It may seem disparaging to say The Lottery Corporation is well rid of its wagering stablemate, but the opportunity to more appropriately value TLC is welcomed.
It might be argued, with the benefit of hindsight, that the 2017 merger between Tabcorp and Tatts Group (after a protracted courtship) should not have happened. The demerger of TLC into a standalone lotteries business largely recreates the Tatts Group entity.
Prior to that merger, Tatts had accumulated the key lottery businesses in Queensland, NSW, and South Australia to complement its Victorian base. Together, these lottery businesses have created a highly attractive investment with strong cashflow generation and defensive characteristics.
TLC holds long-dated lottery licences in nearly every state. Except for Western Australia (a potential longer term acquisition opportunity), TLC is the dominant operator of lotteries across Australia and utilises a network of 3,863 retail outlets and a long-term reseller agreement with Jumbo Interactive (JIN).
TLC has progressively built a sturdy online business that now accounts for 32.8% of total lottery sales and this should continue to increase. The direct benefit of online sales is the absence of the (approximately 10%) commission paid to the retail network.
TLC also holds licences for Keno products which is played at 3,409 venues around the country.
Lotteries account for approximately 84% of group FY21 EBITDA with Keno contributing the balance.
Lottery turnover has enjoyed a compound annual growth rate of 8.4% since 2017 with the division selling over 600 million tickets in FY21 for revenue of $3 billion. Roy Morgan research reveals that nearly half the adult population in Australia purchased a lottery ticket in the 12-months to September 2021.
Powerball and Oz Lotto drive lottery earnings. A good deal of the growth in lotteries is attributable to growth in the key Powerball and Oz Lotto games. Changes to the critical aspects of each game, together with price increases, has invigorated ticket sales.
The increasing frequency of jackpots over $15 million has also stimulated ticket sales. So far in FY22, for example, there have been 12 Oz Lotto and 27 Powerball jackpots over $15 million at an average 1st division prize of about $41 million. Year-on-year lottery sales are up by about 5%.
TLC instigated a change to its Oz Lotto game in May 2022 which should stimulate higher jackpots and more favourable jackpot runs. The addition of two extra balls to the draw (total now 47) increases the odds of winning the 1st division prize to 1 in 62.9 million (from 1 in 45.4m). A price increase of 8.3% or 10c per standard game is not expected to impact on player demand.
TLC’s low capital requirements contributes to a high free cashflow. The long-term lotteries earnings are reasonably steady and appear to be impervious to events such as the recent pandemic. Indeed, sales went up during that period, particularly online, but also as the retail network remained open. TLC’s capex is expected to be around $40 50 million pa over the next few years while free cashflow could head towards $500 million by FY25f.
Investment view
We think of TLC as a quasi-infrastructure business given its long-dated licence structure, regulated industry, and its annuity-like earnings. TLC’s current trading multiple has already re-rated about 2-3pp to the 14-15x multiple implied in TAH’s trading prior to the demerger. Indeed, this re-rate effect is a principal benefit of untethering TLC from TAH, and we see the re-rate process as far from complete.
As a broad guide to infrastructure multiples in the market today, Transurban is at 22x FY23f EV/EBITDA and among recent trade sales, Telstra’s mobile tower assets traded at 28x (for a 49% stake) and Sydney Airport was privatised at a multiple of 24x in 2021.
We think the market is overestimating the gearing the company will carry which in turn will affect the dividend payout being assumed. TLC’s target range for gearing is 3.5-4.0x but we see actual gearing being significantly below this. We think gearing can reach around 2.5x by FY25f due to growth in EBITDA and debt reduction along the way. TLC’s next major licence renewal is not until 2050 (see Figure 4) in NSW and although the Victorian licence is due in 2028, this will not be a meaningful outlay given the licence is for 10 years (TAH paid $120 million at the 2018 renewal).
In contrast, the company is a big free cash flow generator which will facilitate debt reduction and a dividend payout ratio gravitating towards the top end of the 70-90% target range.
Risks to investment view
Unfavourable changes to the regulatory and tax frameworks may impact TLC’s licences and earnings. The licences are all issued by the relevant State Government under individual Acts. The regulatory framework has been quite consistent over the last 10-15 years and the risk of higher taxes/royalties is fairly low compared to other forms of gambling. There could be earnings risk brought about by volatility in jackpot sequencing. A strong run of large, frequent jackpots could be followed by a lean run of smaller, less frequent jackpots. The retail network benefited from COVID-19 with a higher than normal sign-up of new customers. Normalisation of this trend could pose a risk to ticket sales and earnings.
Recommendation
We initiate our coverage of TLC with a Buy recommendation.
