By Randy Durig :
Each week we screen thousands of corporate bond listings to find what we believe is currently the best corporate bond for investors needing or seeking higher yields with the least amount of risk possible relative to its projected return. This week, we examine Tatts Group Limited (TTSLF.PK), a leading provider of wide-area networked gambling services primarily in Australia, and its medium-term floating rate debt denominated in Australian dollars. While a modest premium lowers the current yield to maturity of this bond to about 5¼%, we see this coupon's 3.1% fixed spread rate over the Australian 90-day bank bill rate (BBSW) adding significant value to bondholders, should the underlying bank lending rates move higher. Although we anticipate lowered earnings and a reduction of the high 7.6% dividend rate for Tatts equity holders, we also think that the monopolistic nature of its stock may very well represent a better long-term choice for many of our clients that are looking for future growth in their fixed income portfolio's cash flow. As a result, we believe that both the Tatts debt notes and its equity are worthy of consideration and inclusion in our Foreign and Global Fixed Income Portfolio .
Assessing the Yield Curve
Wealth preservation by achieving returns that can outpace moderately rising inflation continues to be the prime directive from our clients. As the ominous threatening of the "fiscal cliff" waxes old and Washington's intelligentsia labors to conceal the next pitfall to prosperity, perhaps one of the more salient truths to consider should be how their common resolve for political self preservation continues to proliferate big government. In short, this simply means more taxing and more spending (and invariably, the printing of more and more money to be taxed and spent.) Spending less seems to be most applicable only in the government's view towards the 1.7% cost of living adjustment (COLA), which evidently isn't increasing anywhere near as significantly as the costs of governing, regulating, or caring for its constituents.
Nevertheless, we remain focused on achieving yields high enough to outpace whatever measure of inflation is imposed upon our clients. By diligently searching for the highest yields relative to the potential risk, we are working to stack the deck in favor of positively accruing cash flow and sound wealth preservation. Consequently, we believe this medium term, 6-year floating rate note and/or the higher dividend yields offered from Tatts Group are a smart solution to the challenging and unpredictable global economic climate as long as the underlying fundamentals of the issuer, which we will review in more detail here in this article, remain sound.
A look at the issuer
Listed on the ASX since July 2005, the Tatts Group traces its founding to 1881 and is comprised of a portfolio of networked gambling businesses with core operations consisting of lotteries, wagering, gaming and technical services. Tatts is a high volume transaction based business with strong in-house wide-area network technology capability. It also operates gaming machine monitoring, technical maintenance and network support services businesses, and employs more than 3,000 people. Tatts Group is in all States and Territories of Australia, the United Kingdom, Malta, Romania, South Africa, and New Zealand, and is currently bidding for Ireland.
Some of Tatts business divisions are monopolistic in nature, being regulated by and providing funding for local governments. Even though the local municipalities are in charge of licensing and regulation, according to our calculations, this represents about 47-49% of the cost of the state sanctioned lotteries business. That's before any consideration of the corporate taxes that Tatts pays on profits, or what might be retained as taxes on any individual winnings. This means that the local governments always profit very handsomely, and a vendor that provides robust services ensures vibrant revenues for these municipalities. Thus, the financial success of the gaming company is interwoven into enabling and establishing these mutually beneficial relationships. In these tough economic times when most governments are seeking new ways to increase cash flow into their coffers, the alluring additional revenue that state sponsored gaming can generate is being viewed as a vital and necessary income stream for many municipalities.
The Group typically achieves consistent and reliable revenue through technological solutions that deliver high volumes of low average value transactions through a widely dispersed distribution network. The company business focus is to now take its ground game, the lottery and keno gambling machines as individual portholes in thousand of locations, to the lower cost Internet in order to tap a wider user base.
