Rank Group — Update 16 February 2017

Rank is the UK’s largest casino operator with 54 Grosvenor casinos, and the second largest bingo operator with 85 Mecca bingo clubs. Enracha is the fourth largest bingo operator in Spain with nine venues and Rank also has two casinos in Belgium. Overall, Rank has 2.9 million registered customers and c 28m customer visits each year. Rank was founded in 1937 and grew to become a large film and leisure conglomerate by 1990, before streamlining into a gaming-based leisure operator from 2007. It is headquartered in Maidenhead, UK and employs around 10,500 people.

Rank’s shares fell by 32% in 2016 to end the year at 195p, depressed by weakening UK economic sentiment and gaming platform disappointments. Yet forecast reductions have not been overly severe (our current FY17e EBITDA of £127m compares with £136m as published in January 2016) and while the outlook for venues is tough, the core argument for digital growth is very much intact – just six months behind. Against that backdrop Rank’s share rating looks too low, particularly since it should not be affected by the government’s triennial review into gaming machines and could be a beneficiary (unlike the bookmakers, whose share prices have been rattled by fears of cuts to FOBT betting terminal stakes, which will affect their profits). Our sum-of-the parts calculation points to a value range of 277p to 307p per share, 32-46% above the current share price, while our DCF produces a value of 278p per share (based on a 9.0% discount rate). Averaging these produces a value of 287p, which would imply a 2017e EV/EBITDA of 9.0x and a P/E of 18.2x.

We expect Rank’s FY17e normalised EPS to be broadly flat on FY16 at 15.3p, with 2% revenue growth offset by cost pressures despite management’s H2 cost reductions. We also allow for a fairly subdued consumer backdrop in FY18, given Brexit uncertainties, and expect growth in Grosvenor venues to be offset by structural decline at Mecca, with the planned new Luda venues unlikely to contribute materially before FY19/FY20. However, we expect Digital operating profits of £23m in FY19, 64% higher than in FY16 on cautious margin assumptions and despite the extension of remote gaming duty (RGD) to ‘free play’ from August 2017. This drives our forecast 6-7% of normalised PBT growth in FY18-19. We expect this to be augmented by accretive acquisitions – Rank’s proposed consortium bid, with 888, for William Hill in July 2016 is an illustration of management’s ambitions. Its strong balance sheet provides plenty of financial flexibility. If suitable opportunities fail to materialise (which we consider unlikely given the consolidation taking place in the sector), Rank could consider some form of return of capital to shareholders at some stage, such as a special dividend, on top of its progressive dividend policy.

Rank’s gaming businesses are fully licensed and regulated and changes in regulation, both fiscal and licensing, are its biggest sensitivity. Taxes can and do change from time to time (eg RGD is being extended to ‘free play’ from August 2017 and there is some risk that the rate could be increased from 15% to 20% in the Budget). Its operations are also affected by changes to licensing, eg the casino industry is lobbying for an increase in machine allowances, which would be very positive. Its business is dependent on the level of consumer spending, especially in the UK, and to competition from other leisure activities and from other operators, especially in digital. Rank’s major shareholder Hong Leong holds 56%, leaving other shareholders in a minority position; it could look to sell down more of its holding at some stage, which would be a positive, improving the shares’ liquidity (which can be slightly tight).

Rank’ s land-based gaming businesses are fully regulated and leaders in their markets. Its biggest opportunity is in digital, especially in UK online casino where it only has a 2% market share despite being the biggest venue operator. Now that its new platform is fully operational it has a much better product suite, and the arrival of a single wallet from H118 should provide a seamless experience for players online and in-venue, with much better marketing and personalisation opportunities. Rank’s casinos and bingo clubs are mature but highly cash generative; they offer a social experience that cannot be easily replicated online, with a loyal customer base and high dwell time. The UK casino industry is lobbying for an increase in the permitted number of gaming machines (currently the industry total is only 3,013, less than a tenth of the number in betting shops), which would provide a material boost for Grosvenor, if approved. Mecca’s planned new Luda brand should be incremental, tapping into a new demographic once planning obstacles are overcome.

