The success of digital gaming holds the key for Aristocrat Leisure in the short term as the land-based business has been heavily affected by the closure of casinos and a full recovery is not expected until FY22.

-Outright sales likely to decrease significantly in the second half
-Management continuing to invest in Raid development
-More normalised earnings expected in FY22
 

Despite a sharply growing digital business, Aristocrat Leisure ((ALL)) has been unable to escape the impact of the coronavirus pandemic, and earnings in the second half are likely to worsen before a recovery sets in. The land-based business has been heavily affected by the closure of casino venues while the digital business provides the better part of the outlook, with strong growth in bookings.

Ord Minnett is confident in digital execution and outlook but  highlights that the company's strategy will focus on reinvestment and monetising customers rather than solely growing the low-quality daily average user numbers. Hence, outright sales are likely to decrease significantly in the second half.

Citi considers the second half will be highly challenging and the digital profit growth driven by the early stages of the monetisation of Raid will be more than offset by the reduction in land-based business, higher interest costs and continued development investment.

The broker acknowledges gaming operations are the company's strength, relative to competitors, but casino closures are likely to weigh over May and June. Also, a large number of machines will be affected by social distancing even when casinos re-open. The broker envisages outright sales recover by FY22, albeit with a lower margin because of the competitive environment.

During the first half, outright sales revenue fell -20% and North American volumes fell -29%, with Australasian volumes down -15%. Still, UBS suggests the share price reaction was benign and this implies the market is willing to look through a difficult and abnormal trading period.

Higher costs caused the results to miss CLSA's forecasts. Still, the broker, not one of the seven stockbrokers monitored daily on the FNArena database, considers Aristocrat Leisure an industry leader with sufficient liquidity and well situated for a recovery, reiterating a Buy rating with a $32.46 target.

Goldman Sachs, also not one of the seven, retains a $28.50 target and Buy rating, expecting Aristocrat Leisure will attain a dominant land-based position and larger digital business on the other side of the crisis. Citi points out Aristocrat was cycling a particularly strong first half result in FY19 that was characterised by the expansion into adjacent land-based markets.

The magnitude of the de-leveraging of land-based earnings in the first half was greater than expected, particularly when considering casino closures only affected two weeks. There was a lack of opportunity to counter lost revenue through cost reductions, while a slowdown began well before the shutdowns, amid suspicions throughout February and early March that the outbreak of coronavirus would prove disruptive.

Customers deferred orders that would have originally been delivered as venues started to close. Citi points out the capital intensity of outright sales makes expenditure particularly difficult for casinos. Casinos, experiencing declines in visits and reduced revenue, are likely to respond first by cutting discretionary expenditure.

Raid

Raid now accounts for 23% of sales. Management has high hopes for the game and will continue to invest. Morgans notes there has been much debate among investors about the digital vision and the decision to expand from social casino beginnings.

However, the success of Raid has illustrated the benefit of moving into such high-growth genres, providing diversification within the digital segment. Management is also making progress on increasing the number of games being launched by Big Fish.

To achieve Credit Suisse's FY24 revenue projections. around $300m of 25% of total revenue must come from the new games. Despite the subdued environment the broker assesses that Aristocrat is ahead of the competition on sales and service.

By FY22 Citi expects Raid earnings to peak at US$170m compared with a small loss over the past 12 months. The broker upgrades Raid peak annualised bookings to $370m, expecting it will be able to generate a 50% earnings margin once monetised. Still, the success from a bookings perspective requires significant investment in user acquisition costs.

Investment & Outlook

UBS points out the company has retained its R&D staff throughout the pandemic-related shutdowns and the issuance of US$500m in debt brings liquidity to $1.8bn. Aristocrat continues to outspend its competition in R&D.

Citi agrees the liquidity position enables Aristocrat to invest and also helps investors look through the disruptions towards more normalised earnings in FY22. The broker points out it took three years for annual North American unit shipments to recover close to pre-crisis levels following the GFC.

Hence, the reason why many brokers expect an improvement will not be forthcoming until FY22. Citi anticipates tribal gaming markets will hold up relatively well compared to the corporate/commercial casinos.

Macquarie is more inclined to believe land-based casino revenues should rebound quickly. Casinos are re-opening across the world faster than expected and the North American market is expected to be mostly open by the end of June.

The broker acknowledges the operating environment is unclear as to whether the recent data is evidence of pent-up demand or more sustainable. Moreover, social distancing will impact capacity and Macquarie assumes market volumes will recover by FY23.

UBS, too, notes casino openings in the US are experiencing revenue ahead of expectations and in a month's time it should become more evident whether this is a short-term rebound or more sustainable.

This evidence should act as a significant catalyst for the share price, the broker adds. Predicting a recovery over the next 18 months is difficult, but by FY22 UBS expects Aristocrat should have a materially higher share of market demand.

Ord Minnett retains a view that the impact on casinos will take two years to wear off and more capital will be required to compensate. To account for this, the broker reduces net profit estimates by -39.6% for FY20 and -32.5% in FY21. Morgans reduces estimates for FY20-22 and does not expect a dividend in FY20, slowing expectations for the ramp up.

FNArena's database has seven Buy ratings. The consensus target is $28.60, suggesting 8.8% upside to the last share price. Targets range from $21.00 (Morgan Stanley) to $31.80 (UBS).

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