The company transfers overseas patents to IGT (IGT US), effectively removing regulatory barriers in the United States at the cost of writing off HK $439 million of intangible assets (non-cash) in 2016.
After the completion of the transfer transaction, the company's profit margin will decline from the second half of the year, but the visibility of overseas revenue flows will increase, thus opening up a larger market.
Due to the decline in profit margins, we lowered our EBITDA and core net profit forecasts for 2017 by 35-39%, and lowered the target price to HK $1.90, which is 15 and 13 times the forecast EV/EBITDA for 2017 and 18, respectively.
Details of the transfer transaction
On April 25, 2016, Colour Holdings agreed to grant IGT the franchise to produce and sell live hybrid game consoles and random number generators worldwide (excluding Macau), and its US patent will expire in 2026. In return, Colour Holdings will 1) collect an upfront fee of US $12.95 million (HK $101 million) within 90 days, and 2) obtain 3-12% of IGT's revenue from the sale of licensed products.
Profit margins decline, but profit visibility increases
We expect the company to record a gain of HK $101 million from this transfer and a loss of HK $439 million on the purchase and sale of patents in 2016, resulting in a net loss of HK $365 million. In the long run, China Colour Holdings's sales commission from the United States will be reduced (from 30% to 10%). Despite the above negatives, we are now more comfortable with the company's prospects because the transfer will remove regulatory barriers to the distribution of live hybrid games consoles: IGT has about 30 per cent of the US video game market and has a wide range of sales networks and concessions. Therefore, we believe that this transfer transaction will accelerate the growth of the company's profits from US patents.
Assuming a decline in profit margin, the target price is lowered to HK $1.90.
The company is now valued at 33 times forecast 2017 earnings and 10 times forecast EV/EBITDA, compared with 19 times and 12 times for peers. We expect the company's business performance to improve in 2017, and all the negatives will be reflected in 2016. According to the segment plus total valuation method, due to 1) the decline in sales commissions from the United States and 2) the possible delay in the opening of casinos in Macau, our forecast for live mixed games consoles in Macau is more conservative, so after we lowered our profit forecast, lower the target price to HK $1.90.