Rank’s CEO Henry Birch joined in May 2014 and brought in extensive online gambling experience: his previous roles included being CEO of William Hill Online between 2008 and 2012 (page 16). He replaced Ian Burke who stepped up to become chairman, having been Rank’s CEO from 2006 to 2014. Finance director Clive Jennings was appointed in 2011, having been with Rank since 2000.

Rank’s executive committee of nine includes the three divisional managing directors: Martin Pugh (Grosvenor Casinos), Alan Morgan (Mecca) and Colin Cole-Johnson (Digital). Martin joined Rank in January 2015 as MD of Mecca and moved across to Grosvenor in June 2016; he was previously with Adpoints (CEO), Virgin Active (MD), and Camelot UK (MD). Alan joined in September 2016 having previously been chief operating and commercial operator for Spirit Pub Company. Colin joined in September 2014; before that he was director of eGaming at William Hill. Paul Richardson is group director of strategy and corporate development and joined in September 2015; he is a former investment banker and lawyer and was senior VP of international development at Macau casino operator Galaxy Entertainment. Frances Bingham is company secretary, Sue Waldock is human resources director and Keith Woodcock is chief information officer.

Rank aims to be the UK’s leading multi-channel gaming operator. There are five components to its strategy and it details its progress against each of these in its annual and interim reports:

Potential M&A: Rank’s CEO Henry Birch has said that M&A very much forms part of the company’s strategy, most probably to achieve a step change in digital but also possibly in retail gaming (UK land-based casino or bingo acquisitions would cause competition issues). Regulatory changes and economies of scale have prompted a wave of consolidation across the gaming industry, eg Ladbrokes Coral, GVC/bwin.party and PaddyPower Betfair.

The scale of management’s ambitions is illustrated by the proposed consortium bid with 888 Holdings for William Hill in July 2016 (described in our Update report of August 2016). The proposed merger would have created the UK’s largest multi-channel operator with pro forma revenues of £2.66bn, EBITDA of £522m and a land-based/digital split of about 60/40. Henry Birch would have been CEO of the enlarged group 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; Rank and 888 did not submit a firm bid.

Central to Rank’s plan to improve its digital offering and offer true multi-channel gaming was the development of a new gaming platform. When Henry Birch joined in 2014, Rank’s Grosvenor and Mecca digital operations were both on a legacy OpenBet platform, which needed substantial updating. In January 2015 Rank appointed a relatively small software supplier, Bede Gaming, to provide a completely new platform with a flexible open architecture. This is designed to allow Rank to select best-in-class suppliers across different product categories, integrate them rapidly and differentiate itself. Rank is Bede’s biggest customer so the development process has been highly collaborative. It invested £3.5m into Bede by way of a convertible loan note and has the option to convert it into 17.5% of the share capital before June 2018 (implying a valuation for Bede of £20m).

The new platform was launched on time at the end of February 2016 and grosvenorcasinos.com saw an immediate uplift in key metrics. Its revenue grew by 34% in H216 and 39% in H117. However, meccabingo.com volumes are much higher (5.39m customer visits in FY16 versus 0.84m for grosvenorcasinos.com). Although Bede’s platform already linked into the Virtue Fusion bingo network, the platform encountered repeated stability and other technical issues. As a result, meccabingo.com’s revenue growth stalled in H216 and fell by 4% in the 15 weeks to 9 October 2016, against the backdrop of a market growing at 8-10%.

The platform issues put Rank’s digital plans back by at least six months in terms of launching new content and features, especially better bonusing functionality. However, the issues appear to have been fully resolved by winter 2016, with meccabingo.com returning to growth (albeit a modest 3%) in Q217. Most importantly, Rank is now able to move ahead with its planned product enhancements. During H117 it added a sportsbook (supplied by Kambi Solutions) and an improved poker product to grosvenorcasino.com, a new VIP microsite to meccabingo.com, and a range of new games and content from leading suppliers such as NetEnt and NYX. More will follow in H217. Rank plans to launch a new slots-led brand in H217 and the multi-channel new Luda bingo brand will go live later in the year.

