Rating Action Overview

• Australia-based lottery operator and Keno licensee Lottery Corp. Ltd. (TLC) derives its credit quality from high-quality cash flows, its strong competitive position in the heavily regulated Australian market, and its exclusive and long-dated state and territory licenses.
• TLC's competitive position benefits from high barriers to entry, earnings stability, and low capital intensity. As a result, the business can support elevated financial leverage.
• On May 30, 2022, S&P Global Ratings assigned its 'BBB+' issuer credit rating to Lottery Corp. Ltd. following completion of its demerger from Tabcorp Holdings Ltd. (Tabcorp).
• At the same time, we have withdrawn our 'BBB-' long-term issuer and issue credit ratings on Tabcorp at the company's request. The outlook was stable at the time of the withdrawal.
• The outlook on TLC is stable, reflecting our expectation that the company's high quality cash flow and long-dated state and territory licenses, creating substantial market barriers, will continue to underpin its competitive advantage. From this financial position it will be able to absorb any future debt-funded strategic initiatives.

Rating Action Rationale

Our issuer credit rating primarily reflects TLC's strong competitive position within the heavily regulated Australian market. Underpinning TLC's market position is the company's exclusive, long-dated state and territory licenses. We believe these licenses create high barriers to entry into the retail distribution of lottery tickets (and Keno) in Australia. In our view, TLC's dominant position in the Australian market, in which consumers display a relatively high propensity to participate in lottery games, somewhat differentiates it from global peers. Further, we believe the coordinated move by various state and federal governments to prohibit synthetic lottery products in 2019 underscores the defensive nature of the business.

TLC's high-quality earnings are driven by its low capital intensity, low fixed-cost base, and the habitual nature of lotteries customers. We believe the company's track record of stable revenue and EBITDA margins generate high-quality cash flow akin to infrastructure assets. We expect TLC to continue to generate stable revenue and EBITDA growth over the next few years, driven in large part by modest population growth, household disposable income levels, growing digital sales penetration, as well as game innovations and pricing changes. Further, given TLC's strong competitive position in the Australian lottery market, we believe there is limited need for promotional activity to defend its market position. Unlike other global lottery peers, TLC has a very capex-light business model because it does not manufacture lottery equipment. As a result, TLC is also not exposed to the volatility and greater pricing pressure of lottery equipment sales.

We believe TLC has minimal room for any deterioration in the company's business risk profile at the 'BBB+' rating level. In our view, the loss of a key state or territory license is likely to weaken our current assessment of the business. We view the Victorian Lottery license expiry in 2028 as a key license renewal risk for TLC. Given it accounts for a material proportion of TLC's lottery revenue, the loss of the Victorian license would be likely to hinder the company's earnings profile. While we believe the company's incumbency positions it well to renew this license, we cannot dismiss the risks associated with a potential dilution or outright loss of license.

In addition, TLC's business risk is somewhat moderated by its lower EBITDA margins, and smaller earnings and geographic scale compared to global peers. We believe any geographic expansion into less favorable markets may place undue pressure on the strength of its current business. Further, as a form of discretionary consumption, lotteries remain somewhat exposed to demographic shifts as well as changes in consumer tastes and preferences, in our view.

We expect TLC to operate with S&P Global Ratings adjusted debt to EBITDA of between 3.5x to 4.0x. We expect the company to absorb any debt-funded strategic initiatives or potential future funding needs associated with new or renewing licenses within this financial leverage range. Under our base-case assumptions, we estimate adjusted leverage at the date of implementation on June 1, 2022, will be marginally below the bottom of the company's target range of 3.5x to 4.0x and increasing above the mid-3.0x level in fiscal 2023. Relative to other rated gaming peers, TLC is highly rated. As a result, it can support significant leverage. TLC's calculation of net debt to EBITDA is largely in line with S&P Global Ratings adjusted calculation of the ratio.

