Interactive Systems Worldwide ISWI
August 28, 2001 - 5:38pm EST by
zeke375
2001 2002
Price: 3.84 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 35 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

ISWI is a company with a $34.5 million market cap that has a licensing contract for its software and patents that calls for a minimum of $245 mln in revenues over 14 years, commencing in March of 2000. Using a simplified discounted cash flow model with a 12% discount rate, I come up with a pre-tax present value of $82.9 million, or $8.72 per share, for the remaining guaranteed license payments. On an after-tax free cash flow basis, I come up with a PV of $57.7 million, or $6.07 per share. This implies a minimum 50% discount to the current share price of about $3.77 per share.

The current price also contains three sources of "option value" -- and these free options could turn out to have very sizable payoffs relative to the current market cap. I'll describe the nature of these embedded "call options" in more detail below. First, I'll describe the business in more detail.

ISWI has designed and developed a patented software system, called SportXction, that allows users to wager during the course of a sporting event. The SportXction System enables users to wager at fixed prices during the event. In addition, players may place wagers during the event based on specific game situations. These include such wagers as whether a team will make a first down, whether a batter will get on base, will a penalty shot be successful, and so on. The system is unique in that it permits betting continuously while the game is in progress, or between game events, such as downs, pitches, changes in ball possession, and so on. This dynamic betting capability obviously permits more frequent placing of bets, leading to a higher "handle". The software also monitors and changes the bet prices on the contestants in the event to induce the players to wager in betting volumes that will balance the betting pool on each proposition to a pre-set level. A balanced pool is achieved when the money bet on one side of a wager is sufficient to pay off the winners on the other side of that proposition, should that side win. Having a balanced pool is very attractive for the betting provider in that the provider is able to collect a percentage of the bets placed with no risk of loss from having to pay up from the losing side of a lopsided wager.

Wagers can be placed through PCs, set-top boxes, and wireless devices linked to the SportXction system. The system maintains a record of all wagers placed by each bettor and keeps an account for each bettor, subtracting bet amounts and adding payouts.

In March of 2000, ISWI signed a license agreement with Global Interactive Gaming LLC and Global Interactive Gaming Limited ("GIG"), majority owned entities of Prisma iVentures, Ltd, a UK company and a subsidiary of The Kirch Group, a German media conglomerate. The Kirch group is based in Europe and posted recent annual sales of DM 2.7 billion. The company is a large producer of movie and television entertainment, and is the majority owner of Germany's second largest commercial TV network, SAT1. The Kirch Group also owns DSF, a 24 hour sports channel, and owns and operates Premiere World, Germany's leading digital TV pay service. Premiere World's sports programming includes German soccer leagues, international soccer, formula 1 racing, boxing, tennis, hockey, track & field, NFL football, baseball, basketball, and other sports. Under the license agreement, ISWI granted an exclusive license to market, distribute, and use the SportXction system, technology, and patents on the internet and interactive television, in all business activities for which such technology is legally useable, including contests and wagering on sports events worldwide.

Under the terms of the agreement, ISWI will be paid 25% of the gross profit, less direct expenses (such as credit card fees, prizes, and taxes) for the use of its technology for contests. For wagering, ISWI will be paid the lesser of 25% of the gross profit or 1% of the gross handle, less direct expenses. ISWI bears no cost of GIG's equipment, facilities, or other operating expenses. Under the agreement, ISWI issued GIG a warrant to purchase 425,000 shares (or 4.9% of the company's outstanding shares at the time) at an exercise price of $4.38 per share, exercisable 18 months from the issue date with a five-year expiration (or March 2005).

More importantly, the percentages are subject to guaranteed minimum annual license fees, paid quarterly. The minimum in the first year is $3 million, increasing to $5 million in the second year, $6 million in the third year, and continuing to increase by 20% per year thereafter during the 14-year term of the agreement. The total minimum license fees over the 14 year term are approximately $250 million, after which the license is fully paid. At all times the minimum license fee for the next four quarters is kept in a third party escrow account. As of the most recent 10-K, the company was being paid the minimum quarterly rates since modifications to the system specified in the agreement were being completed and GIG had not begun commercial activities.