Rank has c 2.9 million customers across its 148 venues and digital operations; at the moment they have to sign up separately for each channel. The aim is that they should only need to register once, online or in-venue, and have a single wallet that they can access at gaming touch points in-venue or online, to fund, play or withdraw. This will be much easier and more convenient for the player, providing a seamless experience across the different channels. At the same time it will give Rank a more complete picture of its customers, allowing more tailored and personalised marketing and loyalty programmes, as well as more effective social responsibility tools. Currently the only real example of such a solution is the Coral Connect system (powered by Playtech) that was rolled out in May 2014. In a June 2015 presentation Gala Coral reported that it had over 200k new digital sign-ups in the first year alone and that a Connect customer was more than twice as valuable and much cheaper to recruit.

Digital gaming has grown from virtually nothing 20 years ago to account for 33% of the UK gambling market (44% excluding the National Lottery). This proportion is much higher than the global average of c 13% due to the industry’s fully regulated status, consumer trust, high level of mobile penetration and relative advertising freedom. Yet Rank’s digital businesses only accounts for 14% of its revenues and we believe a move towards 25% over the next five years is a realistic target. Casinos and bingo clubs account for 7% and 5% of industry revenues respectively.

The digital gambling market is estimated to have grown at a 15.1% CAGR between 2008 and 2015 and is forecast to grow at 13.1% CAGR between 2015 and 2018 (Exhibit 4). Casino and bingo account for 45% of the market (betting is 43% with poker and skill the rest) and are forecast to grow at 13.4% and 9.1% respectively. Over the past three years mobile has taken over from desktop as the key driver of growth and has proved to be incremental rather than cannibalistic. Operators typically report that multi-channel players spend 2.5x more than those playing on desktop or mobile alone.

UK casino revenues grew steadily between FY09 and FY15, rising at a CAGR of 5.2% over the period, before dropping back by 14% (to £998m) in FY16. We believe this was mainly due to below average win margins in the high roller London clubs (where Rank is not involved); Rank’s FY16 UK casino revenues increased by 1.6%. Casino attendances increased from 17.4 million pa in FY11 to 21.0 million in FY14, helped by the opening of new large casinos such as Aspers in Stratford), but have levelled off since then at about 20.5 million pa, partly due to the introduction of stricter customer due diligence during 2016.

The bingo industry has been in long-term structural decline, exacerbated by the 2007 smoking ban. The total number of clubs fell by 47% between 2005 and 2015 (from 678 to 358) and the number of admissions from c 79m in 2004 to 43m in 2013 (source: Gambling Commission, Mintel). The government recognised the impact of the decline on local communities and halved bingo duty from 20% to 10% in June 2014. This funded increased investment in facilities, while the growing availability and popularity of hand-held bingo terminals (such as Mecca Max) has brought in a younger demographic. FY16 industry bingo revenues of £687m were 3.6% higher than in FY15 and only 2.3% lower than in FY09, with customer numbers broadly stabilising and higher spends offsetting lower admissions (younger players tend to visit less frequently than older regulars).

M&A has been a feature of the gambling sector in the past two years, driven by economies of scale in the business model and cost pressures including RGD in the UK and new taxes and compliance costs in regulating markets. Exhibit 6 shows some of the larger deals that were completed during 2016. In addition, William Hill was involved in two proposed transactions that did not proceed: a consortium bid by Rank and 888 (which valued it at c £3.1bn but was rejected by the board) and a proposed merger with Amaya (AYA:TX, which was vetoed by shareholders).

Grosvenor is the largest operator of casinos in the UK with 54 casinos out of 143 (a 38% market share). Of these, nine are in London and the rest are spread across the UK. The London casinos are recreational rather than high-end casinos (where trading is more volatile), but they do attract a more internationally diverse and higher-spending customer base than provincial casinos: FY16 spend per visit averaged £101.42 in London and £37.88 in the provinces. Strict UK rules on granting new casino licences represent a considerable barrier to entry, but at the same time limit venue expansion. However, Rank does have 12 non-trading licences. Two will be used to expand its Glasgow casino in FY17, and one in Brighton in FY18. Its licence in Kensington & Chelsea would be a valuable opportunity if it can find the right location.

Grosvenor also operates two of the nine casinos in Belgium, but these only account for 3% of divisional revenue (one concession will end in August 2017 but has a minimal P&L impact).

One might imagine that Grosvenor Casinos derives most of its income from slot machines, Las Vegas-style. However, gaming machines are very strictly controlled in the UK, even in casinos, both in terms of numbers and their maximum stakes and prizes (as explained at the Gambling Commission’s website). In FY16, 66% of Grosvenor’s revenue came from casino games such as American Roulette and Blackjack, 22% from gaming machines, 4% from card room games (mainly poker) and 8% from food and drink.

