Description

Price (Friday close)                           $2.87 (147.5p)
Shares                                                 340mm
MV                                                     $977
Less Cash                                              64
Plus DOJ Settlement Estimate              35
Enterprise Value ($mil)                    $947

 

All figured in USD except where noted

Summary

888 Holdings (“888”) trades on the LSE, and is the 2^nd largest publicly trade casino operator.  (Party Poker is #1).  I believe this to be a highly compelling investment opportunity as 888 is a well run growing company with real early-mover advantages in an under-tapped market.    They have such high returns on capital (and negative working capital), that 888 is able to pay out 50% of their cash earnings in a dividend while still growing at 20%+ rates.  I believe this could be a double or more in the next 12 months.

Q4 Results were strong and early signs are that 2008 is looking good as well.  Management’s 2010 forecast of $450 in sales and $150 in EBITDA, may appear aggressive, however, given the current growth trajectory and new product initiatives, it does seem plausible.  Should they get to these numbers, I believe the stock would trade well north of $10/share (plus investors would enjoy another $0.50+ or so in earnings/dividends) – EPS in this scenario would be $0.40/share.

While I wouldn’t hang my hat on the 2010 forecast, a more tempered growth plan still yields 20c a share in 2009 which investors will begin to focus on once 2008 results are posted.  There is no reason to believe that investors will pay anything less than 20x (even at the “more tempered growth”, yielding $4/share + another $0.30 in cash balance and dividends.  At 25x this is $5.

Background

Pre-October, 2006 most online casinos received most of the revenue from the US.  The more poker- centric casinos like Party Poker (“Party”) were even more US focused.    When the UIGEA was passed into law, the listed companies ceased to market to, and accept deposits from US investors.   888 lost 50% of their revenue and Party lost 90% of their revenue post-1996.  Today, many “rogue” operators still exist that continue to accept deposits from US investors.

Currently the DOJ has been in settlement discussions with the major players.  Neteller (payment processor) has reached a settlement to payback profits earned from US investors, and supposedly Party is nearing a settlement.   The best estimate I have for 888 liabilities is from a research analyst which puts it at $35 million.  (I’ve include this amount as a liability in my valuation).

Strategy

Growth is primarily driven by advertising, which management plans to continue at 32-35% of revenue.  Given the high cash margin on new revenue, the payback on these $’s is very quick.  This is a data driven business, and can manage the business in near-real time.  They don’t have to wait until the end of the quarter to see how a big advertising spend went.  They monitor daily revenue/signups and are able to tag advertisements so they know which ones people are responding too.  They can measure success instantly and can therefore re-direct dollars to the highest return opportunities.  If a campaign is not producing immediate results, they will shift the money elsewhere.

Keeping the casino business fresh with new games is key.  They develop many in-house, license others and have recently opened their API platform to outside developers – outside developers can then make a game and if incorporated by 888 receive a small revenue share.   I think of it as being analogous to facebook.  Clearly, a bit different because facebook doesn’t care if applications work properly or not, but the concept of an open API is similar.  888 will be releasing over 100 new games in 2008.

Another component of their growth strategy is their Private Label business.   The only constraint to capacity is adding CPUs and the call center.    Hence 888 wants to take advantage of their immense scalability by entering into JV with various operators in new geographies and/or segments that will be using 888’s “engine” and 10-years of marketing expertise with their own brand.  Management said they’re trying to sign 8-10 of these up a year and expect  $1mm of EBIT from each.

Sportsbook
Launching in Italy this quarter.  This is the first jurisdiction where they have received a license.    I have not been able to begin to quantify how large this opportunity is.

Bingo

In March of 2007, 888 bought a Bingo business for $32 millions.  This business is doing a run rate of $25 million in revenue.  Not to mention the incremental revenue that is being generated by new Bingo players playing other games.   Bingo is very unique in that it isn’t just a new game, but a new demographic.  Bingo players tend to be older and women, which is quite opposite of the rest of the gambling demographic, which largely consists of 20-40 year old men.