The agreement requires ISWI to make modifications to the software to enhance its use for internet and other interactive media. The most significant of the modifications requires ISWI to make the system capable of handling 1.5 million simulataneous users in each of 32 interconnected regional (by country) systems, which each system able to process 25,000 transactions within five seconds. The system must also support multiple languages, currencies, sports, and at least 15 concurrent sporting events. The first phase of the schedule calls for 10,000 transaction capability in five seconds, to be completed by February 2001.

ISWI believes that its system can accomodate up to 50 million players during a major sporting event such as the World Cup. In October, ISWI announced the completion of the first phase of enhancements approximately four months ahead of schedule. Early completion of the software will earn ISWI a $600,000 bonus, of which the company expects to receive half in this fiscal year, half in fiscal year 2002.

The license agreements with GIG excludes continued use of the system in Nevada for wagering, and the application of the technology and patents for lotteries and financial transactions. ISWI has been looking into possibilities in each of these areas, though the company's primary efforts have been involved in the software modifications required for GIG's sports wagering launch.

The financial performance in the last two quarters has been excellent. For the quarter ended March 31, ISWI increased revenues to $974K, and turned in net income of $445K, or a nickel a share. Operating cash flow was $679K, or 69.7% of revenues. The company also announced that it had repurchased 132,100 shares at a price of $136,097, or $1.03 per share. In the quarter ended June 30, ISWI announced revenues were $1.224 million, and net income was $738K, or a 60% net margin, and EPS was 8 cents per share. An additional 110K shares were repurchased in the quarter for $305,232, an average price of $2.77 per share.
The company has issued guidance for fiscal 2001 earnings (ending September 30, 2001) to come in at a quarter per share, which means the company is selling at 16 times trailing earnings.

Company Background

Formerly called International Sports Wagering, ISWI was founded in 1995. Prior to its agreement with GIG, ISWI had cumulative net losses of $9.34 million through Sept 30, 2000. In December of 1999, the company received a letter from Nasdaq stating the company did not meet net tangible assets/market cap / net income requirements for continued Nasdaq small market listing, having neither $2 million in net assets, market cap of $35 million, or net income of $500K. On March 13, 2000, Nasdaq wrote to the company and stated that ISWI had provided a definitive plan evidencing its ability to achieve compliance with the continued listing requirements and granted an extension. To meet the net asset requirements, the company twice sold shares in private transactions: on January 12, 2000, the company sold 800K shares at $1.25 each to accredited investors, for a total of $1 million. And on April 10, 2000, the company sold 333,333 shares at $1.50 each, for a total of $500K. Two insiders, Barry Mindes and Bernard Albanes, together own 38.5% of outstanding shares as of December 15, 2000. Mindes is the chairman and CEO and Albenese is the president and treasurer. According to Yahoo! finance, total insider ownership is 51% of the shares. (Yahoo! Finance also shows Merrill Lynch owning 7,998 shares, with ML being the only institutional investor).


There are three sources of option value for ISWI as I see it.

The first option is that GIG hits revenues that trigger payments above and beyond the minimum guarantees. The second option is any other revenue stream that ISWI can develop outside the scope of its exclusive license to GIG. The third option is any value from the GIG deal that materializes beyond year 14 of the contract -- my assumptions for valuation consider not one dollar of economic value after March 2014.

Let's look at the first option, which I see as the biggest potential value-add. There are two chances for ISWI to break through the minimum payment barrier -- if either 25% of gross profits of GIG's contest operations exceed the minimum -- or if the lesser of 25% of gross profit or 1% of total handle of the wagering operations exceed the minimum. Just to take a random year -- 2007, for example, where I calculate the minimum guarantee payable to ISWI is just over $14 million. To do better than this requires only that the combination of contests and wagering gross profit for GIG exceeds $57 million, which really isn't all that much. In a press release dated July 16, the companies noted that "for countries that do not allow gambling (which mainly applies to the U.S. outside of Nevada), GIG will offer contest-oriented products. Here the consumer will have access to the same live sports events, but wagers will be free with the potential to win points for prizes rather than real money. The revenue model for such contests will be tied to sponsorship and advertising." Basically, you are talking about advertiser-sponsored contests, and one can easily see Budweiser or Miller Brewing or Gatorade sponsoring a sports-related contest to promote their products.