Mr. Robbie Cooke, Chief Executive and Managing Director, has taken the helm in January of 2013. Prior to Tatts Group, Mr. Cooke managed a very successful major Australian internet-based online hotel and travel service. Tatts Online was established in 2011 as a vehicle to harness the investments in technology already made within the Tatts Lotteries and TattsBet businesses, and leverage that investment to create a leading presence in the online channel. Following the investment in an in-house developed lottery system and enhancements to its TattsBet wagering platform, Tatts undertook a major technology project to bring the two together to form a new compelling and competitive online offering - Tatts.com. While Tatts.com launched as a single platform online account for lottery, racing and sports betting services, Tatts committed to delivering on the new technologies headlined by Tatts.com, which is now available through the Internet, Tablet PC's and mobile phone apps. As a result, a wider base of lottery and wagering customers now have a much greater choice of how, when and where they access and utilize Tatts' terrestrial and online channels.
This appears to be the implementation of their strategy to migrate their local proprietor-based lottery and keno platforms to an open gaming platform on the Internet. This United States NFL football betting line link is an example. One of the most significant benefits of this new platform may be that in addition to improved accessibility and ease of playing local lotteries, it enables customers to play any number of Tatts' wagering products at any time through one single account.
We like companies that are profitable
Driven by strong operational performance, the financial results for the year ending June 30, 2012 were outstanding and represent a record profit for the Tatts Group. Currently, one dollar Australian (A$1.0) is equal to about $1.045 US. Year-over-year overall revenues increased 6.3% to $4.06 billion (in US dollars), and earnings before adjustments (EBITDA) was up 5.5% to $679.5 million. Especially noteworthy is the improvement in Tatts more stable Lotteries business revenue stream, which through acquisitions and organic growth has expanded from its 2007 EBITDA of $38.9 million to $233.9 million in 2012. It is projected that this monopolistic portion of their business will soon be their dominate business.
In our multiplicity of reviews of Tatts, we were impressed with its steady growth of sales and earnings (EBITDA) over many years, and see that the biggest risks to earnings and cash flow were not likely to be big fluctuations in the demand for their services, but rather, a loss of licensing such as Pokies. Tatts' Pokies (gaming machines) business has just recently ceased operations (August 2012) following a government decision over four years ago in April 2008. In April 2008, both the bonds and the stock of Tatts were hit hard and continued to languish waiting for the Pokies revenues to end. The yearend annual report (September 20, 2012) forecast that Tatts Lotteries business (which contributed $233.9 million in 2012) would represent around 50% of Tatts' EBITDA in 2013, while TattsBet (which contributed $142.4 million EBITDA in 2012) and Tote Tasmania (expected to contribute $13 million EBITDA in 2013) together were projected to account for about 35% of EBITDA in 2013. In all, over 75% of Tatt's EBITDA (excluding Pokies) is generated from licenses that run for over 35 years.
In November, Tatts announced that it had agreed to pay $446.2 million for the exclusive rights to manage the South Australian brands and products (the high margin Lottery and Keno businesses) for the next 40 years (starting in December) and Tatts expects the deal to bolster a one-third hike in earnings (EBITDA) from its lottery business in the next two years. The deal gives Tatts the rights to operate lotteries in every state and territory except Western Australia, and the company expects to reap significant gains from the efficiencies of integrating the operations, marketing and technology with its existing operations into a single lottery operating system.
Considered together, the loss of Pokies and the addition of South Australian products are likely to equate to about a 10% net reduction. Given its earlier Tasmanian and the Northern Territories acquisitions along with its impressive Online growth, the long coming issue of Tatts losing Pokies reminds us somewhat of the many outlandish Y2K scares of the late 1990's. The world's computer systems did not crash and burn in 2000, nor has the revenues and earnings for Tatts Group. In fact, rumors were growing that Tatts Group might acquire their largest competitor, Tabcorp Holdings Limited. However, the rumor was dampened when retail betting operator Tabcor recently renewed its licenses. As Tabcorp is geared more towards retail betting and Tatts is focused more on lotteries and leveraging off them through one account access online, it seemed this merger might make the economies of scale quite attractive. But as we see it, Tatts appears to be focused more on what is believed to be a better (monopolistic) business model of operating State sanctioned games.
