Edmond Jackson's Stockwatch: Time to accumulate this bookie?

Is Ladbrokes now a valuation anomaly? The mid-250 shares in this betting and gaming group have declined from a 243p high in early 2013 to a recent low of 111p - currently 116p - where they trade on a forward price/earnings (P/E) multiple in the low teens if analysts' 2015 projections (see table) are fair.

A latest, third-quarter 2014 statement shows better-than-expected progress relative to last year's interims - indeed it is the first update in over two years that has beaten profit forecasts, although they may have been cautious following half-year results in August which revealed profit/earnings down by a third.

Chairman spends nearly £48,000 on stock after the fall

The chairman has just bought 40,000 shares at 119.71p yet the market appears unconvinced, the price drifting again despite the board affirming the prospect of a 2014 total dividend of not less than 8.9p a share - i.e. a prospective yield of 7.6%. Frankly, if anything near 8p can be sustained then the shares will eventually re-rate to price the yield more competitively (i.e. reduce it) for risk. It's the crux for valuation.

By way of comparison, William Hill has a roughly similar financial profile and chart, albeit at 353p the shares are priced for a circa 3.5% yield. Earnings cover is about twice compared with once for Ladbrokes (see table).

Cash flow matters more for dividends: Ladbrokes' is historically strong yet the interim cash flow statement showed operational net cash flow down from £114.3 million to £55.1 million, like-for-like, and £98.7 million proceeds from borrowing effectively helping to pay £42 million in dividends besides £65 million repayment of borrowings and £19.5 million purchase of intangible assets. Not the kind of profile a conservative investor wants to see, albeit a snapshot in time which can soon change with better revenue/profit - if also for the worse.

UK consumer spending may be the key factor

While the stockmarket appears to be fretting mostly over regulation, more vital perhaps is whether wage freezes persist to constrain spending. Ladbrokes derived 86% of its 2013 revenue from the UK, so despite worries about a eurozone recession, the consumer outlook here is all-important.

Among risks the interim statement cites Ladbrokes still being a relatively high fixed cost business (e.g. betting shop rents and staff wages) hence changes in revenue can have a significant effect. Mind in this regard how bookmaking is highly competitive. Ladbrokes also has substantial gearing: while the latest update shows net debt reduced by £23 million in three months to £402.9 million, interim net finance costs took 19% off operating profit. That's no big dent, but it could be in a more challenging environment.

So it is indeed possible for the dividend to be prudently re-based if factors conspire negatively. Bookmakers can have a run of bad luck, similarly as big events can provide a boost, such is the industry. Yet with the shares de-rated, a yield over 7% already allows leeway to trim and still offer a useful yield.

While mentioning the balance sheet it should be pointed out that there are £781.4 million goodwill and intangible assets, making for negative net tangible assets despite £405.7 million net assets. Not a major issue but a deterrent for some investors.

Regulatory concerns rumble on

The shares touched a long-term low of 111p on 11 October when a High Court ruling dismissed an appeal against bringing licensing and taxation of online gambling under UK control: a 15% tax on online winnings from bets made by customers based here comes into effect from 1 December.

Bookmakers have located online operations offshore (Gibraltar) for lower taxes, although goal-posts keep moving and naturally the stockmarket wonders what might happen after the 2015 general election. This industry has been slow to recognise politicians' concerns about gambling. Higher machine gaming duty - 25% - from March means ongoing shop closures hence exceptional costs (totalling £26.4 million in the last interims).

Now could still be a useful time to accumulate stock

If early signs of economic slowdown do not amount to much and the company's operations continue to improve then Ladbrokes is now in a useful price range. It's the kind of contrarian/turnaround play where the chart low is impossible to assert, depending whether sentiment weighs adversely or starts to anticipate recovery.

Broker share price targets are mixed with JPMorgan Cazenove and Numis targeting 95p to 100p a share respectively, while at the top end Deutsche Bank targets 165p. Analysts at Davy, the Irish wealth management group, remain cautious how the digital side has yet to show extent of growth needed to offset a likely fall in machine revenues (as a result of changes in regulation) - even to meet Davy's below-consensus forecasts.

So disciplined investors may prefer to see how this pans out, possibly to average-in or avoid the stock for now. Deutsche Bank is more positive, reckoning Ladbrokes' digital side is starting to compete more effectively and has potential to achieve digital casino cross-selling benefits.

Chief executive's interests are aligned with investors'

Owning 1.63 million shares, chief executive Richard Glynn is on a £12 million bonus scheme based on share price performance. It may help explain his positive words in support of sentiment last August, yet they were genuine: "We have made substantial progress and while there is more to do there is also much to play for. We now have the products, the platforms, the people and the brand in place to deliver. Ladbrokes today is a far stronger company and well positioned for growth." The main uncertainty is whether the trading environment will allow this.

The next significant news will likely be an end-of-year trading update in mid-January.

For more information see ladbrokesplc.com.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.