Tag Archives: Online gambling

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.

More musings on the online gambling sector

A previous post on Paddy Power, William Hill and Ladbrokes showed how online sportsbook and gaming revenue are becoming an important part of the revenues of these firms. Another recent post on Betfair showed a similar import. This post will focus on the online gaming (which is a gentlier word used in the sector for what is more aptly described as online gambling) part of the equation.

As a recap, the graph below shows the online gaming revenues from Paddy Power, William Hill, Ladbrokes and Betfair (with PP converted to sterling at today’s rate) which make up 17%, 16%, 8% and 17% of their 2013 revenues respectively. Ladbrokes has approximately half the amount of its competitors. The considerable growth in William Hill’s online gaming (mainly casino) revenue after the creation of WH Online (WHO) in 2008 can clearly be seen. H2 Gambling Capital are forecasting an approximate 9% annual growth in online gaming gross win figures over the next few years

click to enlargeNet Gaming Revenue

None of the firms above split out their operating margins for the online gaming sectors. As casino is the dominant source of revenue for many of the firms, it is interesting to look at a diminutive online casino firm called 32Red, as per the graph below. Although 32Red is relatively small, the reduction in its margin to an average of 6% suggests that competition has pushed margins down in this business.

click to enlarge32Red Operating Metrics

Another two public firms that have a majority of their business in online gaming are 888 and BWIN. 888 is a well established player, particularly in the online casino market, with 40% of revenues in the UK and 40% in the rest of Europe in 2013, and it has been rebuilding its profit margins in recent years. 888’s operating metrics are summarized in the graph below.

click to enlarge888 Operating Metrics

BWIN, following its merger with PartyGaming in 2011, has a higher revenue base across Europe (excluding UK) making up approx 70% of 2013 revenues (25% from Germany) with only 10% from the UK. After some poor results and pressure from shareholders, BWIN is currently cutting its expense base by €30 million or approx 5.5% and is looked at ways it “can increase shareholder value”. BWIN’s operating metrics are summarized in the graph below.

click to enlargeBWIN Operating Metrics

The share performance of these firms has been distinctly mixed in recent years with little old 32Red blowing the others away, as per the graph below. BWIN has clearly underperformed and may likely be broken up. Analysts have speculated that a number of potential bidders, including William Hill and Paddy Power, are looking at various BWIN assets. Janus Capital Management has being building its stake in BWIN over recent months to 11% as at mid-July.

click to enlargeShare price since 2011 888 BWIN 32Red

Comparing the mainly online gaming firms with their more established betting firms in terms of the PBT margin shows the trend for both is downwards, as per the graph below. Headwinds include increased regulation and taxes such as the proposed UK POC tax. Opportunities include the explosion in mobile gambling, the slow re-opening of the US market (although I am sure established US bricks and mortar gambling firms will fight hard for their turf), new product development such as social gaming and the expected market consolidation. Amaya’s recent purchase of PokerStars has focussed minds on what will be needed to succeed in the US.

click to enlarge2003 to 2013 PBT Margin Betting & Online Gaming Firms

One of the more colourful firms in the sector, Playtech, has some interesting things to say about where the future is leading. On increased regulation, Playtech say that “the regulation of online gambling can be a catalyst for market growth, depending on how regulation is introduced, what product verticals the regulator allows and the tax rate applied” and that ”opportunities exist as markets move from a ‘dot.com’ to a ‘dot.national’ regime, although some uncertainties through the transition period are expected”.

Specifically on the UK, Playtech commented that “many smaller operators are understood to generate operating margins lower than the expected tax rate of 15% and in the view of industry experts, will struggle to compete. Larger operators can rely on economies of scale and their leading brands to remain competitive. Analysts expect that in 2015 the UK market will undergo significant change led by consolidation, as those operators with the strongest brands, best technology and means to invest in marketing will prevail”.

