Aristocrat Leisure (ASX: ALL) is performing better than expected. Underlying fiscal 2024 first-half net profit lifted 16% on the prior corresponding period to $764 million. Following results Aristocrat shares jumped over 12%. The previously undervalued shares are now screening as fairly valued despite an increase in our fair value.

The core electronic gaming machines business continues to capture share, increased monetization in digital gaming is more than offsetting falling player numbers, and profitability in the nascent iGaming business is improving.

We lift our fiscal 2024 underlying net profit forecast by 13% to $1.5 billion, a 17% improvement on the prior corresponding period (“PCP”) as earnings from the NeoGames acquisition come online during the second half. We lift our fair value estimate by 7% to $48 per share due to the increase in near-term earnings, a larger installed base leading to higher longer-term earnings, and the time value of money.

Aristocrat’s highly popular and profitable EGM titles, which underpin its narrow economic moat, allowed the firm to dominate the installed base of leased machines in North America. The number of gaming operations machines lifted 10% on the PCP to over 67,000, with particular strength in the premium class III installed base, which increased 18% on the PCP to nearly 40,000 units.

This is in stark contrast to other major players International Game Technology and Light & Wonder, whose installed base expanded about 3% over the same period. Aristocrat’s number of leased units in North America is roughly the size of IGT’s and Light & Wonder’s combined.

Aristocrat maintained market-leading ship share in Australia at about 38%. However, it probably fell to number-two ship share in the March quarter as Light & Wonder hit the top spot for the first time. This is supported by anecdotal evidence of strong demand for Light & Wonder’s new Dragon Train game in particular. At its recent trading update, Endeavour Group—the biggest pub operator in Australia—called out significant deployments of Dragon Train in all markets, alongside machines from Aristocrat and others.

Economic moat

We assign Aristocrat Leisure a narrow economic moat rating by virtue of the intangible assets in its core electronic gaming machine business. Stringent regulatory licensing requirements in major markets create barriers to entry for new players, and Aristocrat's extensive portfolio of popular games allows the firm to enjoy economic returns in this environment. We expect returns on invested capital to average 22% during the next five years compared with 23% in the prepandemic five years to fiscal 2019, materially above the company's 8.7% weighted average cost of capital.

Aristocrat is somewhat protected from new players as stringent regulatory licensing requirements in major markets create barriers to entry for new players. Incumbents have accumulated licences over decades, and electronic gaming machine manufacturers are subject to extensive regulation and licensing requirements. Companies are required to obtain the appropriate regulatory approvals for each new gaming machine and game release in each jurisdiction they wish to distribute. The licensing requirements are onerous and typically require probity checks on company directors, key executives and substantial shareholders before a license can be granted. The company is licensed by every regulatory body in Australia and every US state that allows gaming.

The EGM manufacturing market is highly consolidated and highly competitive. We estimate the three major players—Aristocrat Leisure, International Game Technology, and Light & Wonder—command a combined ship share of more than 80% of North American outright sales and a similar proportion of leased machines. We estimate Aristocrat's North American ship share increased to around 23% in 2019, from around 13% in 2012, behind market share leader International Game Technology and Light & Wonder at around 28% and 26%, respectively. Aristocrat's share of the installed based of leased EGMs is stronger. Before covid-19, we estimate Aristocrat commanded a number-one position in Class II and Class III leased machines with around a third of the installed base.

Aristocrat has been a direct beneficiary of smaller competitor Ainsworth Game Technology's market share demise in Australia. Aristocrat has continued to grow share at the expense of Ainsworth in Australia while achieving modest price increases. Aristocrat nearly doubled ship share in the five years to fiscal 2019 from around 30% in 2014. We estimate Ainsworth's ship share fell from over 20% to less than 5% over this period. We estimate Aristocrat will continue to dominate the local market.

Aristocrat also has an extensive record of research and development to defend its narrow economic moat and aid future market share gains. While R&D spending is not a moat source, maintaining resources is necessary to maintain the quality of the games and differentiate its products from lower-end competitors. Aristocrat's R&D expenditure has been historically maintained at around 12% of revenue compared with around 7% for International Game Technology and 9% for Light & Wonder. This has culminated in highly popular and profitable titles such as the Lightning Link and Dragon Link ranges, allowing the firm to continue to capture share. Aristocrat's R&D spending of around AUD 500 million in fiscal 2020 surpassed the two other major players spending around AUD 400 million.

While the occasional hit game can come down to chance, we expect the ability to consistently deploy popular titles will come down to investment over the long run. The electronic gaming machines industry is intensely competitive. This was accentuated by a spate of consolidation in 2013 and 2014, giving rise to a number of behemoths (including Aristocrat), all much better resourced to invest in R&D compared with smaller competitors. This investment is the lifeblood of any electronic gaming manufacturer, especially given rapidly changing technology.

We do not view Aristocrat's digital business as moaty. Buoyed by the acquisitions of Plarium and Big Fish, mobile gaming now represents more than one fourth of the EGM manufacturer's earnings. The social casino space is a relatively mature niche, and Aristocrat competes with market leader Playtika and SciPlay. Social casino games allow real-world popularity testing of new concepts before implementing on a machine, and also allows Aristocrat to participate in the shift in popularity toward digital gambling. But social casino, along with Aristocrat's other social games, also compete with the wider range of mobile games. While Aristocrat has a number of relatively popular games, such as Vikings and Raid: Shadow Legends through Plarium, the mobile gaming market is highly fragmented, and Aristocrat has yet to carve a niche among competitors such as Nintendo, EA Mobile, and Epic Games.