Most UK casinos are licensed under the Gaming Act 1968 and are only allowed a maximum of 20 gaming machines, whether they have 100 customers a day (such as a high-end Mayfair casino) or 2,000 (such as the Hippodrome in London). The Gambling Act 2005 permitted 16 specified local authorities to offer new licences, eight for ’small’ casinos and eight for ‘large’. The ‘small’ casinos are allowed up to 80 gaming machines or twice the number of gaming tables, whichever is less. In practice this ratio is not attractive in most locations and Rank’s Luton casino is the first ‘small’ casino (Rank extended a smaller venue in August 2015). The ‘large’ casinos are allowed up to 150 machines or five times the number of tables (whichever is less). Three have opened to date, while some of the others overlap with existing 1968 Act casinos. Rank does not hold any ‘large’ licences.

The maximum stakes and prizes offered on different types of gaming machines can only be modified by government (the DCMS). They are reviewed every three years (approximately); the current review started in October 2016 and is expected to report between end-March and May. It is particularly focusing on the stakes and prizes offered on B2 machines, more commonly known as FOBT (fixed odds betting terminals), which offer games such as roulette and are mainly located in betting shops (Grosvenor does not have any of these). They have a maximum stake of £100 and prize of £500, whereas the top machines in Grosvenor (B1 machines) have a maximum stake of £5, although they can pay out £10,000 (£20,000 if linked). The FOBT machines have a high 20-second spin rate, ie theoretically £100 can be bet every 20 seconds, a much higher rate than in casinos (in response to concerns, in 2015 bookmakers voluntarily put in place some time and speed limits). In total there were 34,684 FOBT machines in betting shops at March 2016, generating £1.7bn a year of revenue (66% of all gaming machine revenue and 52% of all betting industry revenue, source: Gambling Commission). By contrast, there were only 3,013 gaming machines of all types in casinos (mainly B1 machines), which generated £195m of revenue in FY16 (7% of all gaming machine revenue and 20% of casino industry revenue).

Competitive advantage for Rank? After intense lobbying it seems likely that the DCMS will cut the maximum stakes permitted on FOBTs, with a range of outcomes from £2 to £25 being suggested by industry commentators. There may also be a reduction in the spin rate. The risks have been reflected in share price weakness, particularly for Ladbrokes Coral and William Hill. We believe that any cut could only be good news for Grosvenor (and Mecca) as it would increase the relative attractiveness of their machines.

Material revenue uplift if Grosvenor is permitted more machines: the casino industry is lobbying for an increase in the number of machines permitted in casinos. Rank has petitioned for the ratio of machines to tables in 2005 Act ‘small’ casinos to be increased from 2:1 to 3:1 and for the allowance for the 1968 Act casinos to be harmonised at the same level, ie 3:1 rather than the present 20 (see Rank’s response to the DCMS at www.rank.com). Currently Grosvenor has 1,372 gaming machines in its venues and they generate £89m pa in revenue (£64,869 each, H117 annualised). If successful, Rank could double the number of machines (yet the total across all casinos would still be very small compared to the number of FOBT machines). It would take time for demand to build and we would not expect revenues to double. However, we believe that a 50% revenue uplift from FY19/FY20 would be very feasible, especially if the move was combined with a FOBT stake cut (ie £45m of high-margin incremental revenues for Grosvenor a year) given that there are often queues for machines at busy times.

Rank is the second largest UK land-based bingo operator with 85 clubs. Its main competitor is Gala Retail (acquired by Caledonia Investments for £241m in October 2015), although it only overlaps with Gala in about a third of its locations and both have an interest in the industry being perceived as vibrant and attractive for younger as well as older players.