Playtech is a software gaming firm which offers a fully integrated platform across games and sports-betting called IMS that many of the main players use (licensees include Betfair, bet365, William Hill, Paddy Power and Sky, amongst others). They also run a white label turn-key operation called PTTS and a joint venture business. Their most well known joint venture was one where they very successfully partnered with William Hill in 2008 in the creation of William Hill Online (WHO). William Hill recently bought out Playtech of their 29% stake for £424 million. In March 2013, Playtech entered into a deal with Ladbrokes (in an attempt by Ladbrokes to diversify their business and catch up with their competitors – see first paragraph of this post) where, according to Morgan Stanley, Playtech “has effectively been given a quasi-equity stake, where it will “own” 27.5% of any increase in profits”. A Morgan Stanley report, although over a year old, has more interesting background on Playtech (they are still hot on the stock). The graph below highlights some of the metrics behind Playtech.

click to enlargePlaytech Revenues and PBT Margin 2009 to 2013

Much of the colour behind the firm has been provided by its 40 year old Israeli playboy founder, Teddy Sagi, who has a bribery and insider trading conviction from his youth in the 1990s. Playtech bought many of the assets used in the WHO 2008 deal from Sagi and also the PTTS assets (70% of this business is from Imperial e-Club licensed in Antigua and Barbuda!) in 2011 which caused concerns about conflicts of interest. Concern over such conflicts on what Playtech may do with its new cash pile from the WHO sale (they returned £100 million in a special dividend earlier this year but still have £376 million in cash as at end Q1) and on potential problems that Sagi’s ownership position may do in gaining access to the US resulted in an offering in March this year which reduced his 49% stake to 34%.

Playtech has stated that their “the Board is seeking transformational M&A opportunities to take the business to the next level.” Although it’s a bit too colourful for me, a number of analysts estimate a 20%+ upside on its current share price and it’s interesting to note that David Einhorn’s Greenlight Capital is a believer with an ownership of 3.8%. That, I think, is a good place to end a post on gambling!

A look over some bookmakers’ books

I have been doing some digging into the dynamics of betting exchanges, the largest and best known of which is BetFair. The betting and gaming sector itself has been the subject of a mountain of academic research, there is even a journal dedicated to it! Quants have moved in and are actively pitting their algorithms against human gambling behaviour on the exchanges. A recent intriguing Bloomberg article on tennis betting illustrates some strategies now common in the marketplace.

Technology has driven disruptive disintermediation across many sectors such as the travel & airline industry and more recently across the retail sector. There was a fascinating documentary on the BBC by Robert Preston late last year on the UK retail sector which concluded that the future for many clothing retail outlets would be to act like galleries for consumers to peruse items with the ultimate purchase decision being made online.

The betting and gaming sector is one undergoing structural changes due to the massive increase in online activity. Additional competitive threats from disintermediated business models such as betting exchange pose interesting questions for the sector. Such structural market changes may be useful in understanding the impact of new business models in other sectors such as financial services –  peer to peer (P2P) lending in banking or the ILS market in insurance come to mind. On the growing P2P lending sector, there was an article on the front page of Friday’s FT on how a UK developer sourced £4 million of debt through online P2P platform Lendinvest which may prove to be defining moment of change. On the impact of the ILS market, there was another interesting FT article that contended that the ILS market is resulting in structural changes in a market with “a lot of excessive overhead, ie highly paid staff, that can be eliminated”.

Before looking deeper into structural changes in the betting and gaming sector, I needed to understand the “traditional” betting market better. Besides the odd poker tournament (with real people), I am not a gambler and therefore not a user of the services provided by betting firms. I know enough that the odds are obviously in the bookies favour but I know very little about the economics of the betting industry. As such, this post details my research on the UK betting industry. A follow on post will go into the broader picture and some (likely rambling) thoughts on the impact of structural changes from betting exchanges like Betfair.

So, I concentrated on the UK market where data is freely available. The graphic below outlines the size of the UK betting and gaming market with the main providers. The market is split by revenue approx 60% retail and 40% online. The retail market is split approx 50:50 between over the counter betting at shops and gaming on machines (aka fixed odds betting terminals or FOBTs). On the online side, sports betting (commonly referred to as the Sportsbook) is approx 40% with gaming making up the remainder, led by casino (approx 30%), poker and bingo (approx 15% each).

click to enlargeUK Gambling Market Size

The main players on the retail side stress the advantages of their multi-access models and, to counter the impression that retail betting shops attach the older demographic, cite statistics that show even younger customers often use retail outlets (more and more in combination with online and mobile).

The gaming machine/FOBT sector has come under renewed focus recently. Derek Webb, a successful gambler, is one of the principles behind the Campaign for Fairer Gambling and has described the machines as “crack cocaine”. Campaigners point to the rapid rise in revenue from FOBT, which were only widely introduced in the early 2000s, the addictive nature of the machines and that users are high frequency gamblers with a concentration amongst younger men with low incomes. Bookies point to the high payouts (the margin taken by the bookmaker is generally about 3% to 4% of the amount staked whereby such margin is referred to as the gross win) and the importance of machines supporting the retail shop model (I estimate that FOBT can contribute 70% to 80% of retail operating profits). Political pressure is mounting to restrict the amount that can be bet on the machines and JP Morgan recently cut its rating on Ladbrokes and William Hill saying that the likely change “could make the bottom 20pc of Ladbrokes and William Hill shops loss-making, with a further 20pc only marginally profitable, and require significant restructuring to close shops in order to cut costs.

