Category Archives: Gambling Sector

Peaky Power

The last time I posted on Paddy Power Betfair (PPB.L), I highlighted it was looking pricey in the mid-to high 90s. It has since traded down to the eighties and recently dipped below £83 after the full year results. Although it has now quickly recovered up around £88, the initial disappointment over the online revenue in Q4 sent the stock down 6%.

The graph below shows quarterly revenues, which met expectations largely due to the favourable A$ rate with Australia revenue up 34% in sterling but only 18% in the underlying currency. Management make a point of stating that “approximately 70% of our profits are sterling denominated, and accordingly, we are not exposed to FX translation fluctuation”. Events such as the summer 2016 Euros contribute to the revenue spike in Q2 2016.

click to enlarge

They exceeded my expectations on the bottom line with an operating profit of £182 million for H2 over my expectation of £160 million, with the merger expense and intangible write-off impacts of £300 million for the full year stripped out. The EPS of £3.30 for 2016 on average 80 million shares was impressive. I messed up on the average share count (again!) in my previous EPS estimate.

PPB stated that they “expect to complete the integration of our European online platforms by the end of 2017” and “until then, new product releases on the Paddy Power brand will be relatively limited, but on completion customers will see immediate benefits”. Despite their market beating margins on their dominant online segment, they caution that “a lot of the sportsbook operators acknowledge that gaming got harder in the second half of last year” and  they always emphasis that they operate in a very very competitive market. It looks to me like PPB management are trying to carefully manage expectations for 2017 and are likely nervous that large competitors like William Hill and Ladbrokes could possibly recover from recent online slumps and (just maybe) finally get their act together online.

There is an ongoing regulatory headwind in this business and 2016 bought items such as the online gaming point of consumption tax, the statutory Horserace Betting Levy, and the UK Competition and Markets Authority (CMA) investigation into UK online gambling (update due in April) to the fore. In addition, South Australia announced a 15% consumption tax effective from July 2017. The UK Government’s Review of Gaming Machines is a much bigger deal for PPB’s larger competitors as it only makes up 6% of their revenue.

PPB have substantially completed the integration of risk and trading functions which means that Paddy Power proprietary pricing and risk management tools are now used for over 85% of the bets on the Betfair sportsbook across 19 sports. They stated that “operating two individual brands on an integrated shared function is also proving to be beneficial for efficiency” and that the “pooling of analytics data has improved our econometric modelling, giving us greater insight into the effectiveness of marketing activity and leading to improved optimisation of spend”. These are critical factors in why PPB is differentiating itself operationally from its peers and are important to the success of the business model envisaged by the merger.

So, although I have likely got the share count wrong again (I am assuming an average of 85 million this time across 2017 and 2018), my new projections are below. I estimate growth of 5% and 11% for revenue in 2017 and 2018 respectively and EPS growth of 14% and 20% respectively. I factored in a degree of topline and bottom line upside in 2018 from the soccer world cup in Russia (assuming politics hasn’t messed up the world order by then!). That represents a PE multiple of 19.4 on an 2018 EPS estimate at a share price of £88 (2017 PE of 23.3). Not bargain basement cheap but not crazy mad either. With a targeted payout rate of 50%, my estimates could mean a dividend yield of 2% and 3.5% for 2017 and 2018 (again at a £88 share price).

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That looks like a better dynamic that the one at a share price in the mid to high 90’s, as per my post in August. If only I wasn’t so negative about overall valuations across the market, I would have added to my PPB position on the dip after the results last week. [Customary caution: PPB is not for the faint hearted, it is the gambling business after all!]. My instinct tells me markets will be bumpy in the coming months, valuation wise (e.g. rising interest rates, politics!). That may prove an opportune time to get more of PPB at a good price. After all, the game of speculation it is all about getting the best odds!

Paddy Power Betfair Revisited

It has been about 10 months since I posted on the potential for the Paddy Power and Betfair merger and a lot has happened since. Brexit and the resulting sterling volatility are obvious events of significance. In the betting sector, consolidation has continued with the Ladbrokes and Gala Coral merger having been announced and approved. The audacious proposed tie up by Rank and 888 on William Hill floundered with recent press reports suggesting Rank and 888 could get together. The consolidation in this rapidly changing sector is far from over.

The initial optimism on the future prospects for the two high achieving entities, Paddy Power and Betfair, resulted in the share price trading above the £100 level earlier in the year. Following Brexit, it traded as low as £80. The merged firm reported their H1 figures earlier this week which showed the full extent of the merger costs and provided an increased cost synergies figure for 2017 of £65 million. With 75% of EBITDA being sterling based, the currency impact was not as material as their multi-jurisdictional operations would suggest.

