Stockwatch: Still a sound bet

Is Ladbrokes on a firm road to recovery, offering value? Competition fears and a profits slide put the mid-cap shares in this retail bookmaker in a bear phase during 2013 to 2015, down from 243p to 93p by last autumn. The dividend had looked risky and was de-based, hence income investors selling.

Yet progress with a July 2015 turnaround plan and a £2.2 billion merger with Gala Coral Group affirms Ladbrokes as industry leader, representing an 87% UK market share, together with William Hill and Betfred.

Gambling in British society is here to stay, and Ladbrokes' average customer stake of just over £8 makes the group unlikely to run into public criticism. So it's a culturally integral service, if not exactly an essential one, and, despite inevitable fluctuations around sporting events, the group offers a fairly dependable base to re-grow earnings and dividends.

Stock jumps after less regulation than feared

I have drawn attention, for example last February at 122p ahead of clarifying the competition effect of the planned Coral merger, partly since the market tends to take a cautious view of such matters, but also because the chairman had bought 30,000 shares and another non-executive director 50,000 at just over 116p.

This represented belief in value from the deal even if the Competition and Markets Authority (CMA) adopted a tough stance. The method is requiring the merged group to close various shops where Ladbrokes and Coral are close to each other - i.e. potentially reducing competition and choice.

A near-term adverse factor is the likely higher profitability of shops to be soldOn 20 May the outcome proved relatively soft, requiring only 350-400 (a tenth) of the high street shops to be sold, whereas the market had been steeled for 400 to 1,000 - hence the stock jumped 14% to 136p, and currently 130p.

Based on forecasts last February-March, this implies a 12-month forward price/earnings (PE) multiple of about 19 times and a modest yield of about 2.5%, part-reflecting equity dilution to help pay for the deal. So the stock doesn't immediately flag value and hoped-for benefits need to follow through.

A near-term adverse factor is the likely higher profitability of shops to be sold, e.g. in busy towns, which Ladbrokes and Coral rightly opted to prioritise. This implies fixed costs over the rest of the estate will rise; analysts at Credit Suisse reckon on a £9 million total cost, in the context of a consensus for about £70 million pre-tax profit this year. Yet it is an issue that it should be possible to work through.

Recent results imply broad-based turnaround

The positive regulatory outcome follows first-quarter 2016 results showing group net revenue up 10.6%, with shops up 4.1% and digital up 36.5%, despite results from Cheltenham races being "the worst in living memory". Intense competition forced unsustainable pricing (in Ladbrokes' opinion), also a reminder how predatory this business can get.

Yet the wider aspect of these results was encouraging and management sees plenty of evidence its strategic plan since July 2015 is attracting more recreational customers.

Leicester City winning the football Premier League meant a circa £3 million hitIndeed, within the headline figures there is plenty of detail implying a broad-based turnaround, e.g. self-service betting terminals helping football stakes up 9.0%, the Ladbrokes.com sportsbook net revenue up 59.0% and its gaming activities up 43.8%, and 73 shops refurbished in the first phase of a UK retail capital expenditure programme.

During 2015, the group derived 86% of revenue from the UK, with Europe and Australia two other areas of focus, so domestic consumer confidence is significant - i.e. a surprise "Brexit" vote could have a negative influence if it checks consumer spending amid uncertainty, and with the bulk of revenues sterling-based. But, with betting outlays modest in scale, discretionary consumer goods are more exposed.

Management said it was a little ahead of its plans on key customer metrics, a good sign in terms of the medium plan. In terms of sporting results, Leicester City winning the football Premier League means a circa £3 million hit - as disclosed as a potential liability in the 21 April results.

There may be scope for claw-back, considering the UEFA European championships this summer, although "we may have to wait until the knock-out stages for the more competitive clashes to deliver a successful tournament".

Balance sheet still needs clarification

Balance sheet reform can be a typical feature of a turnaround, especially where managers over-borrowed. Specific to Ladbrokes is Coral's private equity owners leveraging it up, such that last July's presentation on the merger indicated £1.3 billion net debt and £280 million illustrative operating cash flow.

Some investors may prefer to see the group balance sheet further clarified - for example, at the August interim results, consider also how it is goodwill-heavy. At end-2015 there were £674.3 million goodwill and intangible assets relative to £456.5 million net assets, including £323.1 million debt.

Ladbrokes is doing well operationally but its balance sheet may continue to give concernSo the merged entity looks set to increase the trend in negative net tangible assets and the balance sheet is liable to deter conservative investors. Last year's income statement showed the finance charge swiping a third of normalised operating profit, another hurdle.

This hasn't deterred various brokers from recommending Ladbrokes' equity, albeit with fairly modest targets e.g. Canaccord on 145p and Peel Hunt/Deutsche Bank both around 137p. Liberum Capital is the sole seller, targeting 111p.

So Ladbrokes is doing well operationally, while its balance sheet may continue to give concern. Sentiment - the stock price - is showing itself more attuned to revenues than debt, which could obviously change in a harsher financial climate.

But a 10%-plus jump after the regulators' news shows buyers attuned and responsive to an overall improving story. Assuming management continues to meet its targets, the stock looks worth accumulating on a two-year view.

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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.