Bingo is a pari-mutuel game and the club charges a participation fee, ie there is no gaming risk for the operator. In FY16 Mecca venues derived 15% of revenues from main-stage bingo, 40% from interval games, 33% from amusement machines and 12% from food and drink. Despite the industry decline there are still almost 2.5 million regular bingo players, 5% of British adults, with a female C2DE demographic skew. The perennial difficulty has been to innovate and update the clubs to attract younger players while retaining the loyal older age group. The June 2014 bingo duty cut was worth £11.3m to Rank in FY15 and enabled it to reinvest in its products and venues, including eight club refurbishments in FY15, seven in FY16 and three in H117. Customer numbers increased from 937k in FY14 to 961k in FY15 (the first increase for three years) and to 987k in FY16, but dropped back slightly in H117, to 969k. However, spend per head has continued to rise, from £18.19 in FY14 and £18.65 in FY15 to £20.08 in H117 – still a relatively low-cost entertainment pastime.

Mecca Max illustrates the opportunity for multi-channel gaming at Mecca, and for widening the customer base. The units are essentially tablet computers and the latest ones are little bigger than an iPad. Mecca has about 11,000 units and plans another 5,260 in H217 (2,500 incremental). They are played by about a third of customers whose average bingo spend is reportedly four times that of a paper player. Moreover, Max customers are two-thirds as likely to play online and thus have a much higher level of brand engagement, particularly when they can play the same games on whichever channel they choose – Max units, slot machines, mobile or desktop. As at Grosvenor, we expect a single wallet and account (hopefully in FY18) to materially improve the experience for the customer and the marketing opportunities for Mecca.

New Luda bingo clubs: Rank has developed a completely new bingo brand, Luda, which will be rolled out as clubs and online. It is designed to be a smaller city centre offering - bingo’s answer to convenience supermarkets – reflecting the broader shift in retail and leisure back to the high street. The format will have a coffee lounge at the front, a limited hot food offer, a bingo lounge and an electric lounge with c 40-50 gaming machines. Bingo will be played mainly on mobile devices and players can dip in and out of games (rather like Enracha’s Spanish model), although they will also link into some of the bigger prize games such as the National Bingo Game. Capacity is expected to be 100-150 compared with 800-1,000 for an average Mecca club.

Rank initially tried to get planning permission for two to three sites in 2016, to trial the concept, but failed partly due to local authority resistance to additional high street gambling venues (although the Luda are small bingo-led entertainment venues and will not have FOBT machines). However, it has more applications underway and could also consider acquiring some arcades (AGCs) for conversion. The units are planned to cost c £0.5m to fit out, with a 20% year two return on capital. Thus a chain of 50-100 Luda would cost £25-50m, but could generate £5-10m of EBITDA pa. We believe the majority of this would be incremental, offsetting the Mecca decline such that divisional profits should start to rise from FY19/FY20 (beyond our forecast period) – see Financials below.

During H117 Rank restructured its digital operations in Gibraltar so that it now has a single digital team working across both the Grosvenor and Mecca brands. This should improve product expertise, avoid duplication and facilitate the introduction of two new brands (Luda in bingo and a new slots-led brand).

Grosvenorcasino.com: despite being the biggest UK land-based casino operator, Rank only has a 2-3% share of the fragmented UK online casino market. Only about 3% of its 1.35 million venues customers gamble at grosvenorcasinos.com, yet Rank believes that 50% of them gamble online. On the other hand, about half its digital customers come from the venues, ie it has made little headway against pure digital specialists such as 888 or Sky Vegas. The new Bede gaming platform has enabled a much better product offering, including new games from third-party suppliers and the introduction of sports betting from autumn 2016. Moreover, venues are now beginning to be incentivised to cross-market and, as we have explained (page 5), the introduction of a single account and wallet could be a game-changer. Revenues increased by 37% in FY16 to £30.5m, and a further 39% in H117 (see Financials section below). Continued growth at a CAGR of 30% would imply c £90m of revenues by FY20, which would still only be a 6% market share and could generate over £20m of EBITDA versus only £7m in FY16.

Meccabingo.com: Mecca entered the online market in 2006 and we believe it was a top four brand up until about 2012, when the market became increasingly competitive and Rank management focused more on venues. The arrival of Henry Birch in 2014, with a greater focus on digital, meant that digital revenues increased by 11% in FY15 but growth stalled in FY16 (+2%) due to the platform migration issues discussed on pages 4-5 and declined by 4% in Q117. As a result, we believe that Mecca’s online market share has slipped from c 11% to c 9%. However, the Bede platform is now performing much more robustly and we expect material improvements in Mecca’s product offering over the next six months including better bonusing and more side games (Mecca, in common with other bingo-led operators, derives over 75% of its bingo-led revenues from slots). Our forecast FY18 revenue growth of 7% (Exhibit 15) could be conservative and, as with Grosvenor, the introduction of a seamless single account and wallet should improve cross-sell.