Top-line results for H1 do however indicate that 2016 revenue growth will likely not be as high as the 17% I had expected in November. The reality of issues in this regulated and highly competitive sector also served as a reminder that the path may not be as smooth as initially hoped for. Regulatory headwinds in Australia were an example. As a result, I revised my revenue estimates in November from £1.64 billion to £1.51 billion. The graph below shows the breakdown of my revenue estimates for the next few years with a comparison to overall average analyst estimates.

click to enlargePaddy Power Betfair pro-forma revenue split August 2016

Also, I have revised my previous earnings estimates with an operating profit margin of 20% for 2016, growing to 22% in 2017 and 23% in 2018. Based upon a share count of 86 million as at end June 2016 (which includes 2 million treasury shares), I estimate the H2 EPS at £1.55 which when added to the H1 EPS of £1.45 gives a full year 2016 EPS of £3.02.[ This 2016 estimate does represent an operating EPS of £3.79 which compares to my November estimate of £3.85 albeit that the November estimate was based upon suspect figures like the share count!!]. At today’s share price of £95.65, the PE multiple for 2016 is a hefty 31.6. The graph below shows the multiple based on my EPS estimates for 2016, 2017 and 2018 compared to those using the average analyst estimates.

click to enlargePaddy Power Betfair PE Multiples 2016 to 2018

In conclusion, I remain optimistic about the business model of Paddy Power Betfair particularly given the proven quality of the management team and their history of execution. However, quality doesn’t come cheap and the current valuation is priced for perfection. For new investors, it may be prudent to wait for a better entry point.

Time for a gamble?

While waiting for earnings season to show how firms are forecasting the impact of macro trends, it’s a good time to look over some investing ideas for the future. Having a few names selected that can be picked up in market weakness is always a good way of building quality positions. It also helps in viewing current positions to see if they stack up to alternatives.

Regular readers will know that I think the insurance sector is best left alone given pricing and competitive pressures. Despite the odd look from afar, I have never been able to get comfortable with hot sectors such as the Chinese internet firms (as per this July post). The hype around new technologies such as 3D printing has taken a battering with firms like 3D Systems and Stratasys bursting the bubble. A previous post in 2014 highlighted that a focussed play on 3D printing such as Sirona Dental makes better sense to me. The Biotech sector is not one I am generally comfortable in as it seems to me to be akin to leveraged one way bets (loss making firms with massive potential trading a large multiples of revenue). Firms such as GW Pharma which are looking at commercializing cannabinoid medicines for multiple sclerosis, cancer and epilepsy have had the shine taken off their gigantic runs in the recent volatility. My views on Trinity Biotech (which is not really a biotech firm) were expressed in a recent post in May and haven’t really changed despite a subsequent 25% drop. I need to see more results from TRIB to get comfortable that the core business justifies the current valuation with the upside being in the FDA approval of the Troponin point-of-care cardiac tests. Other ideas such as online education firm Houghton Mifflin Harcourt (in this post) have failed to sparkle.

click to enlargeInvesting Ideas October 2015

This leads me to the online gambling sector that I have posted on many times (here and here for example) and specifically to the Paddy Power/Betfair merge. My interest in this sector has not been one from an investment point of view (despite highlighting that PP and Betfair would make a good combination in May!) but I can’t get the recent performance of these two firms out of my head. The graph below shows the profit before tax margins of each (with my estimate for 2015).

click to enlargePaddy Power Betfair Historical PBT Margins

One of the things that stand out is how Betfair’s margin has improved, despite the recent headwinds such as the UK point of consumption (POC) tax. Indeed the market view that Betfair CEO Breon Corcoran is the new messiah can best be illustrated in the graph below on the firm’s performance since he took charge (revenue in sterling). It shows solid revenue growth (particularly from sustainable markets) and the incredible recent growth in EBITDA margin despite the drag of 9% of EBITDA margin from the POC tax.

click to enlargeBetfair Revenue Split & EBITDA Margin to July 2015

At the most recent results, Corcoran did highlight some headwinds that would bring the margins down (e.g. phasing of marketing spend and increased product investment) but emphasised the “high level of operational gearing” in the business and the “top-line momentum”. The merger of these two high class firms under a proven management team does make one giddy with the possibilities. The brokers Davy have a price target of €129 on the Paddy Power shares (currently trading just below €100). More information should emerge as documents for the shareholder votes are published (closing date expected in Q1 2016). An investor presentation does offer some insight (for example, as per the graphic below).

click to enlargeOnline Gambling Sector

I have calculated some initial estimates of what the combined entity will look like. Using an assumed constant sterling to euro FX rate of 1.30 and trying to adjust for Betfair’s funny reporting calendar, I estimate calendar year revenue growth 2016 to 2015 at 17% assuming a sterling reporting currency, as per the split below.

click to enlargePaddy Power Betfair pro-forma revenue split

I also calculated a profit before tax margin for the combined entity of 18% which increases to 21% post cost savings. Given approx 91 million shares in the new entity, my estimated operating EPS for 2016 is therefore approx £3.85 or approx €5.00 which gives a 20 multiple to operating earnings at the Paddy Power share price around €100 today.

