Is Tabcorp’s demerger of the Lotteries & Keno division a good idea?

Tabcorp has released the results of its strategic review into the structure of the company the board announced three months ago. The decision has been made to pursue a demerger of the Lotteries & Keno division from the company. While a trade sale of the Wagering & Media division has been rejected for the time being under this plan, the company intends to continue talking to the three bidders for the business.

The strategic review didn’t look at the Gaming Services business, but management noted that the business is going through a rationalisation exercise with some changes currently in the process of being implemented.

In detailing some of the expectations around the demerger and what the separated entities would look like, management made the following comments:

• The demerger is expected to be completed by the end of June 2022.
• The demerger will result in estimated one-off costs of A$225-275 million and ongoing costs of A$40-45 million a year as a result of the need to duplicate IT costs across the separate companies, as well as duplicated head office and listing costs. These estimates are before any cost reduction strategies are implemented. Management noted that these estimates are conservative.
• The Lotteries & Keno company is expected to be geared to a gross debt to EBITDA ratio of 3.5 to 4-times while the Wagering & Media company would be geared to 1.0 to 1.5-times.
• Tabcorp has negotiated with the 25 holders of the US Private Placement debt securities and received approval to have this debt allocated to the new Lotteries & Keno company.
• More details regarding the likely dividend pay out ratios of the two companies will be announced with the release of Tabcorp’s FY21 results in August.

The reasons for the company preferring a demerger rather than a trade sale largely relate to the time it would take for:

•  a bidder to gain the necessary approvals from all of the racing and regulatory bodies state
• legislation changes to allow one party to own more than 10% of the NSW licensee's shares.

The demerger does not require any approvals other than from shareholders at a scheme meeting. The company has not yet received roll over relief for shareholders from the Australian Tax Office but does not expect any issues.

Importantly, the board stated in the conference call that it “remains very open to future engagement with bidders and considering alternative proposals” meaning that a trade sale of the Wagering & Media businesses could still occur.

Additionally, the company stated that it remains in discussions with Betmakers about the potential to work together in the rapidly growing US market.

We aren't surprised by the announcement, given the drawn-out negotiations needed to secure the broad range of approvals to acquire the Wagering & Media businesses. We believe this outcome is a better one for shareholders in the long term as it will provide potential bidders with a level playing field and greater transparency.

Additionally, we expect the strong and stable cash flow generation of the Lotteries & Keno businesses, combined with moderate growth from the shift in channel mix to digital, to be materially rerated by the market as a standalone business. It could also attract attention for income-seeking pension funds as a long duration source of stable, growing cash flow.

The market did not view the demerger as positive with the stock selling off after the announcement. We believe this is due to the perception that:

• a trade sale would generate great value in the near term, 
•  the demerger timetable is longer than expected, and 
• the one and ongoing costs from the demerger were higher than expected. 

While we are surprised a demerger would take 12 months to implement, we note that the duplicated cost estimates are at the conservative end of company expectations. Offsets are also likely, as a result of each company being more focused on, and in control of, their strategies.

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