Rank entered the Spanish bingo market in 1994 and Enracha now operates nine gaming venues in Catalonia, Madrid and Andalucia. They offer bingo, electronic casino and slot games as well as food, drink and live entertainment. Compared with Mecca the clubs are smaller and customers have a slightly more male, higher-income skew. Enracha averaged 224k visits per club in FY16 compared with Mecca’s 133k and although spend per head (SPH) is lower, the improving Spanish economic situation meant that SPH increased by 11% in H117 to £16.50 (at constant currency; the £ sterling increase was 35%) versus a 5% increase at Mecca, to £20.08.

Bingo is one of the largest sectors of the Spanish retail gaming market and there are about 350 clubs. The clubs are locally regulated, with regional bingo duty rates ranging from 12% to 25%. Ownership is fragmented with Cirsa being the biggest operator with about 50 clubs. There may be acquisition opportunities for Rank and, in addition, we expect Enracha’s digital operation to grow rapidly. Previously it was very small and was turned off entirely during the Bede migration, but it is now live for online bingo and we expect slots to be launched in H118. Jackpotjoy claims a 25% share of the Spanish online bingo market (source: Jackpotjoy prospectus January 2017) and reported that Botemania achieved ‘triple digit’ growth in 9M16, albeit off a fairly small base.

Rank’s performance and our estimates are sensitive to a number of factors including:

Regulatory: Rank’s gambling businesses are licensed and regulated in the UK, Spain, Belgium and Alderney (online). The licences incorporate a wide variety of tax rates and conditions, as described in Rank’s Annual Report. Changes in regulation, both fiscal and licensing, are Rank’s biggest sensitivity. Taxes can, and do, change from time to time, eg FY15 benefited from a 10% drop in bingo duty, partly offset by the imposition of 15% RGD from 1 December 2014. In FY17 RGD will be extended to gaming ‘free play’ (ie applied to gross rather than net revenue), which we expect to affect digital margins by 3-4%. There is some risk that the rate of RGD could be increased to 20% in the March 2017 Budget, to bring it more in line with rates on gaming machines, but the government’s focus seems to be more on FOBT machines. Rank’s venues may be affected by changes in licensing, including gaming machine allowances (both numbers and mix), loss of licences or new licence awards, either to Rank or to competitors. The industry is lobbying for an increase in permitted machine numbers and harmonisation across 1968 Act and 2005 ‘small’ casino licences which, if successful, would be extremely positive for Rank.

Economic: the gambling industry is dependent on the level of consumer spending, which in turn depends on the strength of the economy, consumer confidence and unemployment levels. Most forecasts for the UK consumer outlook have weakened since spring 2016. For example, the EY Item Club forecasts a 0.3% decline in household real disposable income and for consumer expenditure growth to flatten from 2.8% in 2016 to 1.7% in 2017 and 0.4% in 2018. Rank is a large employer and is affected by increases in the National Living Wage, as well as in property costs and general cost inflation (see Financials).

Operational: the new gaming platform, supplied by Bede, now appears to be performing robustly, but Rank would be affected by any further instability or delays in the planned roll-out of the single account and wallet. Rank’s results can reflect short-term volatility in gaming win, especially in the London casinos, but these smooth out over time. The weather can also affect short-term results.

Competition: Rank’s businesses face competition from other operators and from other leisure activities. Both its venues and digital operations can be affected by the marketing and prizes offered by other operators and by new openings; it may need to increase its own investment to respond. Bingo has been in long-term decline due to changing leisure preferences, although there has been some recent stabilisation. An effective multi-channel product offering should benefit both Rank’s venues and digital businesses.

VAT – potential upside: since 2005 Rank has pursued a series of claims in relation to the calculation of VAT on bingo and amusement machines. An outstanding potential reclaim relates to compound interest in respect of its successful bingo claims (which had paid out simple interest). The Court of Appeal found in Littlewoods’ favour over the issue in a landmark case in May 2015, but HMRC appealed and the case will be heard by the Supreme Court in July 2017. If Littlewoods does win, this could open the door to a £100m+ claim by Rank, a material potential upside that is not in our forecasts.

