Tag Archives: Paddy Power Betfair

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.

The fascinating case of Betfair

With the ending of the World Cup, my attention turned again to my attempts at understanding the issues facing the betting and gambling sector. For the sake of full disclosure, I am a novice on the sector (I am not a gambler if investing and the odd poker game are not included as such) and have no positions in any betting or gaming stock. My ramblings here, and in previous posts, simply illustrate my attempts to satisfy my curiosity about a sector that is at a fascinating point of change.

In a previous post, I highlighted the changes that the internet has had on the betting and gaming sectors. At that time, I thought the impact of the disintermediating betting exchanges on traditional business models could provide interesting insights into other disintermediating businesses in the financial sector. However, as I have found out more about the sector, such as the results of the traditional betting firms in the UK as per this post, there are a multitude of issues facing the sector such that a review of the impact of the betting exchanges in isolation is not that informative and (frankly) outdated given current developments. Recent developments include regulatory changes such as those in the US which has prompted the purchase of the largest online poker firm Pokerstars by approximately $5 billion by Amaya Gaming and new online taxes such as the forthcoming UK point of consumption (POC) tax of 15% due in December.

As the graph of Betfair’s share price since its floatation in late 2010 shows, the betting exchange model clearly has not had much of a disruptive impact on the traditional business models in recent years.

click to enlargeBetfair historical share price

Rather than go over Betfair’s eventful past in detail here, I will focus on current issues. Niall O’Connor in his blog, bettingmarket.com, has a number of informative articles on the history of Betfair, including this one. Below, I show a graph of Betfair’s profit before tax against the other UK betting firms which illustrates its difficulties in the recent past. The 2012 results (which are Betfair’s YE 2013 results as their year ends in April) exclude some write-offs and adjustments as a result of Betfair’s turnaround plan (which are included in the dotted line). The plan involved refocusing on sustainable geographical betting markets with accommodative regulations and developing a fixed odds betting business alongside the exchange to optimise the liquidity advantages of each model.

The new plan, in effect, admitted that the stand alone betting exchange model was flawed and that some markets “may not have sufficient liquidity to offer an optimal betting experience, notably in ante post and ancillary markets“. The firm estimates its share of the sophisticated bettor market of £150 million at 60-70% but its share of the recreational and occasional bettor market of £500 million at less than 10%. This market is where they see growth and Breon Corcoran, previously Paddy Power’s COO, was brought in as Betfair’s new CEO in August 2012 to execute on the new direction. The most recent results show that the new strategy is delivering better results.

click to enlargeBetfair 10 year Profit Before Tax margins

The focus on sustainable betting markets and cost cutting whilst increasing marketing spending (Betfair were high profile in recent World Cup advertising) can be seen in the graph below. Product development in features such as cash out and price rush (automatically gives the best odds from fixed odds and exchange) are being heavily pushed, particularly in the growingly important mobile market.

click to enlargeBetfair Revenue & Expense Breakdown

As mentioned in the previous post, there is a vast body of academic research on the gambling market and with the wealth of data that Betfair offers, the betting exchange market has been no exception in the studies. The Institute for Strategy and Business Economics in the University of Zurich in particular has some interesting papers. This one, for example, contends that there is a growing body of evidence that exchange markets “exhibit high prediction accuracy as they regularly outperform non-market forecasting methods”. The well-documented long-shot bias where the tendency to overvalue underdogs by fixed odd markets “is less pronounced in person-to-person betting” and this can be used by traders on the betting exchange to arbitrage price differences.

There is a particularly interesting paper by Egon Franck, Raphael Flepp and Stephan Nüesch in the University of Zurich from December 2013 on the importance of liquidity in determining price competitiveness which the authors offer as one of the reasons behind BetFair’s move into fixed odds online betting. Other arbitrage opportunities indentified by research include bookmakers actively shading prices in the presence of a partly irrational betting audience in order to increase their profit (e.g. sentiment bias in football games by the home fans) or the movement in odds prior and during games with the growth of in-play betting.

The development of sports investment funds was previously highlighted in a Bloomberg article and despite an early hic-cup with the collapse of a fund called Centaur there are many now developing predictive algorithms which try to take advantage of arbitrage opportunities. BetFair is consistently looking at how it can optimise its pricing (on the exchange it earns its commissions on winnings by a sliding scale on volume) in different geographical areas and sports to maximise its commissions, despite an outcry from a pricing charge change a few years ago.

Although BetFair face considerable challenges (e.g. I estimate that 95% of BetFair’s sustainable revenues are concentrated in the UK and the firm disclosed that the POC tax, if implemented as currently envisaged, would of cost them £36 million for their 2014 year, one with £61 million of operating profit!) in the short to medium term, one of their strengths is the balance sheet with a net asset ratio of 55% and a cash pile of over £200 million and a strong cash generating business. In their latest results Corcoran commented that “the flexibility we retain through our strong balance sheet provides a competitive advantage during uncertain times for the gaming sector. We will continue to review our balance sheet on a regular basis.” Although Betfair are a fascinating case to keep an eye on, the uncertainties on the POC tax issues outweigh any positive investment case for now.

In my attempts at understanding the sector more, these comments led me to look at some other models (and possible acquisition targets) in the other publically traded online firms, mainly on the gaming side. Names that I have looked at include 888, BWIN (currently looking at strategic options!) and 32Red. I am also intrigued by the software gaming firm Playtech which provides the underlying software to many firms in the sector. I will follow-up with a post on further musings.