Edmond Jackson's Stockwatch: Ladbrokes

The 2012 prelims from FTSE 250-listed gambling group Ladbrokes affirm my initially drawing attention last April at 160p following signs of strong revenue growth and directors' share buying; and again at just over 160p after the August interims showed first-half operating profit up 11% and pre-tax profit soaring 48.9%, ahead of the consensus forecast.

The shares have since delivered about 50% total return including dividends, currently testing 230p. The re-rating has evolved from a price/earnings multiple (P/E) under 10 times the forecasts Ladbrokes has anyway beaten; and a dividend yield over 5%, more than twice covered by earnings.

It is a good example of how alertness both to the dividend and earnings rating in a share can exact an excellent return when the business is sound and well established, yet going through a period of unpopularity with investors. A relatively high yield can indicate the shares are priced conservatively for risk; and together with a low P/E it improves the chances of a re-rating. Ladbrokes' overall business is now seen to be in decent health and the market is next likely to peruse the extent to which it can grow.

Investors were worried gambling would be affected by ongoing UK recession, amid tax rises and higher living costs; a not unreasonable view considering Ladbrokes' declining trend in revenue and profit from 2009 to 2011. But history shows gambling also offers escapism during hard times, one reason, I believe, why Ladbrokes' operations have achieved 7% net revenue growth to £1,053.3 million despite weather-related horse-racing cancellations.

The group has also benefited from some favourable sporting outcomes, notably in football, and management expects sports-betting margins to continue to improve this year. They speak with a growth agenda, but it needs watching carefully, partly due to inherent uncertainty with projecting gambling groups. I would not bet on their P/E multiples rising over 15 times and Ladbrokes' may currently be in the low teens. It is however supported by a near 4% prospective yield, covered twice by what may be conservative earnings forecasts.

Total revenue grew by 11.1% to £1,084.4 million when including a £31.1 million contribution from "high rollers". These are a small number of super-wealthy gamblers who bring a modest if lumpy element to revenue/profit: last year as much as a £30 million profit after a £3.2 million 2011 loss. "Net" figures therefore provide a better sense of principal trends. Management cites a 7.2% rise in group net revenue in the first six weeks of 2013, so the year has started well.

Investors should bear in mind that machines' revenue is a double-edged sword currently: in 2012 it grew by 13.9% to £41.5 million, or 17.2% of the total, however there is concern regulation could cut outlays to £2 a spin - in line with bingo halls and casinos - to tackle problem gamblers. The coalition government has agreed to examine a reversal of Labour's relaxation of gambling regulation and while this is a known factor, the actual news could dampen sentiment.

Digital development has also been a touchy point for sentiment after an end-June 2012 profit warning relating to this side. A poor margin in the second quarter and delays in technology delivery meant operating profit fell 39.3% to £31.8 million despite a 9% rise in revenues to £178.1 million. Attention is focused on the Sportsbook product which saw revenues grow 26.1% to £77.8 million, accelerating in the second half also as margins recovered. Management says it is confident ongoing development will enable the digital business to grow profits this year and beyond.

Operating costs rose, but remained within management's 6% target and it was encouraging that operating profit per shop rose 15.7% to £82,000. Openings are being accelerated in areas of unmet demand; also exclusive games being introduced and the roll-out will soon be completed of the Sportsbook and mobile platforms.

I believe the crux of the matter for share trading is a 14.1% increase in the total dividend to 8.9p - an historic yield near 4% after the re-rating - despite a reduction of net debt by £67.0 million to £386.9 million. This ought to be supportive as it is a competitive yield at a time when cash returns will continue to be debauched by quantitative easing, i.e. investors are being pressured to seek yield and capital protection in equities.

So long-termers in a SIPP or ISA may prefer to hold on; but if you are looking to utilise your annual allowance before capital gains tax then consider locking in some gains.

Net gearing still remains high, at 91.6% of £422.3 million net assets where goodwill and intangible assets are £666.6 million or 158%. Such a balance sheet likely deterred conservative investors, but its modest improvement and the market's "risk rally" may also have contributed to Ladbrokes' re-rating.

With fresh money I'd await the regulatory outcome on machines, which might provide a buying opportunity. The re-rating looks fair enough in the circumstances, although the yield and growth initiatives offer longer-term interest.

For more information see ladbrokes.com.