Outside the U.S., gambling isn't so heavily regulated, and in many countries, it is considered a harmless everyday form of entertainment. Take a huge worldwide sporting event like World Cup soccer. It isn't hard to imagine 50 million participants betting on various aspects of the World Cup resulting in something close to a $50 million gross profit -- and that's just one sporting event.

The first platform for the integration of GIG's betting service and live TV broadcasts will be iDTV, a digital television service in the U.K. According to the press release, the company sees the potential to be in 60% of UK homes by 2004, and there was a data collection company estimate that 82% of the UK population has placed a sport-related bet in the last two years. That latter estimate sounds awfully high to me, but clearly there are a lot of people in the UK that like to put a friendly wager on sporting events. Beyond that, GIG's parent, Kirch Group, owns the broadcasting rights to the 2002 and 2006 World Cup and is a majority stakeholder in Formula 1 racing, so I would expect that GIG would have no problems getting some deals done there. In short, I think that there is a pretty good chance that the minimum guaranteed payment will be exceeded in at least some of the years of the contract.

I don't have a good feel for the value of options two and three, but obviously there must be some chance that the company will be able to produce some economic value beyond 2014, and that they may be able to find some revenue-producing operations using their software in Nevada or even in non-gambling related uses.


For those of you who are interested, I noticed while reading the 10-K the following regulatory issue concerning institutional investors (just something to be aware of.)

"The Nevada Act requires any person who acquires beneficial ownership of more than 5% of a Registered Corporation's voting securities to report the acquisition to the Nevada Commission. The Nevada Act requires that beneficial owners of more than 10% of a Registered Corporation's voting securities apply to the Nevada Commission for a finding of suitability within thirty days after notice." An institutional investor that acquires more than 10 but less than 15% of the voting securities may apply to the Nevada Commission for a waiver of such finding of suitability if such institutional investor holds the voting securities for investment purposes only."

I have attached my DCF spreadsheet below. The spreadsheet discounts the value of only those contracted payments that have not yet been received, and I have used a 12% discount rate. I have assumed that the company will begin paying some taxes in mid-2002, and will pay full taxes by 2003. To use the DCF below, it's probably best to copy and paste it to a word document, and separate the "taxes" and "cash flow" columns with a tab. I'll be happy to answer any questions about the spreadsheet or anything else in this write-up.

THE RISKS

ISWI is a bit more of a speculative risk than most of the value ideas presented on this board. Clearly, the real play here is on GIG, in that the success of GIG will determine, in large part, the value of ISWI. The most obvious risk is that GIG decides to discontinue their efforts in sports wagering. According to the contract, GIG can terminate the agreement by stopping payment, in which case all license rights revert to ISWI and GIG forfeits one year of minimum payments held in escrow. To this point, GIG appears to be pursuing this opportunity with all guns blazing, but clearly there is a risk that GIG could pull the plug at any time. GIG's website has additional information for interested investors at www.gigltd.co.uk.

Valuation of ISWI's Licensing Agreement with GIG for SportXction Software

Discount Rate = 12%
Undiscounted total = $245,483,013
Discounted total = $57,694,114

