Aristocrat: Is There Any Light In The Tunnel?

This story features ARISTOCRAT LEISURE LIMITED. For more info SHARE ANALYSIS: ALL

By Chris Shaw

There had been some expectations in the market that gaming machines group Aristocrat Leisure ((ALL)) would cut earnings guidance for 2010 (year to December), but when the downgrade to guidance came through on Friday the reality was worse than had been anticipated.

Management now expects earnings for 2010 will be in a range of $50-$60 million, well below the market's consensus estimate of a result of about $90 million. As Deutsche Bank notes, the downgrade to guidance implies second half net profit of just $13-$23 million.

Deutsche Bank points out the downgrade stems primarily from weakness in both the Australian and US markets, while results for Japan were also a little lower than its recently revised forecasts. The issues in the Australian market include a loss of both market share and margins, RBS Australia attributing some of this to lower conversions given Aristocrat provides less new game support to its old platforms.

To counter this a number of new game releases are planned for the Australian market in 2011, but in the view of RBS Australia any turnaround in the domestic market is likely to take some time. More competitive products are also needed to improve performance in the Japanese market according to the broker.

Citi's take on the downgrade to earning guidance is that as it comes only one month from the end of the year, management had clearly been betting on some large orders that have failed to materialise. This highlights how earnings for Aristocrat continue to be volatile, something expected to continue going forward.

There are a couple of other complicating factors as well according to Citi, as the stockbroker notes while Aristocrat management expect market share gains in Australia in 2011, the emergence of new entrants into that market gives little reason to be confident these gains can be achieved given current market conditions.

As well, Citi notes the Australian dollar remains a significant headwind, as in the first half of this year the currency averaged around US88c but in the first half of 2011 the broker forecasts an average of US102c.

On the back of the new guidance from management, earnings forecasts across the market have been cut, with JP Morgan reducing its earnings per share (EPS) estimates by 37% in 2010, 39% in 2011 and 15% in 2012. This leaves the broker with EPS forecasts of 14.6c, 27.3c and 37.6c respectively.

UBS has cut its EPS forecasts by 33%, 23% and 13% for 2010-2012 respectively and is now forecasting outcomes of 10c, 15.2c and 30.3c, while both Credit Suisse and Citi see 2011 being just as tough as 2010 and so offering little in the way of EPS growth. Consensus EPS forecasts for Aristocrat according to the FNArena database now stand at 13c for 2010 and 14.3c in 2011.

The changes to earnings estimates mean reductions in price targets, with Deutsche Bank lowering its target to $3.40 from $4.20 and Citi to $2.90 from $3.40. These represent the range of price targets according to the FNArena database, with the consensus target now standing at $3.74. This is down from $4.07 prior to Friday's update from management.

What hasn't changed are recommendations for Aristocrat, the database showing four Buys, three Holds and one Sell rating. The Buy argument is that Aristocrat offers strong leverage to an eventual recovery in market conditions, meaning the stock offers good long-term value at current levels.

UBS is one to continue with its Buy rating, even allowing for the expectation it is likely to be 2012 at the earliest before there is is any substantial recovery in earnings. JP Morgan offers a similarly positive view on valuation grounds, even though the latest downgrade to guidance and ongoing tough market conditions are likely to make it very difficult for Aristocrat shares to outperform relative to expectations in the broker's view.

For Deutsche Bank the earnings problems evident in the latest downgrade to guidance mean the market has lost confidence in the stock, so while it also sees value, the broker retains a Hold rating on Aristocrat.

Citi is also neutral on the stock, pointing out the current weak conditions mean there is a growing chance Aristocrat will need to raise capital to fund increased demand on working capital when the market does return to growth.

There is some scope for merger and acquisition activity involving the company in Citi's view given there does appear to be long-term value, but the broker tempers this by pointing out current family shareholder arrangements could prove to be a roadblock to any corporate moves on Aristocrat.

Shares in Aristocrat today are stronger and as at 11.10am the stock was up 6c at $2.76. Over the past year the stock has traded in a range of $2.62 to $4.73 and the current share price implies upside of around 40% to the consensus price target in the FNArena database. This easily explains why half of the stockbrokers stick to their Buy rating (it's a valuation assessment, not a momentum indicator).

Note also, Aristocrat has been one of the standouts when it comes to short positions in the Australian share market, as observed and commented upon by FNArena editor Rudi Filapek-Vandyck in his market analysis on November 10, 2010; "Rudi's View: ASIC's Stock Momentum Indicator". This could serve as an indication that those short positions were speculating on another downward surprise by the company before year-end, and they were correct in this assumption.

Click to view our Glossary of Financial Terms