Interest Coverage Ratios
At 30 June 2012, Tatts' net debt-to-EBITDA was only 1.8 times, with interest coverage being 6.3 times, both of which are exceptionally strong positions. However, factoring in the recent $446.2 million drawdown from its available debt facility for its acquisition of South Australian gaming rights and the projected reduction in earnings for 2013 will likely result in a more modest debt-to-EBITDA nearer to 3x's and an interest coverage of about 4x's.
We like companies with lower debt to cash ratio
Total Cash reported at 2012 year end was $303.2 million, and interest bearing liabilities totaled $1.336 billion. Tatts will pay out 97.5% of its 2012 profits as dividends to shareholders in respect of the 2012 financial year, representing 24.0 cents per share. This was the sixth consecutive year where the dividend payout ratio has been over 90%, a threshold that the Board of Tatts Group intends to continue in the future. The cash flow from the business underpins the Group's consistently high dividend payout ratio and contributes to ensuring that Tatts stays comfortably within appropriate investment grade credit metrics after the Tatts Pokies business ceased in August 2012.
We like companies that have good balance sheets
Tatts Group market capitalization is A$4.54 billion and its total debt is currently estimated to be near A$1.77 billion, which would result in a debt-to-equity position around 39%. Considering its strong earnings, cash flow, and high dividend payout policies, we see Tatts as having very good balance sheet flexibility.
We like higher yields
Whether it's the prospective 5¼% yield to maturity of Tatts floating rate notes or the potentially higher dividend yields and growth from its stock, we believe that both of these Australian investment instruments offer diversification away from overweight US dollar based fixed income positions as well as significantly higher yields than what is typically available from any comparable US based corporation, if such a comparable could even be found. (So far, we are unable to find one.)
The default risk is the Tatts Group ability to perform. Relatively speaking, Tatts is small when compared to other gaming companies such as Las Vegas Sands Corporation ( LVS ), Wynn Resorts Ltd. ( WYNN ) or MGM Resorts International ( MGM ) and it may face increasing competition from substantially larger and better-financed companies for future business. However, its long history (over 130 years) and rather unique strategy of growing Lotteries and then leveraging that business to its low cost proprietary Internet platform inclines us to believe that Tatts has a very desirable business model, with high profit margins and sound governmental support. Given its sound cash position, excellent cash flow, and the flexibility of its balance sheet, it is our opinion that the default risk for this short-to-medium term bond is minimal relative to its much more favorable return potential.
Tatts Group operates within a highly regulated industry and is exposed to licensing risks. Considering that around 75% of the Group's continuing EBITDA is generated from licenses that run for at least 35 years, this also present a significant barrier-to-entry for new competition.
The currency risk of the Australian dollar could and will affect the returns of these bonds and possibly in a negative way as it exposes investors to Australia's economy and the policies of the Reserve Bank of Australia.
We believe these Tatts Group bonds have similar risks, maturities, or yields to other Australian currency bonds such as Morgan Stanley ( MS ), Goldman Sachs ( GS ), G.E. Capital (GE) and JPMorgan Chase (JPM) reviewed previously on our Bond-Yields.com blog.
Summary and Conclusion
It is our opinion that Tatts Group, being the largest in its industry in all of Australia and an important tax contributor to the local governments, has positioned itself extremely well for the future as a monopolistic advantaged company. Being able to leverage that advantage to facilitate increased business and opportunities is very rare in the gaming industry, and with Tatts' move to replace nearly all of its lost license (Pokies) business in such a short period of time, we see both the bonds and the stock dividends potential of this company representing higher yields relative to the risks that we can identify for it. Therefore, we have chosen Tatts Group for addition to our Foreign and World Fixed Income holdings.
ASX (TTS.AX): 3.09
-OTCBB (TTS-F.PK): 3.26
Bond Coupon : 6.29 FRN (90 day BBSW + 3.10%)
Maturity : 7/5/2019
CUSIP : Q8834KAA0
Yield to Maturity: ~ 5.25 %
Disclosure: Durig Capital and certain clients have positions in Tatts Group or Tatts Group 2019 bonds.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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