Cryptologic CRYP W
August 03, 2004 - 9:52am EST by
2004 2005
Price: 14.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 185 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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  • Recurring Revenues
  • Software
  • Casino


Cryptologic: long. Rare is it to find a non-capital intensive business with a 97% recurring revenue base, that is growing briskly, that expenses everything (i.e. conservative accounting), and that produces tons of FCF (in its case, net income is pretty close to FCF). Even more rare is to find one of those companies growing at >30% annually (actually, in Q1 revenue grew 71% and EPS grew 116% yoy) and trading for ~9x EV/ ttm FCF. On top of all that, you have the reasonably recession resistant business of gambling with the growth of online poker as some added juice. A high double digit growing profitable software company trading for single digit trailing FCF multiples? What next? The steel industry turns a profit?

The FD market cap is $185 of which $76 million is net cash and equivalents (or about 40% of the market cap, leaving an enterprise value of approximately $109 million). Shares trade for $13.77 and have $5.67 of net cash per diluted share as of March (leaving an $8.10 EV/share).

The Company:
Cryptologic is a Canadian domiciled maker of software for online casinos. Through its WagerLogic subsidiary, Crypto offers software that creates customizable casino-like gaming environments available in several languages including English, French, Spanish, German, Italian, Japanese, and Chinese and several currencies (U.S. dollar, euro, and pound sterling). Its 80 or so games include most of the popular table and slot games available in land-based casinos as well as poker and bingo (faster growing products). Crypto also has developed its eCash software that processes clients’ transactions. Currently, nearly all clients use eCash thereby making Crypto a financial intermediary between its licensees and the end users (e.g. individual gamblers charge a deposit to their credit cards or other cash source, Crypto hosts the money, when money is gambled Crypto collects its small portion and credits the appropriate balance to the appropriate party).

Crypto focuses primarily on global regulated markets. The more regulation, the more attractive, as far as the Company is concerned. It believes its software meets the highest global standards and it is certified in several very stringent, highly regulated markets. This is a key differentiating factor; it separates Crypto from weaker competition and helps ”moat” the software once it is in use with a partner (that, as well as potentially high switching costs). Because it wants to be seen as a trusted, stable, safe software provider, Cryptologic targets high end partners. William Hill, the UK’s second largest sports bookie, is an example licensee. William Hill is a company that already had a strong position in sports gaming and wanted to leverage its customer base by rolling out more traditional casino games online as well. It has been a successful implementation for both Crypto and William Hill. In light of these types of successes, Cryptologic is positioning itself to be the partner of choice for land-based casinos as they go online. For two years the Company has had just under 20 total licensees (it lost one in Australia and a few domestically as the U.S. market was pummeled, but it replaced these with international licensees).

60% of its revenue (in Q1) was from gamblers outside of North America (up from just under 50% a year ago), though 100% of its licensees are domiciled abroad. The percentage of revenue from gamblers outside the U.S. has grown rapidly and at such a pace that it’s more than offset a decline from U.S. based gamblers. Crypto continues to focus overseas for growth. U.S. legislators are somewhat undecided, for lack of a better word, on what to do with online gambling. Many domestic banks have decided they won’t allow their credit cards to be used by online casinos and this had a significant adverse impact on Crypto’s business in 2001. The business has since stabilized and growth seems on the horizon again. Until there is definitive legislation either prohibiting or endorsing (but regulating) the online gaming market in the U.S., Crypto will remain focused on opportunities abroad (more on this in the Risks section below).

A Bear Sterns report cited in Cryptologic’s 2002 annual report expects the global online gambling market to grow from revenue of $3.5 billion in 2002 to $6.6 billion in 2004 (Bear Stearns assumes essentially no growth from the U.S. in its forecasts). By 2003, internet gambling revenue was already $5.7 billion and the forecast had been revised up to $7.5 billion in 2004. Whether the 2004 forecast becomes reality or not, it obviously indicates a reasonable opportunity for Crypto to continue growing. Specific growth opportunities include two very successful new offerings, Poker and Bingo (both launched in late 2002), which have helped drive significant revenue growth going forward. The Company is also continually rolling out new languages, currencies, and payment methods in order to appeal to a wider audience.

Poker is Cryptologic’s fastest growing product. It is a high growth opportunity and has gone from near 0% of revenues in 2002 to 12% in Q1 04. By its nature, poker is different from most casino table games and therefore most of Crypto’s games. It requires real, human opponents as opposed to most games where the dealer or The House is the opponent. In contrast to its other games which are hosted by licensees on their sites, in order to always have enough players online at one time to satisfy all appetites, Crypto actually hosts all of its licensees’ poker games in one consolidated site (so customers for different licensees are playing against each other). This allows a critical mass to always be available online and it has received rave reviews. It also adds stickiness to Crypto’s product. As the Travel Channel, ESPN, and other cable networks continue to push poker heavily, poker revenue will likely be growth driver for Crypto (poker as well as licensee additions will drive any outsized growth).

Nearly 100% of Crypto’s revenue is recurring. Licensing and service revenue are “calculated as a percentage of each licensee’s net transaction revenues.” The only non-recurring revenue is the occasional customization contract for a customer. In 2003, 97% of revenue was recurring in nature. As the number of licensees and the number of transactions per licensee grow, so does Cryptologic’s revenue.

In 2002, sales declined from $44 million in 2001 to $34 million due to the contraction of the U.S. online gaming market. Despite this precipitous decline, the Company still made $7.6 million pre-tax before writing down a few investments and reorganization costs (legit one time write-offs) versus $19 million in 2001. Obviously there is significant operating leverage in the business (see Q1 of 2003 for further proof). It is a low capex but demanding R&D business. The company expenses all R&D as incurred. It is the largest expense by far runs a bit over $20 million per year.