Major shareholder: Rank’s major shareholder Hong Leong Company (Guoco) holds 56.1% leaving other shareholders in a minority position. It originally acquired a stake in 2007 and increased it from 29.5% to 74.5% during 2011 (which triggered a mandatory bid that did not proceed). The holding was reduced to 68.6% in July 2013 and then to the present 56.1% via a placing (of 50m shares) in February 2015. The major shareholder has been supportive of Rank’s strategy, but liquidity in the group’s shares remains below average; any further reduction in the holding would be helpful.

We look at Rank’s value in three ways: a simple peer group comparison, a multiples based sum-of-the-parts (SOTP) to reflect that high-growth digital gambling businesses are generally more highly rated than mature land-based businesses, and a DCF. Rank’s calendar 2017e EV/EBITDA of 6.6x stands at a 28% discount to the peer group and its P/E is 14% below. Against its land-based peers, Ladbrokes Coral and William Hill, its EV/EBITDA is a c 14% discount but its P/E is a 26% premium; however, their ratings are affected by negative risks attached to the triennial review, which should be neutral to positive for Rank. Our SOTP calculation (Exhibit 14) points to a value range of 277p to 307p per share, 32-46% above the current share price, while our DCF produces a value of 278p per share (based on a 9.0% discount rate). Averaging these produces a value of 287p, which would imply a 2017e EV/EBITDA of 9.0x and a P/E of 18.2x.

Sum-of-the parts: in Exhibit 14 we have valued Grosvenor’s land-based business at a 8.0-9.0x 2017 (calendarised) EV/EBITDA ratio, broadly in line with the international casino average and the 7.9x multiple paid for Les Ambassadeurs in December 2015 (although being ‘high end’, Les A’s earnings are much more volatile). We have used a 5.0-5.5x multiple for Mecca venues to reflect their mature status, slightly above the reported 4.6x valuation for Gala Retail to reflect Mecca’s greater multi-channel opportunity. We believe that both Grosvenor and Mecca digital should command a premium rating to reflect their fully regulated status and expected high growth (especially for Grosvenor). We have used a 7.5-8.0x multiple for Enracha to reflect the improving Spanish economic outlook and its digital potential. Overall, our calculation produces a valuation range of 277p to 307p per share (slightly below the 290-360p valuation published in our September 2015 Initiation to reflect the weaker economic outlook and digital platform delay).

DCF: for our DCF we have run forecasts through to FY21 with the EBITDA margin rising to 18.5% in FY21 and 19% terminal (FY16: 17.0%) as the higher-margin digital proportion grows. We have used a terminal growth rate of 2% and a WACC of 9%. This produces a value of 278p per share. The calculation is sensitive to a range of assumptions including the choice of discount rate – using a range of 8.5-9.5% produces a value range of 261p to 301p.

Our forecasts are unchanged from our Update note dated 26 January (post Rank’s interim results), but we have introduced new FY19 estimates. The FY17 interims reflected high street cost pressures with revenues up 1% (2% l-f-l), but normalised PBT 8% lower at £34.5m. However, management has cut costs across the group and H217 should benefit to the tune of £8.0m (2.5% of the cost base) with £5-6m flowing through into FY18. Digital revenue growth of 11% was encouraging; it compared with 7% for Q117 (to 9 October) as meccabingo.com reversed a Q117 4% decline to post a flat H117 result. Rank remains strongly cash generative: net debt fell to £33.0m at end December (June 2016: £41.2m). We expect a further decline to £23.0m by year-end and a net cash position of £5.5m by June 2018, giving the group plenty of M&A firepower.

Grosvenor Casinos: After 6% revenue growth in FY15 and 5% in H116, Grosvenor’s revenue was broadly flat in H216 and H217 due to below average win margins, more stringent application of customer due diligence and slight weakness across the wider leisure sector. A casino in Glasgow was closed in July 2016 and Rank plans to relocate the licences into its other two Glasgow casinos once planning is approved. Our forecast for flattish revenues out to FY19 may be cautious but allows for strong multi-channel growth to come through the digital line. We expect H217 operating profits to be above the H117 level due to cost-cutting and project modest growth going forward despite cost pressures.

