Description

Please note: October 8th, LAD announced a rights issue and diluted equity holders by ~50%. All my historic and forward looking multiples, my debt related numbers etc are all off the new shares outstanding and the updated balance sheet. If you are familiar with the business and recent events, skip directly to the "THESIS" section. Lastly, multiples above for 09 have caveats as high rollers in H1 09 contributed 58M GBP to EBIT and it is best to look at this business without high roller contribution, and then add on whatever you beleive the high roller business is worth.

SUMMARY
Ladbrokes is a leading UK bookmaker with ~25% market share in betting shops in an oligopolistic market (tied with William Hill for #1 in share). As a percent of EBIT (excluding high rollers), ~70% is from UK betting shops, 20% from eGaming (online - mostly UK), 8% from European betting shops (mainly Ireland, where they are #1 in shops and #2 behind Paddy Power in earnings), and 1% in Telephone Betting (excluding high-rollers). However, LAD also has a high-roller business within Telephone Betting, which over the past 2.5 years has been a significant contributor to group EBIT (10% of Revenue and ~20% of EBIT last year).

Betting shop revenue or Gross Win (GW) is made up of a) Over The Counter (OTC) betting revenue of ~65% (which is predominantly horse/dog racing which is in slow structural decline, and soccer & other sports which are ~12% for LAD and 20% for WMH (William Hill) and are growing, with higher margins and b) Gaming Machine Revenue of ~35% (which is predominantly roulette at 2.77% margin, and ~12-15% is fast growing casino games with margin's of 8-10%).

QUICK NOTE ON GAMING MACHINE REVENUE: In 2005, the bookmakers were given permission to add fixed odds betting terminals (FOBTs or Gaming Machines) to their shops. These have been highly lucrative and now account for ~35% of shop gross win (although there has been a fair amount of cannibalization from OTC). Basically, when punters are waiting for a race to start, they play these machines. There is a limit of 4 machines per shop and LAD and WMH are at their limit (and have been for 2 years)

Recent Profit Warning

On Oct8, 09 LAD issued a profit warning along with announcing a rights issue. For the third quarter 09, group revenue was down 15% YoY and profit was down 58% YoY. Group revenue in H1 09 was down 9% and expectations were for H2 Revenue to be down ~12%. Group EBIT was down 26% in H1 and expectations were for H2 EBIT to be down ~35-38%. On both these counts, Q3 was a big disappointment. However, OTC amount staked was down only 3% (so total money bet was down only 3%), whereas Gross Win Margin (amount bet minus amount paid out - or LUCK), was down 350bps to 14%, the lowest in the history of the company. LAD says this was in large part due to horrible soccer results, specifically a lack of draws thus far this year (worst in 17 years that the Premier League has been in existence). Historically, ~25% of the games end in draws on average, and the bookies make a lot of money on draws as most people bet on wins. In this quarter, ~6% of games have ended in a draw, unprecedented in the history of the premier league. Though consensus has brought down 09 numbers appropriately, they have also turned significantly more negative on LAD's prospects in 2010/11 (2010 and 2011 EBIT numbers have each been brought down by ~7-8%) and are pointing to structural issues with GW margins ("maybe there will be less draws in general as the game evolves", "the ball is different" etc).

CEO's comment to me (right after the warning) on whether this is structural issue in soccer: "Our guys have analyzed the hell out of this and they are all of the belief that this is not structural in any way. If it were, we would have to deal with that by adjusting our risk management but to be frank, we haven't even thought about that because we firmly believe it is not structural and margins should return to normal. Already, in the last week, GW margins have normalized - but it is only a week"

This often happens with gaming companies. Just as these stocks overreact on the upside when sports results are good for the company, they react on the downside when results are bad. Moreover, the bears often question a decline in structural margins when results are good. But margins almost always revert back to normal - this is just part of the risk of owning a gaming stock, but should not be moving the share price as much as it does, and certainly not as much as it has in the past couple of weeks (shares down 25% post adjustment for rights issue dilution!). For what its worth, in the past 4 weeks since the warning, football margins have more than normalized (37% draws vs a historic average of ~25%, and last quarter's 6%)- and this should show in next quarters results.

Rights Issue

LAD announced a 1 for 2 rights issue at a 48% discount to the share price of 181GBp on Oct 7, 09 to raise 275M GBP (so they will issue ~300M shares at 96p/share). They did this to put them in a stronger position to refinance the remained to their debt and to reduce TTM June-09 Net Debt:EBITDA to 2.6x (versus 3.7x) ex-high rollers. Shares have been trading ex-rights since Oct 9th 09, the last day of acceptance/payment was Oct 23rd 09, and dealings in new ordinary shares, fully paid, commenced on Oct 26th, 09.

