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Two Undervalued ASX Shares in a Beaten Down Industry

Morningstar’s two stocks suited to investors with different styles.

Joseph Taylor | Morningstar 

When I was at university, I worked at a bookmaker to fund my social life. As my degree was from the University of Glasgow, you can imagine it was quite the experience. One day a punter made up a fake bet and threatened to “rag-doll” me and my colleague if we didn’t pay it. A few days later someone ran into the shop and threw a tin of paint over the carpet. I loved the job.

Ten years later I’m writing about gambling stocks on the other side of the world. I’m doing so because they have been beaten up recently. So much so, that two stocks in the space have become five-star picks given their discount to our analyst's estimate of Fair Value.

Just because a stock has a five-star rating doesn’t mean that it’s suitable for your portfolio. That depends on your goals and the approach you are comfortable taking to get there. At Morningstar, we recommend using this information to write yourself an Investment Policy Statement. We think that writing it down and keeping it at the forefront of your mind increases your chances of success. My colleague Mark LaMonica wrote about the power of having an investment policy statement here.

This can be useful because it refines what kind of investments you are looking for. It can also keep you sane while you are holding them.

If you are looking for “never sell” shares that will hopefully compound for many years, you may want to focus on companies with a durable moat protecting their profits and returns on capital. If you are just looking for bargains, you might gravitate to out of favour shares with the potential to re-rate if investors become less pessimistic. In other words, you might care less about quality and focus purely on price.

Tabcorp Holdings (ASX:TAH)

Moat Rating: None
Fair Value Estimate: $1.05 
Uncertainty: Medium

Tabcorp conducts wagering through a network of retail venues, including racing venues, hotels, and TAB agencies. The shares have fallen recently due to concerns over a cyclical fall in wagering and the sudden resignation of the company’s CEO.

Our analysts expect Tabcorp to remain the king of physical wagering due to licensing requirements. But they also think the physical side of TAB’s business is in structural decline. The growth of online betting has eroded the value of TAB’s physical business. Punters can use their phone to bet with rival firms while in TAB-exclusive venues. As a result, geographic exclusivity no longer translates to a monopoly.

The shift to online betting was accelerated by Covid-19 shutdowns. And while our analysts expect Tabcorp's digital offerings to pick up some of this growth, the online space is much more competitive. As most online betting uses fixed odds, betting companies are essentially offering a commodity and are competing on price alone.

It’s also hard for companies to deliver a better product without it being replicated quickly. In the UK, I remember when Betfair’s Sportsbook pioneered the ability to “cash out” bets before the match had finished. This was a big innovation but it was soon par for the course. Speaking of Betfair, their dominant exchange business (where punters place bets with each other rather than against a bookmaker) almost certainly benefits from strong network effects. Too bad you can no longer invest in this asset on a standalone basis – it merged with Paddy Power to create Flutter Entertainment (NYS:FLUT) in 2016.

Now for the good news on TAB.

While TAB’s physical channels face a major threat from online wagering, they continue to deliver solid free cash flow. And while the online space is more competitive, the shift to digital betting comes with some benefits too – like the fact that its costs are spread over far more bettors. As TAB’s online offering gains more scale, our analysts expect the firm’s overall operating margins to rise from 5% to 11% over the next decade. Tabcorp also has a strong balance sheet as the demerger of The Lottery Corp in 2022 removed most of its debt.

At $0.74, Tabcorp has fallen to a share price around 32% below our analysts’ Fair Value estimate of $1.05. As well as improved margins, our analysts expect 3% annual revenue growth over the next decade as growth in online wagering offsets lower physical wagering revenue.

Key risks include faster than expected erosion in TAB’s physical business and regulatory risks. While regulators have traditionally focused on electronic gaming machines, they could spill over into other parts of the gambling sector and affect TAB’s business.

SkyCity Entertainment Group (ASX:SKC)

Moat: Narrow
Fair Value Estimate: $3.10 
Uncertainty: High

In contrast to TAB, our analysts think that Sky City has a narrow moat. This stems from its status as a regulated monopoly casino operator. Sky City’s two biggest assets are monopoly positions in Auckland and Adelaide. The exclusive licence for Auckland runs until 2048, while the Adelaide licence expires in 2085 with exclusivity guaranteed until 2035.

These properties have performed strongly thanks to SkyCity's solid record of reinvestment, resulting in high property quality, stable visitor growth, and resilient earnings. SkyCity has continued this reinvestment with a major $330 million expansion for SkyCity Adeleide and a NZD 750 million upgrade to SkyCity Auckland, which will be completed by 2025.

Based on what we learned about the erosion of TAB’s moat in physical wagering, I was keen to hear our gaming analyst Angus Hewitt’s thoughts on whether this could happen to Sky City. Does the ability for people to play roulette, blackjack and slots online reduce the value of SkyCity’s monopolies on in-person gaming?

Angus feels that the experience of going to a casino is much harder to replicate online than betting on a horse race. If you're trackside, the difference between walking up and placing a bet with the TAB versus placing a bet on your phone is negligible. You get exactly the same outcome (a bet) and it may even be a better experience as you don’t need to queue. Spending a night at the casino and feeling the chips in your hand is very different to playing blackjack on your phone.

Why have SkyCity shares fallen?

The weakness in SkyCity shares has mostly been due to regulatory headwinds. A short suspension of the New Zealand casino licence looks likely due to alleged breaches of harm minimisation laws. The Adelaide casino licence is also under review, and there is significant uncertainty around the AUSTRAC civil penalty against SkyCity Adelaide.

Our analysts think a loss of the Adelaide casino licence is unlikely and that the potential impact is limited — Adelaide only constituted around 10% of pre-coronavirus earnings. They do note, though, that SkyCity's regulatory and compliance costs are up sharply and could stay at these higher levels.

The weaker discretionary environment is also weighing on the mass market consumer —notably in gaming machine play. And if that wasn’t enough, investors appear to be concerned that SkyCity’s huge investment projects in Adeleide and Auckland may not pay off. Our analysts think the pessimism is overblown. They expect a recovery from the current cyclical downturn and for the core Auckland property to capitalize on the continued recovery in New Zealand tourism.

Capital spending is also set to ease materially as about NZD 1 billion in major projects across Auckland and Adelaide near completion. When the Auckland project comes online, our analysts expect SkyCity to resume generating excess returns and strong cash flows on a higher earnings base. They think Sky City has a fair value of $3.10 per share – around 49% above current levels.

Different strokes

SkyCity and TAB are both cheap according to our analysts, but their long-term competitive positions look very different. This means the shares will likely be suited to investors with different styles.

For buy and hold investors, short-term uncertainty can provide a chance to scoop up companies with durable competitive advantages for cheaper than usual. Companies without these advantages can also deliver good medium term returns when the price is (very) right.

In these cases, it’s a bit like my job at the Glasgow betting shop. Great for a while, but maybe not forever.

Joseph Taylor is an associate investment specialist, Morningstar Australia.

 

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All prices and analysis at 2 May 2024.  This information has been prepared by Morningstar Australasia Pty Limited (“Morningstar”) ABN: 95 090 665 544 AFSL: 240 892 .

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Morningstar

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