Cryptologic had $76 million of cash as of March 31, 2004. Crypto has historically used its cash in a shareholder friendly manner, repurchasing $20 million of shares in 2002 and $17 million in 2001. Basic shares outstanding had been reduced from 14.1 million at the beginning of 2001 to about 12.2 million in March 2003 (before creeping back up to 12.6 million this past March: booo). I would argue that share repurchases have been more attractive during the past year than at almost any time in the Company’s history, however repurchases are on hold while the U.S. regulatory environment works itself out. In the meantime, a small ($0.12/year) dividend has been authorized. The Company believes that cash is king until things become more certain with regards to the U.S., though it is open to small, well priced strategic acquisitions (particularly lottery or games-of-skill such as bridge). I am actively lobbying for stock repurchases, though if I had to handicap my influence I’d say it’s very low.

In 2004, Q1 (a seasonally strong quarter) net income was $3.8 million or $0.28 per diluted share ($0.25 excluding an insurance recovery) on $15.2 million in revenue. That represents revenue growth of 71% yoy and EPS growth of 67% (using the $0.25 number). However, the beauty of buying this company at this price is that continued growth is completely unnecessary. If the Company’s forecast of $14 million of revenue and $0.20-$0.22 EPS in Q2 are met, we can essentially annualize the $0.45 six month EPS at $0.90. CapEx and D&A roughly offset, so net income is a good proxy for free cash flow. At an $8.10/share enterprise value, the Company is yielding 11% on free cash flow. Awesome. This performance is in the face of an industry that is expected to grow at 30% a year for the next few years (see the aforementioned Bear Sterns report). Continued growth, which we have not accounted for, is icing in Cryptologic’s case.

Because Crypto generates ample cash, maintains excess cash on the balance sheet, has wonderful operating leverage and recurring revenue, and is trading at a low multiple, it seems to have a large margin of safety to fair value. The Company is ripe for a management buyout or a buyout by another highly regulated gaming company (e.g. a company such as GTK).

Share price: $13.77
Cash per share: $5.67
EV per share: $8.10

EPS (ttm): $0.85
Diluted Shares Out: 13.4 million

Founding executives (Andrew and Mark Rivkin) turned over the day-to-day management to a new set of executives, and, until recently, the Rivkins were still the largest owners (Andrew sold half his stake in April and retains 7%, Royce Associates is now the largest shareholder). The Rivkins turned over management to a prior set of executives for about a year before that management was replaced with current management. Current management has been in place for several years and seems to have its act together and is considered to be an upgrade over the replacees. The President and CEO, Lewis Rose, seems experienced and, judging by his letters and statements, is shareholder oriented. The CFO position is currently vacant; it seems that the outgoing CFO was interviewing with a competitor and was given the boot as a result. In the meantime, the acting CFO is Jenifer Cua, Director of Treasury.

40% of the market cap is in cash. The stock has drifted down about from $18 or so in early July to $13.77 on no news and light volume. When I first bought the stock a year ago it was $6/share and I suppose it could go back, though I can’t figure out why it would without a negative catalyst. The two primary risks are customer concentration and the U.S. regulatory environment.

Customer Concentration: The top five licensees have accounted for over 90% of revenue in each of the past two years (though the licensee mix was different both years) and there are only 20 or so licensees in total. Mitigating this risk are the facts that it would cause significant disruption to any large licensee’s online business to cancel its Crypto contract and the Company seems to have strong symbiotic relationships with its customers. Further mitigating that risk is that the company has signed two or three potentially large licensees in the last nine months. It plans to sign a couple per year and diversify its revenue base.

U.S. Regulatory Environment: The U.S. market accounts for about half of the entire online gambling world and for just under 40% of Cryptologic’s revenue (a year ago it was over 50%). That revenue is from domestic gamblers gambling in online casinos domiciled abroad. Cryptologic does not have any North American domiciled licensees. If the U.S. does not adopt more friendly policies toward online gambling, Cryptologic will be forced to continue to focus only on international growth. Further, if the U.S. were to entirely prohibit online gambling, it would be a significant obstacle for the Company and would impair value. Last year, U.S. legislation passed the House that would prohibit U.S. companies from offering online gambling (no major casinos currently do anyway). On the Senate side, the bill got stuck in the banking committee and it was expected to face tougher opposition. It did not get passed before last year’s session ended, but I wouldn’t be surprised to see it revived. The bill does not target individuals, though it would prevent domestic banks from processing online gambling transactions. The good news is that Crypto is not targeting any new North American business, international revenue is growing briskly, and software development is a large and variable expense that could be reduced if necessary. The risk is also somewhat mitigated by having more than $70 million in cash and a briskly growing international customer base. Time is the Company’s friend as it continues to grow abroad.

A third, more generic risk, is the misuse of capital. An ill-advised acquisition could destroy value and has in the past under different management (see the 2002 write-off).

A fourth risk is short term. CRYP expects margins to contract a bit going forward due to increased competition and hiring of more development staff. I expect this to be completely offset by revenue growth, though I don’t think it will be drastic either way.


1) Status quo. The business continues to throw off free cash flow and build its cash balance;
2) Q2 reports this week. I don’t do quarterly predictions, but a “blow-out” quarter could feasibly be a catalyst;
3) Net new licensee growth and/or growth of current licensee businesses;
4) Sale of the company;
5) Renewed stock buybacks;
6) Increased dividend;
7) The U.S. market opens to online gaming in a highly regulated manner (long-shot).
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