Why i think tabcorp is still a reasonable long-term bet

I confess to watching too much sport over summer. First, a cricket season that started to bore and now the gripping Australian Open tennis. Soon, it will be rugby’s turn.

Sadly, watching televised sport means being bombarded by betting ads. And from a stock market perspective, regular reminders about the challenges facing Tabcorp Holdings (TAH) from an onslaught of online gaming services that are disrupting global wagering.

Tabcorp provides wagering and media services through its totalisator, fixed-odds betting and retail wagering networks (42% of FY19 revenue); lotteries and Keno in most Australian states and territories (52% of revenue) after its 2016 acquisition of Tatts; and gaming support services to more than 3,500 venues nationally (6%).

Tabcorp has underperformed the market in the past five years: the annualised total return (assuming dividend reinvestment) is 6.8%, Morningstar data shows. The one-year total return is a lousy 4.5%, in a rallying share market.

Whichever way one cuts, Tabcorp has disappointed. Its $11-billion merger with Tatts, from a share-price perspective, has underwhelmed, raising questions about execution. Tabcorp needs to get faster results from the integration and bring sceptical investors back to its stock.

After rallying in the third quarter of 2019, Tabcorp drifted lower, despite its FY19 result meeting market expectation. It trades at $4.64, down from a 52-week high of $4.98.

Strong growth in Tabcorp’s Lotteries division underpinned the FY19 result, but has not been enough to re-rate the stock. Lingering market concerns about wagering disruption – and how the incumbent bricks-and mortar operator will compete with online insurgents – are weighing on Tabcorp.

I examined this theme in a favourable column on Tabcorp in The Switzer Report in January 2019. My view was based largely on the growth potential of the Lotteries division and it did not disappoint in the FY19 result. But the share price has barely moved since my report ($4.58 at the time).

Nevertheless, I remain positive on Tabcorp’s long-term prospects. In a fully priced equities market, Tabcorp offers reasonable value, although its recovery will take time. The stock looks undervalued against its global peers and on historical grounds.

Chart 1: Tabcorp

Source: ASX 

Lotteries

My positive view on Tabcorp is based mostly on the outlook for the Lotteries and Keno division. An ageing population is good for lotteries because older people tend to follow lottery draws more closely than younger ones. Population growth is another positive, for it means a larger customer base buying lottery tickets and allocating more household income to such entertainment.

Product and sales innovations are other factors. Instant, online lottery draws, more frequent lottery draws and other innovations should continue to attract new lotteries customers. Selling lotteries via digital channels, and use of customer loyalty cards that encourage repeat business, should lower wage expenses and improve lotteries profit margins over time.

Longer term, the Lotteries business should benefit from high barriers to entry because it is hard for new entrants to compete in giant lotteries. Also, government regulations effectively create a lotteries monopoly for Tabcorp in the States and Territories in which it operates.

These strengths were evident in Tabcorp’s FY19 result. Lotteries and Keno revenue rose 22.8% on a year earlier to $2.8 billion. Underlying earnings (EBIT) rose 37% to $425 million.

Innovations in Tabcorp’s high-profile Powerball game, designed to deliver larger and more frequent jackpots and more winners, boosted the performance. A jackpotting Powerball and the publicity it creates boosts Tabcorp’s customer base and benefits sales of its other games.

Remarkably, Tabcorp has 3.3 million registered Lotteries players, up 600,000 on the previous corresponding period. Almost a quarter of Lotteries revenue is derived from digital sales. The increase in Lotteries customer numbers did not get the market attention it deserved.

I doubt the market fully recognises the strength of Tabcorp’s Lotteries division or its potential as customer numbers expand rapidly and more products are sold online. The division is ripe for innovation as digital and personalised lottery products are offered to a fast-growing customer base.

Wagering & Media

As the Lotteries division starred, Wagering struggled. FY19 revenue fell 3.6% to $2.3 billion and underlying earnings (EBIT) dropped 11% to $271 million.

This is partly because of ongoing integration of Tatts Group’s challenged UBET retail betting shops into the TAB brand and heightened investment to maintain customer numbers during the business transformation. Online competition is the big issue.