This is the CFO's explanation for to me for doing the rights issue: "Earlier this year and even at the interims, we were hoping that we could fund our debt through our own accruals and through cutting down dividends, and I admit, that is what we conveyed. However, we never ruled out a rights issue, even when we were asked at the interims (true statement) as we know that this is a highly leveraged business and we were at 3.7xND:EBITDA ex high-rollers. WMH had their covenants slashed from 4.25 to 3.5x earlier this year, so if the high rollers didn't return, we were always going to be close. This run of bad luck made it obvious to the board that it was not worth the risk. We could have done a bond issue i guess, but that would not have reduced our overall gearing, which we decided was the right way forward. The era of running these businesses at 3.5-4x ND:EBITDA is gone for now. We could have waited for a few months more, but choose to act sooner rather than later. With unemployment going up, we are hardly through this recession. I suppose we will never know if this was too premature"

Though I beleive management could most likely have waited a few more months and seen how operations progressed (and if high rollers returned) before doing the rights issue, I believe that management did do this out of caution rather than to use the proceeds to do something silly (like make a big acquisition). When WMH did a more dilutive rights issue earlier this year (granted debt markets were different then), the adjusted stock price actually went up double digits (versus down 25% for LAD).

THESIS

We beleive this to be a true deep value investment, with several catalysts. Apart from the fact that it is a business that has not been given credit for its strong free cash flow generation (stock is at an all time low and has not participated in the rally at all), after the rights issue/profit warning last week, this has also become business that is now burdened with unwarranted fears of a structural decline in margins. At these levels, you buy a real franchise (LAD has been around for 40 years, and betting in betting shops in the UK isn't going anywhere), cheap not only on absolute multiples/relative to other companies in general, but also at all-time low multiples relative to its own history, disliked by the sell-side (they all like William Hill, esentially the same business on the same multiples, but with less self help opportunities than LAD and no high roller business), and most importantly, with real catalysts over the next 12 months. Here are the potential catalysts:

1) We believe gross win margins in soccer will return to historic average (currently consensus is building in only a partial recovery) 16.5% over the next year and given consensus downgrades, this helps provide us with an EBIT 13% higher than consensus expectations. This would mean group EBIT margins reverting to 19-20% from around 16% (ex-high roller) this year.

2) We believe High Rollers will bet again - High Rollers have been a part of Ladbrokes business for over a decade. Higher roller income as a percent of group EBIT for the last 5 halves starting H1 07 has been 31%, 52%, 25%, 26%, and 37%. Consensus is building in no value for high rollers (as per company guidance), as am I in my base case. However, the fact remains that LAD does service these high-rollers, has built strong long term relationships with them, and there is a distinct possibility they continue to gamble with LAD. Also, 1 or 2 more halves like any of the last several halves of high roller revenue would help LAD de-lever significantly (not to mention material upside it would provide to consensus numbers).

3) Self Help / New Initiatives - Ladbrokes has historically been more inefficient than its peers (William Hill and Coral) at managing shop costs, and slower at implementing machine technology changes (but has been a leader in OTC). A) Staff costs (majority of operating costs for these companies) per shop are ~14% higher for LAD (than WMH). Over the last year, LAD has implemented a series of cost cutting initiatives. Already LAD has reported staff costs down 3% in H2 08 and 2.5% in H1 09 (savings of ~7M). Closing the gap completely would result in an incremental cost savings of 20M GBP. B) In addition, management has said there will be another 12M GBP in savings starting H2 2010 as they gradually buy out the staff's option of getting paid overtime on Sunday's and bank holidays. WMH did this exact thing a couple of years back and experienced similar savings (i confirmed with IR). Corporate costs were also down this half. C) Ladbrokes will start to catch up with WMH in gaming machine innovation - one of the big reasons LAD shares have underperformed WMH recently has been that in H1, WMH gaming machine revenue grew 11% and LAD only grew ~2%. We believe part of this is timing and part of it is LAD's failure to implement technological changes quickly enough (LAD trails WMH by 10% in terms of GW per Machine/Week). Speaking with WMH management, the company has benefitted from 1. a switch to a multi-supplier model (rather than exclusively dealing with Inspired Gaming), 2. an upgrade in software last year (new games and more games per terminal), and 3. a more recent upgrade of HD Widescreen "Storm" machines from inspired gaming. WMH says LAD will not benefit from the latter as WMH has a signed an exclusivity contract with Inspired Gaming. However, as with machines all over the world, competitors should be able to build a me-too product within months. I believe there is a real possibility that LAD replaces its machine estate in a 12-18 month time horizon and gets an uplift from a superior offering (much like WMH has been getting and should get over the next 12 months). LAD has historically had only one machine/software supplier in Cyberview, but has also recently (H1 09) switched to a multi-supplier model (added Inspired Gaming and Global Draw as suppliers), and has said they are upgrading their software (and will go from an average of 8 games per terminal to 20 per terminal) in October this year, which should have a positive impact, again, like it did for WMH. LAD is also testing new machines by Global Draw in 8% of its estate starting November 09. D) Getting out of Italy - One of the reasons i have not liked LAD in the past is that LAD has had a strategy of growing its land based gaming internationally (Italy, Spain), and the market/analysts were willing to attribute profitable future growth to that business (i didnt believe in it). 2 months ago LAD announced that they are getting rid of their Italian business, which will add ~4-5M GBP (or ~3%) to net income from next year, and hopefully result in a cash inflow of ~40-50M GBP (LAD claims there have already been several interested buyers)