I selected Ladbrokes, William Hill and Paddy Power as firms to do some deeper analysis. William Hill and Ladbrokes are long established firms, particularly in the retail sector. William Hill is also the market leader in the online sector with a particular strength in online casino gaming. Paddy Power is the new kid on the block growing aggressively in online, particularly over the past 5 years, from its Irish base into the fourth largest in the online sector. Size wise, William Hill and Ladbrokes had revenue of £1.3 billion and £1 billion in 2012 respectively while Paddy Power had 2012 revenue of €650 million (approx £570 million). It would have been interesting to have a deeper look at the online only Bet365, which was founded in 2000 by Denise Coates and is now the number 2 in the UK online market with over £200 million in revenue, but unfortunately Bet365 is private. The graph below shows the share price moves of the selected firms since 2009.

click to enlargeShare Price William Hill Ladbrokes Paddy Power

The graph below shows the profit before tax margins of the firms since 2003. As can be seen, profit margins have been under pressure, particularly for Ladbrokes in recent years.

click to enlargePBT % William Hill Ladbrokes Paddy Power

Revenue and operating profit breakdown for William Hill is below.

click to enlargeWilliam Hill Revenue & Operating Profit Breakdown

Revenue and operating profit breakdown for Ladbrokes is below.

click to enlargeLadbrokes Revenue & Operating Profit Breakdown

Revenue and operating profit breakdown for Paddy Power is below.

click to enlargePaddy Power Revenue & Operating Profit Breakdown

As mentioned above, the percentage that a bookmaker takes as a margin in each business is called the gross win (another commonly used term is the overround which refers to the excess above the sum of the odds). Net revenues are gross wins less VAT and fair-value adjustments for free bets, promotions and bonuses. Care needs to be taken when comparing gross win percentages (i.e. gross win divided by amounts staked) across firms as the make-up of the underlying books is important (gross wins varies by sport type such as football, horses, tennis, etc and by geography). Also items such as betting levies and charges vary and some are not deducted in the gross win to net revenue calculations but rather in operating expenses. Items such as the new UK point of consumption (POC) tax that is due to be introduced later this year also need to be understood in their potential accounting treatment. The graph below compares the reported gross win percentages amongst the firms in the retail over the counter (OTC) business and in the online Sportsbook businesses for the firms.

click to enlargeGross Win Percentage

I have found it difficult to get metrics for the profitability of both the retail and the online gaming businesses. As discussed above on the FOBT business, the operating profit contribution from gaming can be significant. I suspect that online gaming also contributes significantly to the online operating profit although not as high as the 70% to 80% contribution that I estimated for the retail business

Online gaming is also a more cross border business and is the fastest growing segment of the gambling industry. H2 Gambling Capital, a leading supplier of data and market intelligence on the global gambling industry, puts the size of the global online gaming market at approx $30 billion. Large markets such as the US are seen as ultimately providing a massive opportunity for growth once regulatory issues are resolved. Although firms withdrew from the US in 2006 after the passing of the Unlawful Internet Gambling Enforcement Act (UIGEA), individual States such as Nevada and New Jersey are looking at ways that they can approve online gaming and challenge federal restrictions.

Although the established firms like William Hill and Ladbrokes are facing headwinds in their business with significant competition from online upstarts like Paddy Power, Bet365 and Betfair, they have size and powerful brands on their side. Both have made significant investments in IT infrastructure to support their business. The area of liability management is one that is particularly interesting. Ladbrokes, for example, has made significant investment in enhancing their trading abilities through the development of Morse, their own algorithmic robot. They cite the use of Morse in improving pricing which is particular important in the growing bet in play (BIP) market, as the exhibit shows.

click to enlargeLadbrokes Pricing & Trading Exhibit 2012 Investor Day

They also cite the use of such active liability management tools in improving outcomes such as the Royal Ascot results below.

click to enlargeLadbrokes Liability Management Exhibit 2012 Investor Day

Changes in the whole betting and gaming sector have been rapidly evolving over recent years. These changes and the impact of betting exchanges will be the subject of a follow on post with some further musings in the coming weeks.