Analysts urge punt on 'resilient' gambling firms

Leisure Report, May, 2008

The stock market's pricing of gambling stocks has thrown the form book out of the window, and applied too great a weighting to downside risk, overlooking the habitual nature of gambling, its relative resilience, strong cash generation, high margins, barriers to entry and secular online growth, according to Dresdner Kleinwort.

In a new research note, 'The business of gambling', analysts at the investment bank suggest that much of the sector's recent poor share price form has been impacted by the market's incorrect extrapolation of short-term issues into longer-term trends (for example unfavourable football results in the second half of 2007, the Turf TV legal wrangle, FOBT machine legislation).

The firm maintains "significant pent-up demand for gambling exists, particularly in Europe and Asia, and our universe of market-leading gambling stocks is in a strong position to capitalise on this growth".

Dresdner Kleinwort also pointed out that recent share dealings by directors have seen a flurry of purchases from executives and non-executives alike at Ladbrokes, PartyGaming, Rank Group, Sportingbet and William Hill, among others--a clue from within the stable, it suggests.

While the majority of gaming stocks have outperformed their rivals in the wider travel and leisure sectors since the peak of the cycle (given as 23 May 2007) analysts at Dresdner Kleinwort maintain that: "Given the relatively defensive nature of gambling, driven by its habitual and low ticket price nature as well as secular growth online, we still believe he market has de-rated the subsector far too aggressively."

Overall, the gambling sector has been de-rated by between 0-52%, with only 888 delivering a positive return over the period, while Rank and PartyGaming are down by more than 50%.

Onling gaming stocks have also fallen along with the market, however, there have been no downgrades to three of the four online stocks covered by Dresdner Kleinwort--the price decline in each case has has been driven entirely by the de-rating.

The research points out that the gambling sector was already trading at a P/E discount to the overall leisure sector prior to its peak, very little material freehold property is owned, and many firms have positive cash balances with zero debt. In addition, none of the stocks covered by the research have mentioned to date any impact of a weakening consumer on current trading or been cautious in their outlook. In contrast, the majority have been relatively bullish about prospects in updating the markets, especially given their desire to win concessions on issues such as FOBT machines.

There is also a sizeable discrepancy between individual stocks, with William Hill down by 40%, compared with a 21% slide for Ladbrokes, while 888 has gained 27% compared with PartyGaming's 51% fall. Although William Hill's deficit to Ladbrokes narrows to 17% on an EV/Ebitda basis, this, along with 888's 54% P/E premium to PartyGaming, seems unjustified.

The low ratings also belie the sector's historic form, the research suggests. Dresdner Kleintwort's nine covered gambling stocks trade on an average 2008E P/E of 13.2x, falling to 11.7x in 2009E. Whilst the note concedes the consumer and travel & leisure sector outlook remains uncertain, it suggests William Hill (8.9x 2008E P/E), PartyGaming (10.5x) and Sportingbet (8.8x) stand out and offer the greatest upside potential and relatively limited downside risk, without the need for earnings upgrades.

As the analysts note: "Form is temporary, class is permanent: But much of the sector's recent poor share price performance is down to form". While the risk of further machine curbs remains, Dresdner Kleinwort says the threat is limited. "The growth of machines is a naturally easy target for the anti-gambling factions of society. It is not surprising, therefore, that the government wishes to be seen to be actively monitoring the development of these products ... the latest government decision to review machines is therefore not unprecedented and should not automatically be assumed to have negative implications."

In addition, FOBT revenues contribute about 350m [pounds sterling] a year to the Treasury, and the bookmakers also hold the trump card of being able to move their telephone and online operations offshore--a move the analysts estimate could save William Hill up to 35m [pounds sterling] in corporation tax, Levy and GPT.

In the online sector, covered stocks experiencing top-line growth of more than 20% to date in 2008, meaning that macro-economic issues will have a limited impact on the sector. Despite this, the shares are trading at just 12.7x e2008 P/E--Dresdner Kleinwort says the market is double counting the downsides.

Most industry voices agree that consolidation, especially in the online market, is a natural next step, although the catalyst depends largely on the outcome of individual company discussions with the US Department of Justice. The bank believes M&A will be driven by three subsectors: Online 'pureplays'; Land-based operators with existing online operations; and new entrants.