 

Industry

Most mature market is UK, still growing at 15%.  Below are the rest of the results for European growth in %.  According to Management, the larger players are growing faster than the market.  Brand and scale are starting to matter, as you’d expect in a maturing market.  They have very good brand awareness in UK.

 

Why not just invest in Party Poker.

Party Poker (LSE: PRTY) - $2B Market Cap.  Sales of$380mm for 2007.

It is a land grab, and Party is the biggest.  So, suppose the industry thesis is right, why not invest in Party?  The answer is I believe that 888 to be the better operator. 

·         888 is a better brand in Europe

·         Casino is a better business than Poker.  Outside US, poker is not the #1 game.   Party is just NOW talking about growing their casino business.  They are behind the game here.

·         Poker is being further hurt by the rogue “US Facing” operators attractive all the players.  Poker players are driven to where the most players are due to the unique characters to poker.  Full Tilt and Poker Stars are the biggest.

In a regulated market such as UK, 888 has proven that they are the best and most innovative operator through their success in marketing and branding. 

 

What is the Market Missing?

1.       Lack of presence in US.  Out sight, out of mind?

2.       Erroneous assumptions about regulation outside US

3.       Potential DOJ settlement.

4.       Restated accounting blurs earnings power of business.  Historical results have been restated to exclude US business, but here is where it’s interesting.  Because certain costs cannot be allocated to specifically to the US, the restatement excludes the revenue but fully burdens the non-US revenue with virtually all the costs. 

 

Projections

The major assumptions in my projections are as follows:

·         Continued 30%  y/y growth for 2008.  Then 20%

o    Given that they’ve already announced daily January Revenue is up 3% over Q4, even a flat run-rate from this quarter would imply 2008 vs. 2007 is 21%.  (I’m taking at face value that January is not just a seasonably good month and that it’s fair to extrapolate from here.)

o   30% growth would only require an additional 1% m/m growth from January

o   Nothing baked in for Sportsbook, Bingo, Private Label

·         Advertising 35% of revenue.

·         Other costs fixed (growing at 5%) – inflation, plus some growth. 

 

Risk to thesis

·         Execution risk appears to be the biggest threat.  My initial conclusion is that Management is making the right decisions and have a very smart data-driven approach to growing their business.

·         Could management hit numbers by overspending on marketing?  Only top line has been released for 2H 2007.

·         Correlation to consumer spending.  Seems to make sense.  However, management has  said the results they’ve seen are the opposite.  They believe that because gaming a relatively low cost of form of entertainment that their customers do from home, and therefore will be less likely to give up this activity vis-à-vis other “luxury” entertainment. 

·         Growth slows, and we have a company earning $0.15/share with low single digit growth.   In this scenario, I would argue that the current valuation doesn’t reflect much of a premium over this.   At 15x + cash, we’d still have a $2.50 stock.

·         New competition with more innovative games.  Clearly switching costs for customers are low.

o   Scale economies are huge in this world.   The large operators therefore have built somewhat of an economic moat around them. 

·         Legislation risk – 50% of business is in UK.  This is a regulated and explicitly PERMITTED domicile to operate.  Regulation is a net positive for the larger players because in a regime where only licensed operators will exist, competition will be low.    The US was a bit of a red-herring because so much of the revenue was from an unregulated geography.

·         Bears have said that casino isn’t a growth business, but these numbers seem to contradict that.

Catalyst

1. This year will be the first year that we will have good compares year-over- year comparisons, because previously numbers were restated to exclude the US revenue but are clouded by the full burden of costs.

2. Once deals with DOJ are done, there could be massive consolidation of industry. Because of the huge scale economies, the smaller players could all be absorbed by the larger players. This could either be on a private label basis or rebranded as part of 888.

3. Realization by US investors that this business isn’t dead, but rather thriving outside US.

4. In the long-term, the US market could re-open. No part of my thesis relies on this.

5. Broadband penetration. Older age groups are getting more comfortable on internet. Management believes this is what is driving bingo