Lame duck, in literal sense, refers to a duck unable to keep
up with its flock. Market sure thinks that the Ladbrokes Coral Group (LCL) - the
second largest gambling operator globally in terms of net revenue - is a lame
duck. LCL lags its peers by a big margin - trading at 7.4x FY18 consensus
EPS (peers trade at 13x), under 6x FY18 forecast EBITDA (peers are at 9x), and at
11.12% FY18 forecast free cash flow yield (peers are at 8.5%). If LCL were to
match its peers, its shares should be around ~£2, which at the current share price
of £1.2 implies a discount to peer multiple of ~40%. For the second largest operator
in the sector, LCL sure looks cheap (see key stats below).
But, there is a reason for market’s concern. The UK’s Department for Culture, Media and Sport (DCMS) is carrying out a review of the perceived harm caused by fixed-odds betting terminals (FOBTs or B2 machines in technical jargon) – these are gaming machines within betting shops which offer games like roulette and have acquired an infamous reputation as the “crack cocaine” of gambling. FOBTs currently allow a bet of up to £100 per game every 20 seconds, although in practice the average bet tends to be a lot lower and there already is strict self-regulation where bets over £50 are heavily policed. However, FOBTs have a bad name and the DCMS is set to publish its Triennial review in October 2017 where it will likely recommend restrictions on them, including a cut to the maximum stake per bet. Rumours are that the review will contain four options for FOBTs: status quo, max stake cut to £30 per bet, max stake cut to £20 per bet and max stake cut to £2 per bet. In all likelihood, the eventual outcome, after a period of consultation, will be a cut to the maximum stake per bet of a material number. Analysts predict that a cut to FOBTs max stake to £2 per bet could result in LCL’s revenues falling by £450m per annum, and a cut of £20 or £30 lead to LCL’s revenues falling by ~£90m. The market clearly is concerned and appears to be pricing in a bad outcome.
However, based on the price targets of 17 analysts who cover
LCL, the market appears to be pricing in too much of a discount.
If the median estimate of the 17 analysts offering a target
price for LCL is to be believed, the current share price offers a ~33% upside
over the next 12 month period. This is worth looking into in a bit more detail.
Breaking down LCL
In addition to its UK retail estate which is in the eye of
the regulator, LCL has a fairly decent European retail estate and a strong
growing Digital platform. Both European retail and Digital divisions combined
delivered ~37% of the group’s revenue in FY16; this is set to grow with Digital
continuing to perform very well operationally. None of these divisions are
impacted by any changes to the FOBT regulations.
Applying peer multiple of 7x EBITDA to the European retail
division and 12x EBITDA to the Digital division’s forecast FY18 numbers, the UK
retail estate trades at a paltry 1.3x forecast FY17 EBITDA (see table below).
This implies that the market expects a disastrous outcome for the UK retail
estate revenue and profitability going forward.
UK Retail estate and
FOBTs
LCL’s UK retail estate generates revenues from both over the
counter (OTC) bets on sporting events and from machines (both FOBTs and B3
machines). Both OTC and B3 machine revenues are not the subject of the
regulatory review. Based on available historic results for the combined group, LCL
derives ~35% of its total revenues from gaming machines in its UK retail
estate; based on management’s recent presentation, approximately 67% of machine
revenue comes from FOBTs (B2 machines) which are subject of the review; the
rest of LCL’s machine revenue come from B3 gaming machines where the max stake
is currently at £2 per game and is not subject to the regulatory review.
Therefore, ~25% of LCL’s revenue is at risk [35% machine revenues x ~70% B2
revenue] from the impending regulation on FOBTs (this can’t be strictly true as
there will be a number of shops where the machine revenue partly subsidises the
OTC business without which the shops will be loss making and need to shut
resulting in a reduction of a part of OTC revenues, but for the purposes of our
analysis I am solely focusing on the direct FOBT revenues which is at risk from
the regulation).
25% of LCL’s revenue equates to ~£530m based on an average
of last two year’ results. How much of the £530m is at risk if the maximum
stake falls to £2 or £20 or £30? Management do not give this information or
provide sufficient background information for us to be able to estimate this
precisely. However analysts have forecast a fall in LCL’s revenues of £450m if
the FOBT max stake is cut to £2 and a fall in LCL’s revenues of ~£87m if the
FOBT max stake is cut to £20/£30.
I think the analyst forecast makes sense in both scenarios.
Data from the UK’s Gambling Commission shows that a B3
machine, which has a max £2 stake per bet, yields roughly 30% what a B2 (FOBT)
machine does. Therefore, if the FOBT stake is cut to £2 and all of LCL’
machines (regulation restricts 4 machines per shop equating to 14.6k machines
in total across LCLs 3,660 shops) lose 70% of their yield, the revenues would
drop by ~£380m; add a trimming to the shop estate of ~5-10%, the total revenues
would drop by ~£450m under a £2 FOBT scenario.
As for the analyst forecast of ~£87m drop in revenues if the
max FOBT stake is cut to between £20/£30, this one is more difficult to
reconcile. Detailed information on the gross yield per machine per stake bet is
not available. The best stat I could find was from a report published by
Responsible Gambling Trust in 2016 that uncovered data on FOBTs. The report
found that the average bet on a FOBT was £8.17 across a total of 9.2 million
bets sampled (which is a fairly large sample size). The report found that the
average max stake bet lost 50% more per bet (£15.39 per gambling session)
compared to a non-max stake bet, which lost £10 per gambling session. Using
these stats, and assuming just over 30% of the losses are incurred by players betting
max stake bets, one can work out a loss in revenue of ~£85m for a cut in max
stake to £20/£30. Another study by RGT which surveyed 4001 loyalty cardholders
found that ~16% players placed max stake bets, therefore assuming 30% of losses
are incurred by max stake bets appears more than prudent (that said, not sure
if a max stake player would necessarily respond to a survey in the
affirmative). Broadly, the prediction of revenues falling by ~£87m for a
£20/£30 FOBT scenario also appears reasonable.
Applying peer multiple to the FY18 EBITDA forecast for both
my worst case (max stake cut to £2) scenario and my base case (max stake cut to
£20) results in a per share value of £1.47 and £1.62 respectively. This
represents an upside to current share price of 22-35% (see table below).
FCF forecast and DCF valuation for base case and worst case
Below, I present my DCF valuation for LCL using a WACC of
8.8% and nil terminal growth rate.
Valuation summary
Risks
-
European retail and Digital don’t perform as
expected
-
Revenue and margin fall due to FOBT regulation
are more severe than forecast
Additional potential
upside
-
GVC, the online gambling group, has previously
shown interest in LCL and rumours of GVC’s continued interest in LCL have been
doing rounds lately. GVC will likely wait for the outcome of the FOBT review
before making a move, but its interest provides downside protection and
potentially an upside if the FOBT review outcome ends up in the base case
scenario.
- My forecast above assumes that any reduction in
FOBT stakes will take effect from FY18 onwards; it is highly likely that the
period of consultation will mean that the effect of a stake reduction is likely
to kick in later or from FY19, which should be an upside to my forecast. This
will also allow the company sufficient time to cut overheads and shops (with an
average lease length of ~3.5 years and well negotiated terms for lease breaks
according to management, the company has good flexibility).
