In a recent announcement, the fortunes of two of Australia's biggest gaming companies were reversed after a High Court ruling on poker machine compensation paved the way for Tabcorp Holdings Limited (ASX: TAH) to try to claw back a $686 million windfall from the Victorian government, and for rival Tatts Group Limited (ASX: TTS) to try to keep its $540 million in compensation.
While the outcome, which hinges on a 2008 decision by the Victorian Brumby government to remove the companies' duopoly to operate poker machines in the state, will have a significant impact on both companies, let us take a look at which is the best stock pick.
Price performance
In the past 12 months, the share price of both companies has outperformed. The share price of Tabcorp has grown by 35% from $3.42 to $4.59, while rival Tatts Group has grown by 23% from $3.08 to $3.80. Both shares have outperformed the S&P/ASX 200 (Index: ^AXJO)(ASX: XJO), which is up just 3%.
Revenues and profit margin performance
Since 2005, Tabcorp's revenue has fallen by 6.6% per year from $3.7 billion to $2 billion, while the Tatts Group's revenue has grown by 33% per year from $198 million to $2.8 billion.
In 2014, the operating margins for Tabcorp were 15%, while Tatts Group's were 14%, and net profit margins were 6% for Tabcorp and 7% for Tatts.
Since 2005, Tabcorp has seen its earnings per share (EPS) fall by 17% per year while Tatts Group's EPS has fallen by less than 1% per year. Both companies have good forecast EPS growth for the next year.
Debt and return on equity
In 2014, Tabcorp had cash and short term investments of $126 million and debt of $1.1 billion, while Tatts Group had cash and short term investments of $186 million and debt of $1.3 billion. At the same time, Tabcorp had a debt-to-equity ratio of 74%, while Tatts Group's debt-to-equity was 47%. The return on equity (ROE) for Tabcorp was 10%, while Tatts Group's ROE was 8%.
Cash flow performance
Since 2005, both companies have a long-term funding gap. That is, their cash flows after investing, dividend payouts, foreign exchange effects and other financing cash flows have left both with a funding gap — Tabcorp with negative $462 million and Tatts Group with negative $506 million. Tabcorp has a fully franked dividend yield of 3.8% and Tatts Group has a fully franked dividend yield of 4%.
Valuation
The price-to-earnings ratio (P/E) for Tabcorp is around 20 on a price of $4.66, and the Tatts Group's P/E is around 24 on a price of $3.69. The price-to-book ratio (P/B) for Tabcorp is 2.4, and 1.92 for Tatts Group.
Competitive advantage
Tabcorp offers a range of gambling and entertainment products. Its major business units include wagering, gaming, Keno and media activities across Australia.
Tatts Group is active in the wagering, lotteries and gaming industries with an operational footprint extending across every state and territory of Australia, throughout New Zealand and into the United Kingdom
It's clear to me that the competitive advantage both companies have enjoyed has been eroded. Online gambling will have a significant impact on both companies, and on their vast physical retail wagering networks. In order to compete with online gambling competitors, which company will better manage the inevitable migration to the Internet?
Of further concern, the Australian gaming industry is highly regulated and state governments rely heavily on gaming tax revenue. What future legislative changes may take place in the gambling sector as governments attempt to compensate for tax revenue shortfalls from gambling harm-minimisation measures?
Finally, the Victoria Racing Club has just formally committed to the new Seven West Media Limited proposal, meaning Victorian racing will be back on television this week. The VRC joins the Melbourne Racing Club, the Moonee Valley Racing Club and Country Racing Victoria in signing up to the Seven West Media proposal, which will showcase the sport on a new dedicated free-to-air channel, further eroding Tabcorp's competitive advantage.
Which should you buy? Maybe neither
There is very little difference between these two companies in terms of which is a better stock pick. It is the competitive advantage of the sector that is clearly being eroded, and therefore the sector is at risk. I think both of these stocks are overvalued and while I do not disagree that both will have some good growth in EPS in the short term, 9.7% for Tabcorp and 12% Tatts, I think now is the right time to sell both of these stocks.
