Paddy Power rating cut to ‘underperform’

Davy Stockbrokers has downgraded its rating on the Paddy Power stock, citing slow market growth in Italy, a declining customer base for its online operation, and potentially faltering returns in the UK retail segment.

The move drove the company’s share price down by more than 6% in early trading yesterday, representing its biggest daily fall in seven months. It closed down 5.7%.

Just last month, the leading Irish bookmaker reported record annual pre-tax profits of €139.2m for 2012, but warned that continuing negative exchange rate patterns could hit operating profits by around €10m this year.

Yesterday, Davy said it was cutting its rating on the stock — from ‘outperform’ to ‘underperform’ — for the first time in nearly three years, even though the Paddy Power stock has delivered a total return of over 300% since Jun 2009.

“In our view, the group remains — by some distance — the highest quality name in the European gaming sector. Therefore, our decision to reduce the stock to ‘underperform’ is not one we take lightly,” Davy said.

“Our decision reflects the fact that the stock has re-rated significantly in recent months at the same time as we have observed signs that group returns are starting to fall. These two occurrences do not sit comfortably side-by-side.”

The note on Paddy Power — researched and written by Davy analysts David Jennings and Simon McGrotty — suggests that the company’s UK and Ireland online division is suffering continual reductions in earnings and user numbers, increasing the reliance on new customer acquisition to drive future earnings growth.

It said that adding so many new customers is likely to become increasingly difficult and future earnings growth will be further threatened if incremental spend per customer continues to fall. Davy estimates that average online spend per customer, via paddypower.com, is already down by 20% over the last four years.

On the Italian expansion, Davy suggests the move is “a real concern”, stating a lack of sufficient market growth will translate into “a far longer payback period” in terms of the company recouping its substantial investment.

Davy also foresees returns from Paddy Power’s UK retail operations falling as the business further expands on the British high street — saying its next 200 shops in the UK could generate up to 30% less earnings than those opened to date.