Shares in online lottery ticket seller Jumbo Interactive Ltd (ASX: JIN) are trading near record highs following a positive half year trading update released earlier this month.
Management expects revenue to increase between 13% and 16%, and earnings after tax to improve 23% to 29% for the first half of 2017.
Jumbo operates the Oz Lotteries website, selling tickets under agreements with Tatts Group Limited (ASX: TTS). In May this year, Tatts extended Jumbo's reseller arrangement in several Australian states to 2022, with additional provisions to continue beyond then.
Around the same time, Tatts acquired a significant stake in Jumbo, purchasing 6.6 million shares and options to acquire another 3.5 million within 12 months.
The re-seller arrangement with Tatts represents a key business risk for Jumbo; if Tatts were to end their relationship, it would cripple Jumbo's revenue and earnings. Having said that, while the agreements are in place, Jumbo has access to a growing, defensive stream of revenues.
Now that Tatts has made a significant investment in Jumbo, Tatts is less likely to either end the business relationship or allow a new re-seller to enter the market.
I say the lotteries business is defensive because the industry is subject to strict regulation in Australia and its states and territories. Potential competitors cannot easily enter the market, where Tatts maintains a dominant position.
Tatts provided a trading update in late November, stating lotteries revenue were 8.8% higher during the first quarter of FY2018 compared with the prior corresponding period. Digital sales also increased 29.6% and represented 16.4% of total lotteries sales.
So not only are online ticket sales on the rise, but there is still plenty of room for further growth.
This is where Jumbo comes in; as a pure online re-seller. I believe this online growth trend will continue, as the digital-savvy, younger generation is more likely to buy tickets using their mobile devices rather than step foot into the shrinking number of newsagents across the country.
Looking at Jumbo's financial statements for FY2017, the company is both profitable and generating positive operating cash flow. The balance sheet is very strong, with no bank debt and cash and equivalents of more than 3x total liabilities.
The $43.32 million in cash at 30 June 2017 equates to almost $0.85 a share, with Jumbo currently trading around $3.35.
Furthermore, being a pure online re-seller, Jumbo does not require significant capital investment each year. The business model is highly scalable, meaning revenues may rise at a higher rate than costs, allowing economic profits to be made.
Again, all this depends on the Tatts re-seller arrangements remaining in place, a key business risk that is worth reiterating to potential investors.