4) World Cup Soccer next year - starting June 2010, this should add ~3-5% to revenue and ~5-7% to earnings (online and OTC). This is what management of william hill/lad and paddy power said it added last time around. The market is ignoring this is the face of all that's been going on. Also, last word cup was a great recruiting tool for all these player's online divisions as first time gamblers surface to bet on the world cup, which could be an incremental benefit next year.

5) Deleveraging/LBO candidate - its strong FCF have made bookmakers ideal LBO candidates (LAD has never been LBO'd but its two biggest competitors WMH and Coral have been). It is not difficult to envision a scenario where net debt:ebitda goes down to ~1.6x (on my numbers this should happen by 2011 due to regular cash paydown and selling the Italian business for 40M), which would make it a prime candidate if credit markets recover. Either way, as the company de-levers, investors will feel more and more comfortable with the stock.

VALUATION & MULTIPLES

On multiples - LAD is trading at all-time lows to its historic multiples - at 5x '08 PE and 5.4x '08 EBITDA (ex high roller PE of 8.2x and EV/EBITDA of 7.0). 10 year average PE for these businesses is ~14x and EV/EBITDA is 9x (i use William Hill as Ladbrokes was part of Hilton until a few years ago, and so is not as relevant). Even closing the gap half way on these multiples results in >~40% upside. On my numbers, LAD can earn ~16p in earnings next year vs consensus expectations of 14p. Applying conservative/mid-cycle multiples of 12-14x to that gets us to 192-224p/share (56-82% upside). FCF to equity Yield (what I believe to be the most important multiple for this kind of low growth, low capex intensive, high cash generative business) for 2008, 09 and 10 is 15%, 10.5%, 12% respectively. Net Debt to EBITDA post rights issue will come down to 2.5x with interest cover >4x. This is all excluding any contribution from High Rollers.

Based on a DCF valuation, I calculate a two year target price of 220p, representing a total potential capital return of ~78% (excluding a dividends). I have used a 0% terminal growth rate in my model to account for the possibility that land based gaming is in slow structural decline (no evidence of that yet but the logic makes sense over the very long term - though i woud argue that the online player is very different from the older blue collar player that frequents a betting shop).

Lastly, I have completely excluded any future contribution from the highroller business - if i include this business, it conservatively adds another 25p (20%) to my target price, for a total upside of 98%.

MY FINANCIAL FORECASTS FOR FY09/FY10 AND BEYOND

FY09 revenue will fall around ~12% YoY and EBIT margins will fall ~500bps, in part due to a weaker consumer and in part due to very weak sporting results (bad luck) this quarter. I believe normalized (FY10) figures are as follows: Revenue - 1.03B GBP, EBIT - 215M GBP, FCF of 180M GBP (post interest FCF 132M GBP). EBIT margin should revert back from 16% in FY09 to ~19-20% in FY10 and beyond (historic margins have been 21-22%). This implies EBIT growth of ~20% (my EBIT is 13% higher than consensus/market expectations). I think revenues will grow slightly above inflation after next year and margins should stay steady at ~19-20%. I AM NOT EXPECTING A MATERIAL CYCLICAL RECOVERY over the next 2 years as I believe next year and possibly the year after that will continue to be difficult for the UK consumer (but not more difficult than 2009) due to rising unemployment and rising interest rates in the UK. I am building in a slighly more difficult peak to trough (2007 to 10) revenue decline on OTC than WMH had during the 1990s recession (WMH said that during the early 90s recession, OTC revenue from peak to trough fell 8%). All my forecasted recovery in revenue/EBIT in 2010 comes from normalizing GW margins, cost cutting, Gaming Machine improvements, and a minor world cup boost.

