Tag Archives: regulatory changes

Paddy Purgatory

The last time I posted on Paddy Power Betfair (PPB.L) in March, I highlighted the rich valuation and cautioned better value may be had on future dips, ending with the comment that “the game of speculation is all about getting the best odds”. Well, PPB.L has been on quite a ride in recent months. First the prospect of disappointing operating results put the stock under pressure and last week the bombshell that the golden boy CEO, Breon Corcoran, wants to do something more meaningful with his time. The result, as can be seen below, is PPB.L down 15% since the start of the year and 20% since this time last year.

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The revenue for the latest quarter, even after adjusting for the lack of the Euro soccer tournament in 2016, disappointed analysts who are fretting about whether reduced net revenue margins are part of a trend.

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Despite the firm putting reduced net revenue margins primarily down to unfavourable sports results (increased promotion costs also contributed, doing things like paying out on Hilary Clinton prior to the actual election results doesn’t help!), the worry is that competitive pressures rather than bad luck are resulting in reduced net revenue and gross win margins. [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 margins (i.e. gross win divided by amounts staked) and net revenue margins across firms as the make-up of the underlying portfolio is important (e.g. gross wins varies by sport type such as football, horses, tennis, etc and by geography) and firms may account for certain items differently. Also, the absence of the largest online player, the privately owned Bet365, makes industry analysis difficult for amateurs like me.

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Taking into account that gross win and net revenue margins can differ by around 100 basis points, the trend at PPB.L seems to be also present in William Hill’s results. Ladbrokes results have been all over the place in recent years and the impact of their merger with Coral needs to be further understood given their high margins of late.

Of course, this sector is haunted by regulatory risk. The predicted restrictions of the highly addictive gaming machines by the UK Government is expected to impact PPB’s high street competitors much more that PPB.L. For example, PPB.L only derives 6% of its revenue from gaming machines compared to 30% for William Hill. The reaction of PPB’s competitors to compensate for restrictions on gaming machine revenue is likely to have a bigger potential impact on PPB.L’s future results.

For me, the biggest disappointment in the Q2 results wasn’t the revenue line but the operating margins. The full year 2017 EBITDA projection was nearly 10% shy of my estimates. The firm acknowledged that the platform integration has been taking longer than planned and took up over 70% of internal technology resources in Q2. This is projected to reduce to 60% and 30% in Q3 and Q4 respectively before been completed by year end. Releasing these resources will allow a refocus on product development and on fixing other problem areas such as their online gaming offerings. As a result of the Q2 results, I have taken a knife to my earnings estimates (my revenue estimates only required minor adjustment) for 2017 and 2018, as the graphic below shows.

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My 2017 and 2018 EPS estimates have reduced to £3.72 and £4.01 respectively, down 10% and 12% from my previous estimates. That puts PPB.L’s current market cap at a PE of approximately 20 and 18 for 2017 and 2018. That’s not bad for a firm with EPS growth of 13% and 8% for 2017 and 2018 respectively although, if these figures turn out to be accurate, the share price is likely to have gone lower that it currently is on worries about reducing operating metrics in a fiercely competitive market.

These estimates are conservative in my view, possibly overtly so. They reflect a sense that Breon Corcoran’s reason to go off into the tech sunset now is really due to concerns about the medium-to-long term prospects for the sector. Corcoran obviously has put a different explanation forward, one which is suspiciously unconvincing given the amount left undone at PPB.L, although he still does have about £40 million of share options in PPB.L. No firm is simply about the CEO and at the end of the conference call an indication was given of ensuring more exposure to the full management team in future investor engagements. That should help investors get more comfortable with management depth at the firm. I know nothing about the new CEO, Peter Jackson, so he has a real challenge in gaining investor’s confidence. He has big boots to fill as far as investors are concerned.

So, yet again, I suggest the best course of action is to wait, both for existing and new shareholders, and see how 2017 develops for PPB.L. There can be little doubt that recent events mean that the odds on PPB.L have lengthened.

PS- PPB have already paid out on Floyd Mayweather prior to his 26th of August fight with Conor McGregor. In the unlikely event that the Irishman does achieve the impossible PPB’s Q3 net revenue margins will suffer……

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.

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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.

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.

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.