Rank Group — Update 23 August 2016

Headline numbers showed revenue up 2% to £753m, normalised operating profit down 2% to £82.4m and normalised PBT up 4% to £77.4m. We had forecast operating profit of £85.0m; the difference was due to a shortfall in Grosvenor, partly offset by a better than expected result at Mecca. Interest is falling slightly faster than we had allowed for, helped by the refinancing of bank facilities in September 2015. Normalised FY16 PBT of £77.4m was only 2% below our target and our revised FY17 PBT is £81.5m, which implies 5.3% growth.

FY16 revenue increased by 4% and operating profit was almost flat at £66.2m, within which digital increased by £2.2m to £5.3m (despite an extra £1.5m full year effect of RGD gaming duty) but venues fell by a similar amount to £60.9m. Grosvenor digital’s migration to the new Bede gaming platform (end February) went well. The new sportsbook (powered by Kambi) and digital poker (Microgaming) were successfully soft-launched in June and should increasingly contribute in the current year. Venues’ revenue increased by 2% but Q416 win margins and visits were disappointing both in London and the provinces, in line with the industry (we believe that visits may have been impacted by uncertainty ahead of the June 23 Brexit vote). This left venues’ H216 operating profit at £30.0m, £4.3m below the prior period despite an uplift in trading in the Luton casino, where a £4.3m expansion and refurbishment was completed in September 2015.

For FY17 we expect a good recovery in Grosvenor venues’ operating profit, with trading reported to have normalised so far in Q117, a full-year benefit of a £10m investment in new slot machines and electronic roulette tables and the benefit of refurbishments in Leeds and Nottingham. We also expect further strong growth in Grosvenor digital, with better products and marketing and rising margins as it scales up. The cross-selling opportunity is a key plank of Rank management’s organic growth strategy: less than 3% of its venues’ customers play at grosvenorcasinos.com, yet at least a quarter of them are estimated to play online. Its UK online casino market share is less than 2% and management’s medium-term goal is to attain nearer 10% (which would imply revenues of over £100m, double what we are currently forecasting for FY18).

Mecca’s FY16 revenue increased by 2% l-f-l but reported was 1% lower at £287.7m, with three clubs closed during the year. Operating profit declined by £1.5m to £41.5m, better than we had expected due to a strong second half in the bingo clubs. Mecca has worked very hard on its multichannel product offering and in widening its demographic appeal, which has paid off in the form of increased customer numbers. For example, younger players’ visit frequency might be less but they are more likely to play on Mecca Max tablets (5,600 added at the beginning of FY16 and 2,500 incremental units to be rolled-out in FY17). A Max customer’s spend is typically four times higher than that of a paper player. Overall, Mecca venue’s operating profit increased by 14% to £32.9m. With the industry in structural decline, and some cost pressures (increased marketing and a full year of the Living Wage in FY17) we expect venues’ operating profit to settle back to around £30.0m in FY17, still ahead of our previous £27.5m forecast.

Mecca digital’s platform migration disruption was flagged in the May IMS (Edison update note of 12 May) and the final results showed the impact on operating profit, down £5.5m to £8.6m (with £3.3m of the reduction due to the full year effect of RGD and some impact too from increased self-exclusions). We believe that Mecca digital is probably six months behind target in terms of functionality, but the platform is now performing much more robustly and new games will soon be added from leading providers such as Net Entertainment and NXY. Management intends to focus on customer retention and on widening the VIP customer base during FY17. Mecca has a 9-10% share of the growing but competitive UK online bingo market and we expect stronger revenue growth and higher EBITDA margins in FY17 as the business scales up.

During FY17 we expect Rank to introduce its new cross-channel (digital and retail) bingo brand. Part of the quid pro quo for the 2014 bingo duty cut was a commitment to opening three new bingo clubs, which are intended to offer a different proposition to traditional retail bingo and appeal to a different demographic. Rank is awaiting planning permission on a number of venues. For Mecca digital, the new brand will enable it to cross-sell, retaining players who may have been on a losing streak and attracting players who are looking for something different.

