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Betting giant Tabcorp Holdings' $300 million jackpot

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These lottery ticket sellers have penned a new distribution agreement, but with one clear victor.

In business, some situations are win-win. Tabcorp and Jumbo Interactive just showed us the other kind.

Michael Porter's five forces theory explains what went down. Porter believes that a company's competitive position depends on five factors: the threat of substitute products and new companies entering the industry, the intensity of rivalry between competitors, and the bargaining power of customers and suppliers.

Jumbo scores well on most of Porter's forces. The company buys lottery tickets from Tabcorp and re-sells them online, and there are few digital alternatives; it's a heavily regulated industry, which discourages new competition; and customers don't have any bargaining power due to ticket pricing being regulated, too.

On the whole, Jumbo is in a cosy position with more than 2 million punters using its site and a 20% share of online ticket sales.

It's the last of Porter's forces - bargaining power of suppliers - that's Jumbo's Achilles heel. The company's business depends entirely on Tabcorp, which has a monopoly over Australian lotteries.

Tabcorp and Jumbo have announced an eight-year extension to Jumbo's re-seller agreement through to July 2030. We previously flagged this agreement's renewal as the biggest risk to investing in Jumbo, so, if nothing else, the agreement's finalisation removes significant uncertainty around what Jumbo and Tabcorp's future earnings will look like.

Tabcorp currently pays Jumbo a 9% sales commission on the ticket price, and Tabcorp left that commission in place. But the company has introduced a new 4.65% service fee on ticket sales that Jumbo needs to pay, which lowers the effective commission from 9% to 4.35%. Tabcorp is also charging an up-front $15 million extension fee.

Jumbo got what it wanted - continued status as an authorised re-seller - but the negotiation had a mafia/shopkeeper tone: 'Sure, we'll watch over your store ... but there's now a monthly 'service fee' ... and we can't guarantee your safety if you refuse.'

The service fee will scale up from 1.5% in 2021, to 2.5% in 2022, 3.5% in 2023 and 4.65% thereafter. However, if ticket sales exceed $400 million the higher fee kicks in straight away. Jumbo's management expects to sell $335-341m worth of tickets in 2020, so there isn't much room for growth before the full 4.65% starts.

One $300 million pie, please

The new agreement won't have any effect on ticket sales, so this is purely a re-slicing of the pie in Tabcorp's favour. Jumbo's effective margin on ticket sales is 20% (its 9% commission from Tabcorp and an 11% premium charge, which the ticket buyer pays). But the new agreement lowers that to 15.4% - a 23% revenue cut that will cut profits by 30% or so looking 10 years out.

Jumbo could increase its prices to make up the difference, but that would encourage punters to save by buying directly from Tabcorp. We think the premium is more likely to be lowered over time as the company tries to hold onto market share.

Accounting for lost future profits, the new agreement reduces Jumbo's valuation by around $300m compared to the status quo. And that's been entirely captured' by Tabcorp, though the deal only adds a few percent to the company's intrinsic value, given its larger size.

Still, the new agreement shows Jumbo's customers are valuable to Tabcorp - the company could have squeezed Jumbo even more or refused to renew at all, but it would risk losing additional ticket sales. Jumbo clearly has some negotiating power, just not as much as the mobster holding the lottery licence.

This was a good outcome for Tabcorp shareholders. And while Jumbo has given up some future profitability, the added certainty around what that profitability will look like gives us more confidence in the company. It also provides more certainty to pursue other growth opportunities, such as lotteries for charities and overseas lotteries.

Jumbo's share price is down 7% since we downgraded to Sell in February and could be slightly undervalued, but there isn't enough margin of safety to warrant an upgrade to Buy. We're removing Jumbo from ongoing coverage until the share price falls below $8.50 when we'll consider upgrading.

Our Tabcorp valuation already incorporated a favourable outcome from the agreement, so our price guide remains unchanged. We're sticking with BUY.

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Graham Witcomb is a senior analyst at Intelligent Investor owned by InvestSMART Group. Graham has a degree in psychology from the University of Sydney and is a Chartered Financial Analyst charterholder. He previously worked for one of the world's most successful professional gamblers, and joined InvestSMART in 2013 where he focuses on healthcare, insurance and transport infrastructure. This article contains general investment advice only (under AFSL 226435). To unlock Intelligent Investor stock research and buy recommendations, take out a 15-day free membership.
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