetration of its suite of top performing products along with a strong pipeline of new games--both off the back of substantial investment into design and development. Additionally, operating leverage should assist North American EBIT margin to expand by another 200 basis points to 57% during the same time period.

Digital is likely to remain the fastest growing segment of the business for the next five years. The casual game and social casino segments (which make up the bulk of digital earnings) are growing at a low double-digit pace. We project Aristocrat to grow at a slightly faster clip, underpinned by an additional AUD 100 million investment into user acquisition during fiscal 2019, although the benefit from this additional investment should materialise from the second half of the fiscal year and onward.

We continue to believe the firm’s ship-share in the mature Australian market has peaked and should remain stable at the current 60% mark. Strong sales of the top performing games Dragon Cash and Dragon Link will support this leading position for the next few years. Australian platform unit sales declined by around 2%, although this earnings base will become more stable as the company continues to transition customers to its new ACCESS fee per day product, which allows customers to choose between a wide range of game content on a subscription basis.

With the lower margin digital segment making up a significantly larger portion of group earnings, we are unsurprised by the group’s EBIT margin dropping by 4 percentage points to 31% during fiscal 2019. While the additional investment into digital user acquisition, and decision to maintain game design and development at around 11% of the (increasing) revenue base will limit margin upside, we think these both make sense from a strategic viewpoint. Notwithstanding, we continue to believe the ongoing growth in the North American division, strong pricing, and operating leverage will help lift the group EBIT margin by another 100 basis points by fiscal 2023.