Negatives and Risks

A) Online and Gaming Machines untested in a recession - this is only partially true given we are in the middle of one and up till H1 09 both had been growing (GW fell drop has been mainly due to lower win margin as amounts staked grew mid single digits). Moreover, my assumptions are very conservative on online. On Gaming Machines, I believe the initiatives I have listed (under "catalysts") should mitigate a potential slowdown from less visitor arrivals. We should also keep in mind that the bookies have also gone through a tough period in H1 07 and H1 08 with the smoking ban being implemented in the UK, so comps are depressed.
B) High Roller's win big - resulting in a big loss for LAD - I spoke with LAD about this and they say that they have rarely lost money on high rollers over s significant period, and it is not very likely this will happen for several reasons: a) the high rollers bet with high frequency (law of averages), b) LAD has limits on maximum bet size, c) worst case, LAD can lay off a portion of the bet if it feels uncomfortable with the risk (bet against the high rollers bets to hedge risk), d) the spread they charge high rollers is significantly wider than the published spread (so should almost always make money over a meaningful period of time).
C) Regulation/Tax - As with all gambling companies in the UK, the regulatory environment in the can be quite unpredictable. Recently there were fears that the Gambling Commission was doing a study to see if there was a link between problem gambling and Gaming Machines (which could lead to increased tax). Also, Gaming Machine tax is currenlty being reviewed and could go up next year as the government is switching from one kind of tax (AMLD and VAT) to another (GPT or Gross Profit Tax). A 1% increase would result in a 2.8M GBP hit to EBIT, but the govt has said it aims for the tax switch to be revenue neutral (but i dont trust the UK government when it comes to screwing over gaming companies). My best guess is that machine taxe will go up by 1-2%, but i beleive the analyst community already expects that.
D) Structural fears over land based betting - yes these exist, but amounts staked have been pretty resilient so far, and customer base that bets online is quite different from land based customers so i am not worried about this over a 2-3 year horizon.

Other Dilligence Issues/Things I Haven't Discussed

Online Division - there are varying opinions on how fast/slow LAD and WMH's online businesses will grow. I dont have a strong opinion but i do know LAD and WMH have strong brands in the UK and so should be able to grow at least as fast as UK online grows (i don't buy the online penetration in the rest of Europe story, but again, i haven't done too much work here)

Why not William Hill considering it is trading on similar trailing multiples? - I hinted at this earlier.  Clearly William Hill has done a better job managing costs, a better job implementing gaming machine changes, and even a better job timing its rights issue (Feb this year - when the market actually viewed rights issues as good things).  However, as these two companies stand today, LAD has a lot more opportunities to improve its earnings by doing things WMH has already done. On those improved earnings, LAD is materially cheaper than WMH.  Also, LAD is hated by the sell side (ie lower expectations) and William Hill is loved - all one needs to do is pull up 5-10-15 year figures on these two, to see how closely these two companies have performed relative to each other over any meaningful amount of time.  Lastly, optionality on LAD's high roller business is certainly worth something (WMH does not have a high roller business). 
Make sure you adjust WMH's numbers by removing Playtech's minority stake from WMH's online business.

Disclaimer: We own shares of LAD. We may buy or sell these shares at any time without notice. The information in the write-up is believed to be correct as of the date written but VIC members should do their own verification of this information and analysis of this potential investment

Catalyst

1) Gross Win Margins will normalize to long term average in soccer. Once this happens, stock should start to rerate to mid cycle multiples as strong cashflow generation is evident.

2) High Rollers will likely bet again - potentially providing material help to pay down debt further AND material upside to 2010 numbers.

3) Self Help / New Initiatives - all detailed above (cost cutting, gaming machine revamp, sale of Italian business) and evidence of it working seen in competitor's estate.

4) World Cup Football next year

5) Further Deleveraging

6) Earlier than expected cyclical recovery (i beleive this to be unlikely).  Using 07 (peak) numbers: Current EV/07 EBITDA is 5.1x, Current Price/07 Earnings - 5.8x.  2007 FCF/Current Price (FYF Yield) - 17%