Date Cash Flow Expenses Taxes Cash Flow Pres Value

Sep-01 $1,250,000 $500,000 $0 $750,000 $729,049
Dec-01 $1,250,000 $500,000 $0 $750,000 $708,683
Mar-02 $1,250,000 $500,000 $0 $750,000 $688,887
Jun-02 $1,500,000 $500,000 $100,000$900,000 $803,571
Sep-02 $1,500,000 $500,000 $100,000$900,000 $781,124
Dec-02 $1,500,000 $500,000 $100,000$900,000 $759,304
Mar-03 $1,500,000 $500,000 $100,000$900,000 $738,093
Jun-03 $1,800,000 $500,000 $260,000$1,040,000 $829,082
Sep-03 $1,800,000 $500,000 $260,000$1,040,000 $805,922
Dec-03 $1,800,000 $500,000 $260,000$1,040,000 $783,409
Mar-04 $1,800,000 $500,000 $260,000$1,040,000 $761,524
Jun-04 $2,160,000 $500,000 $498,000$1,162,000 $827,089
Sep-04 $2,160,000 $500,000 $498,000$1,162,000 $803,984
Dec-04 $2,160,000 $500,000 $498,000$1,162,000 $781,525
Mar-05 $2,160,000 $500,000 $498,000$1,162,000 $759,694
Jun-05 $2,592,000 $500,000 $690,360$1,401,640 $890,768
Sep-05 $2,592,000 $500,000 $690,360$1,401,640 $865,884
Dec-05 $2,592,000 $500,000 $690,360$1,401,640 $841,696
Mar-06 $2,592,000 $500,000 $690,360$1,401,640 $818,184
Jun-06 $3,110,400 $500,000 $861,432$1,748,968 $992,411
Sep-06 $3,110,400 $500,000 $861,432$1,748,968 $964,689
Dec-06 $3,110,400 $500,000 $861,432$1,748,968 $937,741
Mar-07 $3,110,400 $500,000 $861,432$1,748,968 $911,545
Jun-07 $3,732,480 $500,000 $1,066,718$2,165,762 $1,097,242
Sep-07 $3,732,480 $500,000 $1,066,718$2,165,762 $1,066,591
Dec-07 $3,732,480 $500,000 $1,066,718$2,165,762 $1,036,796
Mar-08 $3,732,480 $500,000 $1,066,718$2,165,762 $1,007,834
Jun-08 $4,478,976 $500,000 $1,313,062$2,665,914 $1,205,924
Sep-08 $4,478,976 $500,000 $1,313,062$2,665,914 $1,172,237
Dec-08 $4,478,976 $500,000 $1,313,062$2,665,914 $1,139,491
Mar-09 $4,478,976 $500,000 $1,313,062$2,665,914 $1,107,660
Jun-09 $5,374,771 $500,000 $1,608,674$3,266,097 $1,319,122
Sep-09 $5,374,771 $500,000 $1,608,674$3,266,097 $1,282,273
Dec-09 $5,374,771 $500,000 $1,608,674$3,266,097 $1,246,453
Mar-10 $5,374,771 $500,000 $1,608,674$3,266,097 $1,211,634
Jun-10 $6,449,725 $500,000 $1,963,409$3,986,316 $1,437,506
Sep-10 $6,449,725 $500,000 $1,963,409$3,986,316 $1,397,349
Dec-10 $6,449,725 $500,000 $1,963,409$3,986,316 $1,358,315
Mar-11 $6,449,725 $500,000 $1,963,409$3,986,316 $1,320,371
Jun-11 $7,739,671 $500,000 $2,389,091$4,850,579 $1,561,757
Sep-11 $7,739,671 $500,000 $2,389,091$4,850,579 $1,518,130
Dec-11 $7,739,671 $500,000 $2,389,091$4,850,579 $1,475,721
Mar-12 $7,739,671 $500,000 $2,389,091$4,850,579 $1,434,498
Jun-12 $9,287,605 $500,000 $2,899,910$5,887,695 $1,692,572
Sep-12 $9,287,605 $500,000 $2,899,910$5,887,695 $1,645,290
Dec-12 $9,287,605 $500,000 $2,899,910$5,887,695 $1,599,330
Mar-13 $9,287,605 $500,000 $2,899,910$5,887,695 $1,554,653
Jun-13 $11,145,126 $500,000 $3,512,891$7,132,234 $1,830,667
Sep-13 $11,145,126 $500,000 $3,512,891$7,132,234 $1,779,528
Dec-13 $11,145,126 $500,000 $3,512,891$7,132,234 $1,729,818
Mar-14 $11,145,126 $500,000 $3,512,891$7,132,234 $1,681,496
$245,483,013 $28,000,000 $57,694,114

Catalyst

1) 20% minimum revenue growth for as long as the contract is in effect, and 2) positive news flow on announcements of cable and digital TV contracts expected by GIG as well as the launches of any additional internet gambling or contest initiatives.
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