LNW - Light & Wonder: Valuation Leaves Me Wondering

2023-11-01 05:27:59 ET

Summary

• Light & Wonder is streamlining its focus on land-based and online slot machines and related products as the company divested its sports betting and lottery businesses in 2022.
• The iGaming and SciPlay segments should be able to grow significantly, but the more stable land-based Gaming segment represents the majority of Light & Wonder.
• The current valuation seems too high as I don't believe that the company can grow as fast as the valuation seems to expect.

Light & Wonder ( LNW ) operates gaming solutions for both brick-and mortar and online gambling operators. The company has divested its sports betting and lottery businesses in 2022, streamlining the company’s focus on slot machines and similar products. The company has been able to grow its revenues well, but the current valuation seems quite high. In this text, I take a look at Light & Wonder’s valuation through a discounted cash flow model.

The Company & Stock

Light & Wonder operates through three segments – Gaming, iGaming, and SciPlay. The Gaming segment provides land-based gaming systems for brick-and-mortar gambling operators. The Gaming segment’s offering includes products such as slot machines, electronic table systems, shufflers, and casino management systems. Of the company’s operations, the Gaming segment represents the majority with 64% of revenues and 74% of AEBITDA:

On the other hand, the iGaming segment provides online casino slots. Light & Wonder’s iGaming segment includes names such as Rainbow Riches, Into the Storm, and Dancing Drums. The company’s iGaming offering is expanding rapidly as the company has ten internal game projects projected to launch in November, as can be seen on the company’s roadmap . The iGaming segment is small, but I believe that it should growth in significance as the iGaming segment grows fast in the United States.

Lastly, the SciPlay segment provides social games that range from slots-style games to table games. The SciPlay segment has grown very rapidly in the company’s history:

Light & Wonder has previously held the majority of SciPlay’s shares. In May, Light & Wonder offered to buy the remaining 17% of shares at a price of $20 per share. After lengthy discussions, the companies’ shareholders reached an agreement at a moderately higher price of $22.95 per share , and the deal finally closed in October.

The stock has performed very well in the past ten years with a CAGR of 14.9%:

Financials

Light & Wonder’s revenues have been quite turbulent from 2015 to the current date. As Light & Wonder has had a good amount of acquisitions and divestitures, revenues have had significant turbulence. Further, in 2020, the Covid pandemic caused Light & Wonder’s revenues to decline by -28.9% . The company’s revenues have still grown at a compounded annual rate of 8.9% from 2002 to 2022:

The company has recently divested its lottery business and sports betting businesses in 2022 for a total consideration of around $6.5 billion. The divestments haven’t affected Light & Wonder’s revenues very much so far, as the company’s revenues grew by 18.3% in the first half of 2023 driven by good organic performance.

Light & Wonder’s EBIT margin history is quite turbulent. The company has achieved an average EBIT margin of 11.8% from 2002 to 2022:

After a worse performance during the pandemic, Light & Wonder’s margin has risen into a current trailing level of 19.1% as the company has achieved a good amount of operating leverage. I believe that the operating leverage should continue largely into the future, as the iGaming and SciPlay segments operate at very high gross margins and a low amount of incremental expenditures needed to grow.

Valuation

Light & Wonder currently trades at a forward EV/EBIT ratio of 17.2. The ratio is significantly below the company’s ten-year average of 26.0:

Yet, the ratio seems quite high in my opinion, as the company operates in a low-ESG industry. To further analyze the valuation and to estimate a fair value for the stock, I modeled a discounted cash flow model as usual. In the model, I estimate Light & Wonder’s revenues to grow by 14% in 2023, signifying a slightly worse second half as in H1 the company’s revenues grew by 18.3%. After the year, I estimate Light & Wonder’s organic growth to slow down in steps as the company matures. The estimated growth eventually comes down into a perpetual growth rate of 2.5%. From 2022 to 2032, the DCF model estimates represent an organic CAGR of 6.7%.

For Light & Wonder’s EBIT margin, I estimate a significant amount of operating leverage. The company has demonstrated an ability to expand margins so far in 2022 and 2023, as the company’s EBIT margin has expanded significantly. For 2023, I estimate an EBIT margin of 20.8%, 4.1 percentage points above the achieved 2022 level. Beyond 2023, I still estimate a good amount of operating leverage, as in the model the EBIT margin ends up at a level of 24.0% in 2032. The company also has a very good cash flow conversion, as the company’s accounting earnings includes a large amount of amortizations from previous acquisitions.

The mentioned estimates along with a weighted average cost of capital of 13.16% craft the following DCF model with a fair value estimate of $47.42, around 35% below the price at the time of writing. With my estimates, the stock seems to be substantially overvalued:

The used weighed average cost of capital is derived from a capital asset pricing model:

In Q2, Light & Wonder had $78 million in interest expenses. With the company’s current amount of interest-bearing debt, Light & Wonder’s interest rate comes up to an annualized figure of 8.03%. The company seems to use a large amount of debt as a form of financing; I estimate Light & Wonder’s long-term debt-to-equity ratio to be 40%. Currently, the company’s long-term debt seems quite excessive as interest expenses cover around 57% of the company’s operating income, but I believe that the debt balance should be low enough to be kept as Light & Wonder’s earnings grow.

On the cost of equity side, I use the United States’ 10-year bond yield of 4.85% as the risk-free rate. The equity risk premium of 5.91% is Professor Aswath Damodaran’s latest estimate for the United States, made in July. Yahoo Finance estimates Light & Wonder’s beta at a figure of 1.83 . The figure seems very high, as gaming is often associated with stable revenues; I believe that the company has had a high beta as a result of the pandemic, which has functioned as an external factor that influences both the stock market as a whole, but Light & Wonder even more as the company’s brick-and-mortar revenues have been dependent on a subsiding pandemic. For the time being, I still use Yahoo Finance’s estimate, as I don’t see a better figure. Finally, I add a liquidity premium of 0.25% and an ESG addon of 2%, crafting a cost of equity of 17.92% and a WACC of 13.16%.

Takeaway

At the current price, Light & Wonder stock seems too expensive. The company should be able to achieve a significant amount of growth through the iGaming and SciPlay segments, but as the Gaming segment operates on a mature industry with the majority of Light & Wonder’s revenues, I don’t see the growth being as high as the stock price seems to estimate. For the time being, I have a sell rating for the stock.

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