Tabcorp’s strategy is to modernise, digitise and optimise its wagering operations in FY20. It wants to establish a unique brand and purpose for TAB, enhanced digitisation to compete with online rivals, use data to personalise services, reinvigorate its totes and transform its media.

The next step is creating a seamless omni-channel spanning bricks-and-mortar and digital wagering products in FY21. I’ve written before that Tabcorp reminds me a little of Flight Centre – retail shopfronts when you need them and a comprehensive online offering when you don’t. And the ability to move easily between the two.

Omni-channels sound good in theory, but are hard to implement in practice. Tabcorp’s bigger problem is that young people are less inclined to spend their afternoon at the local TAB placing bets than previous generations. Today’s twentysomethings are more likely to place bets with an online-only provider via an App on their smartphone.

Tabcorp’s Wagering business has had some growth in customer numbers and digital-channel sales.  However, UBET’s performance remains challenging ahead of its TAB integration and the Wagering division has execution risk and uncertainty.

The flipside is the Wagering business has significant upside potential if Tabcorp can accelerate its digital growth and better link it to its traditional sales channels.

Valuation

The market is factoring in too much future bad news from Tabcorp’s Wagering business, and not enough good news from Lotteries at the current price.

On Macquarie Group forecasts, the Wagering & Media division is trading on an EBITDA multiple of about 5 times (compared to 17 for the Lotteries and Keno division). If correct, this would value Wagering & Media at a 50% discount to Tabcorp’s global peers and a similar discount compared to Tabcorp’s pre-merger valuation (before it acquired Tatts Group).

Macquarie wrote this week: “Some investors may see the discount as appropriate, but we see a re-rating towards our 7 times valuation (from 5 now in the wagering business).” A 1 point re-rating in the Wagering division EBITDA multiple adds 21 cents to Tabcorp’s share price.

Macquarie has an outperform recommendation and a 12-month target of $5.25. An average share-price target of $5.19, based on the consensus of seven broking firms, also suggests Tabcorp is moderately undervalued.

If the consensus view is correct, Tabcorp’s total return over 12 months should be around 20 per cent (including its dividend yield). An estimated grossed-up dividend (after franking credits) of almost 7% in FY2020 should support demand for Tabcorp in an income-focused market.

With the integration of Tatts and Tabcorp due for completion in FY2020, the business will have more bandwidth to integrate UBET, revitalise the Wagering business, derive greater synergies and accelerate innovation in its high-performing lotteries division.

Nevertheless, prospective shareholders should not expect windfall gains from Tabcorp and owning a gambling company is not to everyone’s taste in this responsible-investing era.

However,  Tabcorp looks like it has been left too far behind in an increasingly overpriced stock market – and a solid rather than spectacular opportunity for patient value investors at the current price.

Update: Tourism stocks

I began 2020 with a bearish column on tourism stocks. My view was based on the effect of the bushfires on domestic and international tourism – and on company valuation grounds.

Sydney Airport (SYD) has fallen from a peak of $9.04 in 2020 to $8.15, in a mostly rising market. Qantas Airways (QAN), a stock I nominated as key sell idea in 2020, is down from a $7.20 to $6.36. SeaLink Travel Group (SLK) has slumped from a high of $4.89 to $4.16.

Chart 2: Sydney Airport

Source: ASX

 Chart 3: Qantas Airways

Source: ASX

Suffice to say my bearish view remains after several tourism operators in affected bushfire areas this month said forward-looking bookings have slumped – and the industry has warned of deteriorating trading conditions generally.

If that wasn’t enough, the outbreak of the Coronavirus in China will further dent travel here as the Chinese government bans overseas tours.

According to media reports, China’s move puts at risk up to a quarter of the travellers that Australia receives from there. Also, the ban coincided with the Lunar New Year period when more than half of Chinese tourism occurs. A tour ban that lasts longer than expected could have a catastrophic effect on Australian tourism operators that service inbound Chinese tourists.

Either way, I wouldn’t be buying tourism stocks yet, despite price weakness. Industry conditions will worsen before they improve, as the Coronavirus spreads.