Mecca Bingo: Venues’ revenues have declined steadily at 1-2% pa with increases in spend failing to offset lower visits, although Rank has done well to broadly stabilise customer visits. Operating profits increased by 14% in FY16 due to lower operating costs, but dipped back by 7% in H217 as cost pressures resurfaced (employment, property etc). We allow for a modest decline in profits through to FY19, but with capex of c £10m pa (ex the planned Luda roll-out) versus EBITDA of c £42m, the division is highly cash-generative.

Digital: we expect Digital profits to increase by c 50% over the next two years as grosvenorcasinos.com continues to increase market share off a very small base and meccabingo.com returns to c 6-7% revenue growth, helped by cross-selling into the two planned new digital brands. Grosvenor’s digital revenues increased by 37% in FY16, to £30.5m, producing £5.3m of operating profit (a 17% margin), up from £3.1m in FY15 and a £0.9m loss in FY14. Meccabingo.com is much bigger but it only grew by 2% in FY16 (due to the platform migration issues), to £66.2m. Its operating profit of £8.6m (13% margin) was down from £14.1m in FY15 (£3.3m of the reduction was due to the 15% RGD introduced in December 2014 [H115]).

Now that the two brands are merged Rank only reports profit for the division. Grosvenor increased H117 revenues by 39% and Mecca’s flat performance was an encouraging result, with Q2 up 3% after Q1 (to 9 October) having been 4% down, and platform issues apparently resolved. Operating profit was 9% lower due to higher operating costs (including an unsuccessful Mecca TV advertisement). However, Rank expects margins to improve significantly in H217. Profits growth will be restrained in FY18 by the extension of RGD to free play (which we expect to impact on margins by 3-4 percentage points), but economies of scale and the benefits of the divisional restructuring should drive underlying margin improvement and our 15.7% operating margin forecast for FY19 could prove conservative (H117: 13.9%).

Enracha: profits have grown steadily even during the Spanish recession in FY15; the H117 contribution was also helped by £/€ weakness. Revenues increased by 7% in FY16 and 11% in FY17 in euros, helped by a stronger economy. Operating profit rose by 38% and 79% respectively and on a sterling-reported basis, H117 operating profit more than doubled.

H117 group operating profit fell by 9% to £36.6m due to flattish revenues and cost pressures, but management has implemented cost savings across the group which are expected to save £8m in the second half. Our H217 operating profit estimate of £43.4m is £6.8m above H117 and 3% above H216 (Grosvenor should also face slightly easier win margin comparatives in H217). Our forecasts for FY18 allow for continued economic pressures and the £5m increase in operating profit that we project comes entirely from the flow-through of the cost savings. Our new FY19 forecast for £90.0m of operating profits assumes the UK economy and consumer spending remains subdued through Brexit uncertainties, but as noted above there may be significant upside to our digital margin and profit assumptions. Our estimates do not assume any contribution from possible increased machine allowances in Grosvenor venues nor from Luda (where any contribution would mainly fall outside the forecast period).

Rank’s underlying businesses are strongly cash generative and we expect it to eliminate net debt by the end of FY18 in the absence of any acquisitions, despite a progressive dividend policy and ongoing investment in its venues and digital capability. Rank has guided to £50-55m of capex in FY17, down from its previous £60-70m guidance as it has scaled back on machine numbers for Grosvenor and the Luda roll-out has been delayed. We estimate that c £30-35m is maintenance capex and on that basis, Rank’s free cash flow is over £60m in FY17e and over £75m in FY18e. Its balance sheet is very strong with net assets of £362m at December 2016 and its bank facilities were refinanced in September 2015. Net debt of £33.0m at 31 December 2016 represented gearing of only 9% and annualised adjusted EBITDA leverage of only 0.3x. Debt has fallen from £52.9m only 18 months previously (June 2015) and we expect the group to reach a net cash position in FY18.

Thus management has considerable financial flexibility to pursue M&A, with undrawn RCF funds for potential smaller-scale digital deals, and scope to gear up and likely shareholder support (including the major shareholder) for the right deal. In the absence of M&A we believe Rank would consider some additional return of cash to shareholders, such as a special dividend.