Gaming: a solid, defensive sector in a value portfolio

In this sector overview, we ask Bruce Du, Equities Analyst, and Daniel Moore, Portfolio Manager and Senior Equities Analyst, what Investors Mutual Ltd (IML) sees in the gaming sector, which companies stand out and which companies IML avoids.

What does IML look for in the gaming sector?

Daniel: With any sector, we’re always looking for companies with four criteria:

• A strong competitive advantage
• Recurring earnings
• Capable management
• Ability to grow earnings over time

and we like to buy these companies when they are trading at what we assess as a reasonable price.

When we look at the first two factors – competitive advantage and recurring earnings – a number of gaming companies fit nicely into these categories.

In some cases, the competitive advantage is very strong as they may often be the only player in a particular segment of the market. The companies in which we’re invested in have exclusive, long-term licences – and by long term, we’re talking 50 years plus.

What about recurring earnings?

Daniel: The gaming sector, in general, has always enjoyed fairly solid recurring earning streams – these earnings streams also tend to be more defensive than most other sectors. 

While not completely immune to economic conditions, many gaming companies’ earnings have tended to hold up relatively well even when economic conditions have softened.

Lotteries is a very good example of this. Historically, lottery spend grows steadily over time even during slower periods of economic growth. In fact, studies have been done globally over the past 20 years showing that lottery spend actually grew during periods of recession in places as diverse as the US and Iceland.

Not all gaming companies are the same. Can you explain the differences?

Bruce: Yes that’s right. Not all companies in the gaming sector are the same as there are a number of sub-sectors. IML is attracted to certain stocks in the gaming market where we can see the criteria Dan mentioned earlier – a good track record of recurring earnings, a strong competitive position – in most cases, anchored by long-term and exclusive licences – and run by competent management teams.

As can be seen from the chart below, the total turnover in the Australian gaming sector has grown at 3% per annum in the past six years, and we would expect this trend to continue over the next 3 to 5 years.

Largest sub-sectors by revenue: 1) Poker machines 2) Wagering 3) Casinos 4) Lotteries and 5) Keno 

Source: ABS, Evans & Partners Poker machines are also known as electronic gaming machines (EGMs in the chart).

What sort of returns should investors expect from the gaming sector?

Daniel: Well-run gaming companies tend to produce strong free cashflow, which means that most gaming companies can pay good consistent dividends to shareholders.

In the case of Tabcorp, the current dividend yield is around 4.5% fully franked; in the case of Crown, it’s almost 5% fully franked; and in the case of Sky City, it’s 5% as well.

As an investor your total return is sourced from two components: capital growth and dividends. The dividends received from well-run gaming companies should be fairly predictable over time and, because dividends can often make up a large part of your total return, the returns from gaming companies should be less volatile than the overall sharemarket.

The capital growth aspect of the sector depends on many things, such as how competitive the sector is and how successfully management rolls out new products for its customers, as well as broader factors, including population growth.

What are some of the risks involved in the gaming sector?

Daniel: Regulatory changes are a key risk for the sector and it is something that we have to constantly monitor. This involves regular contact with gaming companies, regulatory authorities and government officials.

Bruce: Another area of potential risk is digital disruption. Fifteen years ago, if you wanted to place a wager on the Melbourne Cup, you had to line up at a TAB shop. Today, people can turn on their smartphones and place a bet instantaneously on one of numerous betting apps. Gaming companies have to be aware of how trends change as this is critical to staying relevant to consumers.

In terms of the specific stocks that IML currently holds, could you break these down for us?

Bruce: Absolutely. Our three main holdings in the sector are Crown, Tabcorp and Sky City – which I will talk about in a bit of detail.

Crown sold out of its Macau and Las Vegas operations in recent years and is now focussed on optimising its Australian operations. Crown has two long-term, exclusive casino licences: one in Perth and one in Melbourne. The WA licence has an indefinite life while the Victorian licence expires in 2050. Crown is building a third integrated resort in Sydney at Barangaroo. This complex will include a six-star hotel, apartments and a casino, for which Crown will have a 99-year licence.

