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Morningstar | Tabcorp Fiscal 2018 Earnings Miss, but Positive Outlook Driven by Synergies and Digital Growth

Tabcorp's fiscal 2018 underlying net profit rose by almost 40% to AUD 246 million, although the bulk of the growth was due to the half-year earnings contribution from the recently acquired Tatts. This fell short of our expectations, however, reflecting timing of the merger synergies. We have not changed our AUD 4.50 per share fair value estimate, as our long-term outlook remains broadly unchanged. We maintain our narrow moat rating, and despite the shares trading marginally above our fair value estimate, they still offer an attractive 5% fully franked dividend yield. Had the acquisition taken place at the start of fiscal 2018, group revenue and underlying EBIT would have increased by a modest 3% and 2%, respectively. The board declared a final dividend of AUD 10 cents per share, taking the full-year dividend to AUD 21 cents per share. Management is aiming to pay out 100% of fiscal 2019 underlying earnings, equivalent to AUD 22 cents per share.

The company's primary focus remains the integration of the recently acquired businesses. The firm delivered AUD 8 million in EBITDA synergies in the fiscal year (mainly on the cost side) and expects synergies to increase to AUD 50 million in fiscal 2019, reaching the unchanged target of AUD 130 million annually by fiscal 2021. Around two thirds of the target benefits are on the cost side, which will include consolidating corporate overheads, rationalising the corporate property, and removing duplication of technology and sales departments. The remaining third of the earnings synergy will come about through revenue improvement, particularly in the wagering segment where the Ubet brand will be changed to the stronger TAB brand and customers migrated to the new platform, featuring improved digital capability, and more flexible betting options. TAB's wagering has consistently outperformed Tatts' Ubet in fixed odds yield and digital turnover, which are both large opportunities for management to drive revenue growth.

We have slightly trimmed our near-term earnings projections to reflect the updated synergy timeline, although our estimates from fiscal 2021 onwards are unchanged. Group revenue should grow by around 5% on average in fiscal 2021, around 1% of which will be generated through the previously mentioned revenue opportunities. We forecast group EBITDA margins expanding by approximately 250 basis points to 24% by fiscal 2021 (compared with our fiscal 2019 forecast), mostly driven by cost synergies, with a slight uplift from operating leverage, and increasing digital penetration across both wagering and lotteries.

Performance in the wagering division (which accounts for approximately one third of fiscal 2018 pro forma EBITDA presynergies) was mixed during the year. On a pro forma basis, combined wagering revenue increased by 2%, although it was the TAB brand which did most of the heavy lifting, offsetting Ubet's 1% decline. Ubet did grow revenue in the second half by 1%, and while this improvement is modest, it is a good indication of Tabcorp's ability to turn around this business which has experienced declining revenue for the past four years. The TAB brand continues to deliver strong digital turnover and fixed odds revenue growth, both in the midteen percentage range, which continues to offset deteriorating retail distribution. The company also exited the loss-making Luxbet and Sun Bets businesses during the fiscal year, which should support margin improvement during fiscal 2019.

We expect the highly resilient lotteries business (which generates around one third of group earnings presynergies) to continue delivering mid-single-digit earnings growth for the foreseeable future. The recent launch of the new Powerball game will increase the number of large jackpots in line with consumer preference, which gives us confidence in our revenue growth expectations. Historically, the segment has delivered steady revenue growth on average, and consistent with this trend, fiscal 2018 pro forma revenue rose by around 5%, supported by a favourable jackpot sequence. We expect lotteries EBIT margin to increase by around 100 basis points over the next few years reaching 15%, primarily driven by cost control, and the increasing penetration of digital, which is higher margin, and has doubled during the past five years to 18% of lotteries sales.

The recent regulatory changes should continue working in Tabcorp's favour. The ban on synthetic lotteries has eliminated the threat of Lottoland, which previously offered consumers the ability to bet on the outcome of international lotteries. This will ensure Tabcorp retains its monopoly over the lotteries in each of the states in which it operates. The introduction of the wagering point of consumption taxes should also help level the competitive playing field. Within the next 12 months, we expect each major state to introduce a wagering point of consumption tax, in a similar fashion to early adopter South Australia. We believe this will have the largest impact on the online-only, corporate bookmakers, which operate with a material cost advantage over Tabcorp and its legacy brick-and-mortar business. As most online competitors are licensed in the Northern Territory and paying very little tax, we believe the higher tax rates will force them to offer less favourable odds to defend their margins, which ultimately should help Tabcorp defend and improve its market share.