Aristocrat Goes To Video

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

-Enhancement to cash flow
-But question over returns
-Clear strategic merits
-Timing delays in Macau, Japan
 

By Eva Brocklehurst

Aristocrat Leisure ((ALL)) is expanding its US frontier. The company is acquiring Video Gaming Technologies, a US-based manufacturer of Class II machines for Native American casinos, for US$1.28 billion. The deal will be funded by a mix of debt and a $435m equity raising. The equity raising includes a placement of up to $30m to the Ainsworth family, an institutional placement of $375m and a share purchase plan up to $30m.

The acquisition appeals to brokers on the basis of the free cash flow that VGT generates and the recurring nature of the revenue stream, which JP Morgan expects will help smooth the volatility in Aristocrat's earnings. The main adjustment to earnings will come from tax and interest rate benefits but the cash flow should allow Aristocrat to invest in other areas such as online. For JP Morgan, the key question emanating from this acquisition relates to the future changes to VGT's installed base. The company already has more than 90% of the mechanical reel market in the US State of Oklahoma, so growth will need to come from the video market or from other Class II states.

Most brokers believe the deal is highly accretive, providing a complementary product to Aristocrat's Class III machines and exposure to a new customer segment. BA-Merrill Lynch agrees, to some extent. The broker takes issue with the returns rather than the earnings, suspecting the company has just plugged a potential hole in a subdued market. The broker thinks the returns are unattractive versus the cost of capital, while the balance sheet will be stretched post the deal. The broker always thought second half FY14 earnings assumptions were stretched, even with the delays in Macau and Japan the company has now alluded to. The broker cannot help but suspect the underlying market remains challenged.

Deutsche Bank estimates a pre-tax return on capital of 8.7% with a debt/earnings ratio increasing to 2.7 times from 0.7 times. Execution will be therefore be critical, to ensure the transaction does not become value destructive. To this end it will require the maintenance of long-term commitments and relationships as well as the production of compelling content, in the broker's opinion. Several brokers wistfully note a lower Australian dollar would also be of great help to Aristocrat.

While there is a strategic rationale in the acquisition, brokers also acknowledge VGT is heavily exposed to Oklahoma. Merrills observes VGT seems to have reached a saturation point in that state and stalled from a growth perspective. It is unclear how relevant the product is to other jurisdictions. Deutsche Bank also suspects the new much smaller Class II market will challenge Aristocrat at the same time as it is gaining considerable traction in the Class III market. Macquarie observes the Class II segment is well supported by Native American casinos and that there is no requirement to share revenue with the state, as is the case for Aristocrat's Class III machines. On the downside, Aristocrat inherits exposure to lumpy product churn down the track, given the nature of Class II contracts.

VGT will operate as a stand alone division and there is minimal product and geographical overlap, so Citi envisages an opportunity for Aristocrat to develop Class II video games and cross-sell product into an expanded customer network, both in North American and internationally. The broker expects profit accretion of 20% but earnings per share accretion of just 4% in FY16, because of the capital dilution. The deal should provide for faster paying down of debt. Citi estimates net debt will peak at 3.2 times earnings in FY15 before declining to 2.1 times in FY16. More than 60% of Aristocrat's earnings will now be based in the US. Citi's Buy rating is based on market share gains through an expanded product portfolio.

UBS is also attracted to the acquisition's strategic merit and has upgraded its rating to Buy from Neutral. The broker thinks the acquisition provides the opportunity to grow North American recurring revenue and leverage from the Native American relationships. UBS does not expect any meaningful improvement in demand for replacement machines in 2014, as casino gaming revenues are subdued across the key US markets. The broker assumes modest improvement in FY15.

Brokers have reduced FY14/15 earnings forecasts, while incorporating the benefits of the acquisition from FY16. The reason for the reduction in near-term forecasts is a timing issue. Regulatory changes in Macau, which will require a large number of gaming machines to be replaced, are now assumed to provide benefits only from FY15, while the release of Black Lagoon 2 in Japan is now expected in FY15 not late FY14, as the company is yet to receive regulatory approval. Equity dilution from the placements is also expected in FY15.

CIMB thinks the opportunities that come with VGT are clear, via enhanced content library and video terminal expertise. The broker has also had a closer look at the regulatory situation in Macau. Aristocrat is the major player with about 60% market share and the broker understands, while the Viridian Widescreen boxes require only small changes to become compliant with regulations, both the company's Xcite MK6 and Standard Viridian boxes need to be replaced. CIMB thinks the market is not factoring the extent of the earnings upside that will come from this replacement cycle in FY15, perhaps as much as 20%.

Aristocrat attracts five Buy ratings, one Hold and two Sell on the FNArena database. The consensus target is $5.79, which suggests 9.3% upside to the last share price. This target compares with $5.71 ahead of the announcement.
 

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