Perth and Melbourne are relatively mature properties, with a mix of world-class gaming entertainment, accommodation, shopping, bars and restaurants. Both these assets are well capitalised and generate strong free cashflows – which are being used to pay a healthy dividend while also being used to fund the expansion into Sydney.

Thanks to the proceeds from the sale of the Macau and Las Vegas operations, Crown also has a very strong balance sheet with no net debt and an apartment sale program which will significantly defray the capital costs of building the new Sydney resort. The Crown Sydney resort is expected to open in the first quarter of 2021 and all things being equal, we think Crown can generate free cashflow of up to $1 per share once the Sydney property is fully functioning.

SkyCity is the owner of long-term licences to operate casinos in Auckland, Adelaide, Hamilton and Queenstown.

Auckland casino is the key asset for Sky City as it generates more than 80% of Sky’s earnings. Given its dominant position in Auckland, the casino there has generated very strong, recurring cashflows over time.

Over the next two years, Sky is expanding and ramping-up its Adelaide casino with the opening of a new hotel and carpark on the site which we expect should increase the visitation and returns from this property over time.

Currently trading on a PE of around 16x and a 5.5% dividend yield, we think Sky is attractively priced given the quality and resilience of the business.

We also have a good holding in Tabcorp across our portfolios. Tabcorp is clearly a very different type of gaming business than Crown or Sky City. Following its merger with Tatts in 2017, Tabcorp’s gaming portfolio now consists of a lotteries business, a much larger wagering business and an expanded gaming services business. Tabcorp has been granted exclusive licences to operate these businesses across Australia for the next several decades, putting it in a very strong competitive position.

We especially like the lotteries business which now makes up about 50% of the company’s earnings. The lottery business has very strong defensive characteristics and a very solid earnings growth profile. The increasing penetration of digital lotteries is a significant opportunity as digital customers spend approximately 50% more than non-digital customers.

Within wagering, Tabcorp’s apps are among the best, if not the best, in the market.

Traditional wagering is a more competitive part of Tabcorp’s business portfolio, and recent changes to tax and marketing regulations have significantly increased the financial burden on the company’s competitors. We believe this development will help Tabcorp’s business improve returns in the years ahead as we will see a more rational industry structure going forward.

Does IML research the other gaming stocks in the sector?

Daniel: We always like to look at sound companies that fit our criteria especially when their share prices are weak. Star Entertainment is a company that falls into that category. Having researched the company, in our opinion it is not in the same strong position as Crown is in Melbourne and Perth especially with Crown moving into the Sydney market with its Barangaroo casino from 2021 onwards.

Star is also expanding its hotel at its Gold Coast casino resort and building a new casino in the Brisbane market. We are uncertain whether the company will generate great returns from this expenditure so at this stage, and we continue to monitor the company closely.

Aristocrat is another company in the gaming sector – Aristocrat is a manufacturer of poker machines (pokies) as well as a developer of mobile games. Aristocrat has done extremely well of late as the company has had certain gaming products that have had amazing success over the past three or four years both in Australia and the US. While we clearly should have invested earlier in the company, we are cautious around the sustainability of the company’s earnings over the long term given its huge success around just a handful of titles. We are also uncertain as to how sustainable the current earnings stream will be over the longer term.

What type of investor would be attracted to the characteristics we find in the gaming sector?

Daniel: Gaming stocks would appeal to investors who prefer less volatility in their portfolios compared to the overall market, as well as a fairly reliable income stream.

This sector could appeal to people in the pension phase of their lives who need consistent income in the shape of dividends. With interest rates where they are today, this could be attractive to many investors.

It could also appeal to those in the accumulation phase of their lives because these companies should deliver solid capital growth over the long term as gaming spend continues to grow over time.

Conclusion

IML is a bottom-up, research-driven manager so every stock is looked at on a case-by-case basis. Having said this, because of the strong competitive position and recurring earnings generated by many companies in the gaming sector, we are always looking for opportunities in the sector and we believe our current holdings in Sky City, Crown and Tabcorp should all do well for investors in our Funds in the years ahead. 

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