We expect the high-quality lotteries cash flow to remain resilient through economic cycles. TLC has a demonstrated track record of stable earnings through periods of economic stress. Underpinning this resilience are the low-price points of lottery products, ease of access, and the habitual nature of lottery purchases for many consumers. Global lottery industries recovered faster from the COVID-19 pandemic than other gaming products. Despite reduced foot traffic, newsagencies remained open during periods of government-enforced lockdown in Australia. This resulted in reduced earnings volatility during the height of the pandemic. In fiscal 2021, TLC revenue increased 9.8% to A$3,206 million highlighting the company's resilient business position. In addition, TLC was successful in converting a large proportion of its existing lotteries retail customer base to its digital channel. TLC's digital share of sales has increased materially to 36.7% in the six months to Dec. 31, 2021, from about 23% in fiscal 2019 pre-pandemic, which supported EBITDA margin improvement to 20.1% at Dec. 31, 2021, from 17.7% in fiscal 2020.

In our view, TLC has ample buffer to accommodate the company's dividend policies, minimal capital expenditure (capex) requirements, or any near-term liquidity pressures. In our view, the long-dated nature of the company's debt profile, internally generated funds from operations (FFO), and undrawn facilities and available cash of about A$500 million support TLC's liquidity position. The company intends to target a dividend payout ratio of 70% to 90% of net profit after tax excluding significant items.

Outlook

The stable outlook reflects our view of TLC's position as the largest lottery operator in Australia, underpinned by the industry's substantial barriers to entry because of the company's exclusive, long-dated state and territory licenses.

We expect the group will continue to generate consistent revenue growth, driven by its active product portfolio management and growing penetration of the higher-margin digital sales. In addition, we expect the company to operate with debt to EBITDA comfortably below 4.0x, and to absorb any debt-funded strategic initiatives within this range.

Downside scenario

We could lower the ratings if we expect S&P Global Ratings' adjusted leverage will remain above 4.0x on a sustained basis. This could occur because of:

• Loss of a major lottery license resulting in a material reduction in earnings;
• Weaker-than-expected EBITDA performance because of a reduction in consumers' discretionary spending on lottery and keno products; or
• Debt-financed acquisitions or shareholder-friendly actions.

We could also lower the rating if significant regulatory or structural change led us to view TLC's competitive advantage as somewhat compromised. This could occur through the loss of a major lotteries license, a material escalation in license costs, or a venture into a less favorable offshore market.

Upside scenario

We view the probability of upward rating momentum as low given the company's financial policy objectives. However, positive rating action could occur if the company was committed to operating with a debt-to-EBITDA ratio comfortably below 3.0x under a range of variable conditions, including the possibility of corporate activity and capital management. We would expect a set of robust, publicly articulated financial policies to underpin this commitment.

Company Description

TLC is Australia's leading lottery and Keno operator with a portfolio of high-profile, recognized brands and games. TLC's portfolio of brands includes the Lott, Tatts, NSW Lotteries, Golden Casket, SA Lotteries, and Keno. TLC operates via retail and digital channels with a distribution network of about 3,900 lottery outlets, 3,400 Keno venues, and digital platforms.

Our Base-Case Scenario

• Australia real GDP growth of 4.0% in 2022, 2.7% in 2023 and 2.4% in 2024.
• Australian unemployment rate of 3.9% in 2022, 3.8% in 2023 and 3.9% in 2024.
• Expected increase in Australia consumer price index of about 3.9% during calendar year 2022.
• High single-digit lotteries revenue growth in fiscal 2022, driven by game development, active product portfolio management and growing digital sales penetration. Keno revenues to benefit from the abatement of operational disruptions.
• EBITDA margins to remain in the 18%-20% range, with the increased proportion of digital earnings to support gradual margin accretion.
• Capex of about A$50 million-A$60 million in fiscal 2023 exclusive of standalone IT requirements post-demerger;
• Dividend of A$260 million-A$340 million, representing a payout ratio of 70%-90% of adjusted net profit after tax before significant items; and
• We have not incorporated any debt-funded acquisitions or share buybacks for the next two to three years.

Based on these assumptions, we arrive at the following credit measures:

• S&P Global Ratings adjusted debt to EBITDA of about 3.4x at the end of fiscal 2022 post-demerger, below the bottom of the company's target range of 3.5x to 4.0x.
• We expect leverage to increase modestly through fiscal 2023 as EBITDA and EBITDA margins normalize and TLC incurs about A$150 million in additional cash demerger implementation costs.
• Absent any material debt-funded acquisitions or additional upfront license payments, we expect a gradual deleveraging toward the mid-3.0x thereafter.