So is buying into the merger of two quality firms with top management in a sector that is undergoing rapid change at a multiple of 20 sensible in today’s market? That depends whether you think it’s time for a gamble or whether patience will provide a more opportune time.

Gambling Problems

It has been about 6 months since I posted on the gambling and gaming sector (also earlier here) and there has been a lot going on. BWIN, after being on the block for some time, is closing in on a sale of its business with 888 and GCV (in conjunction with PokerStars and FullTilt owner Amaya) the speculated favourites. 888 itself rejected an offer from William Hill earlier in February this year. Meanwhile, Betfair and PaddyPower opted to return their cash piles of £200 million and €440 million respectively to shareholders rather than get involved in any M&A.

Ladbrokes, after a series of poor results, promoted the digital head Jim Mullen to CEO who is currently involved in a route and branch review of the firm with the outcome due to announced in June. His first move was to put the Irish business into examinership. Ladbrokes woes have continued with poor gambling Q1 results, continuing a run of bad luck after a disastrous boxing day football gross loss, as the exhibit below shows.

click to enlarge2014 Boxing Day 11 standard deviations

As can be seen by the graph below, Breon Corcoran’s rehabilitation of Betfair’s exchange model has resulted in an outstanding performance with a near doubling of the stock. The ex-Paddy Power executive has delivered on his plans for the betting exchange (as detailed in this post). [Update: Numis just released a note on Betfair’s rich valuation as per this article.] The tiny casino player 32Red has also had a good run due to solid 2014 results and M&A speculation.

click to enlargeShare Price 6months to May 2015 William Hill Ladbrokes Paddy Power Betfair 888 BWIN 32red

Internal candidates in William Hill and Paddy Power, James Henderson and Andy McCue respectively, also took over the CEO role.

The challenges for the sector are considerable. In the UK, the point of consumption (POC) tax of 15% has been in force in the UK since December and a new 25% rate of Machine Games Duty (MGD) applied from the 1st of March. Uncertain regulation across Europe and the lack of traction in opening of US markets are other headwinds.

Operator’s ability to reduce pay-outs to punters to counter tax increases is restricted by the competitive nature of the market, particularly online as the graph below on gross win percentages illustrates.

click to enlargeOnline Sportsbook Gross Win Percentage

Taking the commentary from the operators on the impact of increased taxes, I estimated the likely impact on net margins for a number of firms (as the graph below shows).

click to enlargeNet Margin estimates to 2015 gambling firms

The market is giving Betfair and Paddy Power credit for their recent revenue growth, strong operating results, product development and strong mobile adoption. Based upon my estimates, both trade on a 2015 PE in the low 30’s.

click to enlargeMarket valuations gambling firms

A brief review of the business profile of a selection of firms illustrates the differing models, as per the exhibits below.

click to enlargeGambling Sector Revenue Split & EBITDA estimates

click to enlargeGambling Sector Revenue Geographical Split 2015

It will be fascinating to see how the remainder of 2015 plays out for this sector. Scale is undoubting going to be a strength for firms in the future. What the large UK operators, Ladbrokes and William Hill, will do to counter headwinds will be intriguing. Although there is nothing to suggest it is remotely likely, it occurs to me that a tie-up between Paddy Power and Betfair would make a powerful combination.

Uniting Gamesters

BWIN’s on-going search to “create shareholder value” seems to be moving on with the announcement that it “has entered into preliminary discussions with a number of interested parties regarding a variety of potential business”. A previous post on a number of the main players in the European gambling sector highlighted that William Hill and Paddy Power were speculated to be potential bidders for all or parts of BWIN, a European online gaming firm with a concentration of approx 25% of revenues from Germany. Now press reports speculate the potential interested parties include the Canadian firm Amaya, who purchased PokerStars/Full Tilt earlier this year, and Playtech, a software gaming firm that are “seeking transformational M&A opportunities to take the business to the next level”.

Commentators raised an eyebrow about the speculated 45% premium on offer (from before discussions were reported) given BWIN’s operating metrics and the uncertainty over the key German market. Speculation involving Playtech focussed on their recent debt raising which brings their cash-pile to around €700 million. Playtech’s shareholders may not be too pleased if their new strategy moves too far away from the very profitable software business, particularly considering the alternative of continuing with their generous special dividends. Taking on businesses such as BWIN, or even another speculated target like Ladbrokes, is a far cry from what made Playtech such a star.

In fact, the best performer in the sector (in fact the only name that’s in positive territory!) is the reinvigorated Betfair under Breon Corcoran (see previous post on Betfair) as can be seen below (they also have cash to spend on potential M&A).

click to enlargeShare price YTD selected betting stocks

This is a fascinated sector that is in the midst of considerable change. Although I have no financial interest in the sector, I am an intrigued bystander. Bring on the next development.