Rank’s Spanish bingo business had a very good year with revenue up 6% (7% in euros) and operating profit up 38%, reflecting the improving economic backdrop and the benefit of product improvements. The number of customers increased by 2% and the number of visits by 10%, although the spend per visit fell 4%. Our forecasts assume steady growth in euro terms, with a translation boost assuming sterling stays at €1.15-1.2.

Rank’s FY16 EBITDA of £128.2m converted into £110.2m of cash generated from operations (Exhibit 3), an 86% conversion rate, despite a working capital outflow. Capex was £52.7m, up from £31.9m in FY15 and included £24.8m in Grosvenor venues (including the Luton extension and The Park Tower refurbishment), £9.1m in Mecca venues and £7.5m in the new gaming platform and data analytics. Other material cash flow items included a £21.5m payment of disputed tax (as expected, relating to a tax avoidance case). Overall Rank’s net debt fell from £52.9m to £41.2m in FY16. Net debt/EBITDA was only 0.3 times and gearing was only 11.7%; net assets at 30 June 2016 were £352.6m, up from £294.4m a year earlier.

Management now plans capex of £60-70m in FY17, well above our previous forecast of £45m. Additional areas include new gaming machines in Grosvenor Casinos after the positive pay-backs in FY16, as well as the Leeds and Nottingham casino refurbishments. As a result, we now expect June 2017 net debt of £34.0m (previous estimate £9.0m) but we still expect the group to have eliminated net debt completely by end FY18 in the absence of any major acquisitions.

On 25 July Rank and 888 Holdings (888) confirmed they were considering a possible consortium offer for William Hill and on 10 August they submitted a non-binding proposal worth 364p per William Hill share (versus a share price of 313.6p on Friday 22 July). On 15 August this was increased to a proposal worth 394p per share (before expected cost and revenue synergies and a potential re-rating). Following completion William Hill, Rank and 888 shareholders would have owned 48.8%, 23.8% and 27.4% of the enlarged group respectively.

The proposed merger would have created the UK’s largest multi-channel operator (ahead of Ladbrokes Coral) with proforma revenues of £2.66bn, EBITDA of £522m and a land-based/digital split of about 60/401. Proforma net debt would have been £2.2bn or 4.3x proforma EBITDA and cash restructuring costs were forecast at c £69m, but as synergies flowed through the net debt leverage ratio was expected to fall rapidly to 2.5-3.0x in 2018. Combined marketing spend of over £300m and strong brands across the full suite of sports, casino, poker and bingo were expected to produce material revenue synergies (eg cross-selling 888 and William Hill’s content to Rank’s c  three million customers) while the auditors signed off on net cost-savings of at least £100m even without input from William Hill management.

Rank’s CEO Henry Birch would have been CEO of the enlarged group and we believe the management and operational structure would have been more straightforward than perhaps perceived with, broadly, 888 in charge of digital, William Hill running the betting retail estate and Rank the bingo/casino venues and corporate functions. The proposal was supported by Rank and 888’s major shareholders but was rejected by the William Hill management on the grounds of price and complexity. Having failed to persuade them to engage, Rank and 888 decided not to further improve the proposal and withdrew on 18 August (before the Takeover Panel deadline to submit a firm bid on 21 August). William Hill’s management now needs to show that it can justify turning down a proposal that was already at a sizeable premium (it has just upped its 2016 profit guidance), while Rank and 888’s management have demonstrated an enthusiasm to participate in sector consolidation, but not at any price.

Exhibit 2 updates our peer group comparison; we show the average both with and without Paddy Power Betfair, which trades on a noticeably above average rating. As a generalisation, land-based operations are more mature and capital-intensive and trade at lower EV/EBITDA multiples than pure online. Applying a sum-of-the parts approach our valuation would be 277-309p, which would still only imply a calendarised 2016e EV/EBITDA of 8.6-9.5x.