Liquidity

We assess TLC's liquidity as strong. We expect the company's sources of liquidity to cover its uses by more than 1.5x over the 12 months ending June 30, 2023, and the ratio to exceed 1.0x over the following 12 months. We also expect the company to maintain ample headroom within its debt facility financial covenants. Our assessment of TLC's strong liquidity includes prior sound relationship with banks and relatively strong standing in capital markets of Tabcorp Holdings Ltd.

We note TLC is targeting to complete its demerger from Tabcorp Holdings Ltd. in June 2022. TLC's proposed capital structure includes drawn debt of about A$2.1 billion-A$2.3 billion, with undrawn facilities of about A$300 million to A$350 million. This will comprise a combination of committed bank facilities, with an initial facility limit of $950 million, as well as all existing US Private Placement notes.

We believe TLC will generate sufficient cash flow to support its strong liquidity. In our view, TLC's robust cash flow generation; undrawn facilities, available cash balance and minimal debt maturities will help to shield the company against near-term liquidity pressures.

As of June 1, 2022, we expect TLC's sources and uses of liquidity over the next 12 months to include the following:

Principal liquidity sources

• About A$150 million of unrestricted cash and undrawn bank facilities;
• Undrawn facilities of between A$300 million-A$350 million; and
• Our forecast for FFO of $500 million-$550 million in fiscal 2023.

Principal liquidity uses

• Capex and additional cash demerger implementation costs of about A$200 million to A$210 million; and;
• Expected shareholder distributions of between A$260 million-A$340 million.

Covenant Analysis

The company's key financial covenant measures are expected to incorporate a net borrowings-to-EBITDA ratio and EBIT-to-net interest measure. We expect TLC to remain compliant with its financial covenants.

Environmental, Social, And Governance

ESG credit indicators: E-2, S-3, G2

Social factors are a moderately negative consideration in our credit rating analysis of TLC. Like all lottery and gaming operators, TLC is exposed to regulatory risks as it faces a high degree of regulation across jurisdictions in which it operates. The increased use of digital platforms has also raised the importance of customer privacy and data security. In our view, the risk of future digital breaches has the potential to affect TLC's reputation or customer confidence in the security of their personal information. We note TLC proved resilient during the pandemic, with minimal impact on cash flow as its retail channel remained open because of its classification as an essential service.

Issue Ratings - Subordination Risk Analysis

Capital structure

We expect TLC's capital structure to consist of about A$2.1 billion-A$2.3 billion of unsecured debt. TLC's funding is expected to be diversified through a mix of bank facilities and US Private Placement notes.

Ratings Score Snapshot

Issuer Credit Rating: BBB+/Stable/--

Business risk: Strong

• Country risk: Very low
• Industry risk: Intermediate
• Competitive position: Strong

Financial risk: Significant

• Cash flow/Leverage: Significant

Anchor: bbb

Modifiers

• Diversification/Portfolio effect: Neutral (no impact)
• Capital structure: Neutral (no impact)
• Liquidity: Strong (no impact)
• Financial policy: Neutral (no impact)
• Management and governance: Satisfactory (no impact)
• Comparable rating analysis: Positive (+1 notch)

Stand-alone credit profile: bbb+

Related Criteria

• General Criteria: Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021
• General Criteria: Group Rating Methodology, July 1, 2019
• Criteria | Corporates | General: Corporate Methodology: Ratios And Adjustments, April 1, 2019
• Criteria | Corporates | General: Reflecting Subordination Risk In Corporate Issue Ratings, March 28, 2018
• General Criteria: Methodology For Linking Long-Term And Short-Term Ratings, April 7, 2017
• Criteria | Corporates | General: Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Dec. 16, 2014
• Criteria | Corporates | Industrials: Key Credit Factors For The Leisure And Sports Industry, March 5, 2014
• General Criteria: Methodology: Industry Risk, Nov. 19, 2013
• Criteria | Corporates | General: Corporate Methodology, Nov. 19, 2013
• General Criteria: Country Risk Assessment Methodology And Assumptions, Nov. 19, 2013
• General Criteria: Methodology: Management And Governance Credit Factors For Corporate Entities, Nov. 13, 2012
• General Criteria: Principles Of Credit Ratings, Feb. 16, 2011

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