|Shares Out. (in M):||350||P/E||0||0|
|Market Cap (in $M):||3,800||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
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Playtech (“PTEC” or the “Company”) is the world’s largest B2B software provider for online casino operators. The Company offers an extensive suite of games (casino, sports betting, bingo and poker) in addition to an industry-leading backend system. This includes hosting, network management, payment advisory, marketing, customer relationship management (“CRM”) and various other products aimed at providing an effortless experience for the bettor and maximizing customer lifetime value for the casino operator (“operator”).
The Company serves an industry that is at the infancy of its development cycle; despite continual growth over the last 2 decades, online gambling constitutes less than 10% of the total gambling market. Playtech’s products are tailored towards land-based betting shops, casino, and others (e.g., media outlets) that are inexperienced in software development and technology, but have large customer databases that can be monetized online. New clients are typically based in newly regulated/legalized countries and are looking for a one-stop shop that can quickly jumpstart their online offering. PTEC is the only company that provides a high quality turnkey solution, and their historical performance reflects the power of their differentiated offering. Over the last decade, PTEC has grown adjusted earnings at a 20%+ CAGR while deploying capital at an average ROIC of ~50%.
This market leading, high growth company trades at only 11x 2017 earnings (excluding net cash and its stake in two other publically traded companies) as a result of market fears regarding the Company’s exposure to grey markets, the reputation of its controversial founder (who is only an advisor to the company and has significantly reduced his stake), and suspect capital allocation historically. We believe that these risks are more than priced in and that there is material upside to the stock at current levels.
Business segments and market share
Online gaming software is Playtech’s core business segment, responsible for more than 90% of revenue and earnings for the Company. Playtech typically earns 10%-15% of the net revenue generated by clients from PTEC content, depending on the client and the number of products provided. According to H2 Gambling Capital (“H2GC”), the total online gambling market is €35B in 2016. Therefore, we estimate that Playtech is a supplier to ~12%-18% of the global software market (PTEC gaming revenue of €643M). The rest of the market is highly fragmented, with a few global suppliers (e.g., Microgaming, NetEnt, NYX) and a long tail of small software providers catering to niche markets in addition to casinos that develop software in-house.
Graph 1. 2016 Gaming segment revenue breakdown
The relatively small size of the online industry is a product of the slow regulatory evolution globally. Outside of pockets within Europe (mainly UK, Denmark, Italy, and Spain), South America (Mexico), and APAC (Australia for sports betting only), the rest of the world is almost entirely unregulated. The unregulated markets have often not updated older laws to address internet suppliers, or online gambling generally, where a number of cross border transactions may be involved. Frequently within these regions, the legality of online gambling is subject to uncertainties arising from differing approaches by regulators, enforcement agents and legislative entities. In order to address these markets, gambling companies and suppliers typically use a risk-based approach, with the goal of balancing the higher regulatory risk (more on this later) against the more attractive returns (which are derived primarily from the lack of local taxation).
Playtech serves casino operators in both regulated and unregulated markets, with a focus on European and Asian countries. Over the last 5 years, PTEC’s exposure to unregulated markets has declined from 66% to 49% (or 54% of gaming segment only) reflecting the regulatory advancement in these markets.
Graph 2. Playtech regulated revenue as percent of total group revenue
Since its founding, Playtech has recognized the opportunity for technology companies to drive the transition from land-based to online gambling. Instead of specializing in one aspect of an online casino (casino games, sports, CRM, etc) like many of its peers, PTEC saw that the market was ripe for a more comprehensive system that would enable operators to seamlessly and quickly flourish in an otherwise unchartered environment. By reinvesting heavily back into the business through R&D and bolt-on acquisitions, Playtech built an unrivaled turnkey solution. While it is the ease of the plug-and-play nature of this system that attracts new operators to them, it is their product quality and network that keep seasoned clients married to their solution. From less than 40 operators a decade ago, PTEC now boasts the largest network of over 130 (including all top ten online casinos in the UK), with extremely low churn in their client base.
Playtech’s competitive advantages are derived from:
Due to the rapid advancement of technology, consistent investment in R&D is a critical element of the long-term success in the industry. Playtech is the largest supplier of online gaming software and therefore, has the most resources to deploy. The Company currently spends ~€90M-€100M a year on product development, and over half of its earnings on bolt-on acquisitions that strengthens its product offering. Other competitors simply do not have the scale to match its development spend (e.g., game provider, NetEnt, is less than 1/5 in sales and profits).
In addition, insourcing, a topical point amongst bears, is also uneconomical given the fragmentation of the online operators (estimated 450+ globally). Ladbrokes Coral for example, one of the largest operators of online casinos, has €400M+ of gaming revenues. Therefore, it incurs ~€40M in procurement cost for its software (assuming 10% profit sharing), less than 50% what PTEC spends on R&D. If Ladbrokes moved development in-house, it would either have to double its current spend, cutting into already slim margins (2016 EBIT of 6%), or risk providing a substantially lower quality product. This is in addition to the hundreds of millions of dollars of catch-up R&D spend that would be necessary to develop a product comparable to PTEC’s current offering. Operators almost always choose external suppliers. In fact, Ladbrokes Coral, despite its size, chose to outsource all of its gaming products and services in a landmark joint venture with PTEC in 2013.
PTEC also benefits from economies of scale in several other important ways. First, PTEC owns the largest network of affiliates (50,000+), allowing the Company to efficiently direct traffic to operators’ websites. Second, PTEC owns the largest network of operators (130+), which provides greater rewards for the bettors through increased liquidity in poker, bingo and slots, by pooling together bets across all of its operators. PTEC’s accessible liquidity pool for slots, bingo and poker is the largest of any supplier . Third, PTEC’s size enables it to access exclusive brand licensing deals (e.g., DC Comics in 2016) by spreading the cost of content across a larger customer base. Lastly, PTEC’s scale allows it to collect user data across all its operators and games, which is then analyzed to understand the bettor, personalize the user experience, and ultimately maximize life-time value of those customers.
2. Differentiated turnkey solution
PTEC is the only company to offer a high quality turnkey product that enables both front and backend operations of any online casinos across devices. Other suppliers have no choice but to focus on individual verticals due to resource constraints and existing capabilities. For example, Microgaming and NetEnt focus on casino games, while Openbet focuses on sports betting. In fact, Microgaming began as a full-suite provider but over the years has deprioritized the rest of its portfolio to focus primarily on content. This has a couple of consequences. First, other suppliers are less entrenched because their singular lines of products are easier to displace (more below). Second, PTEC is unparalleled in its ability to offer seamless integration between multiple products, which is increasingly vital in capturing clients in newly regulated countries, who do not have the software development experience necessary in order to integrate modules from various suppliers. Caliente, the leading land-based casino operator in Mexico, chose to partner with PTEC in 2012 for their entry into the online market. Since then, the operator has grown to become the undisputed leader in its markets across all channels. PTEC has indicated that Caliente will likely become one of its top 10 clients in 2017 and will act as an anchor for future growth in Latin America. This is a classic example of how PTEC leverages its turnkey platform to gain access to key players and establish dominance in newly regulated markets. However, even with clients in more developed markets like the UK, PTEC supplies significantly more backend solutions than other B2B gaming players, who only provide content.
3. Deeply integrated relationships with customers
Playtech’s products are extremely sticky. In fact, we had a hard time finding examples of sizable contract losses over the years. This is because 1) PTEC’s products are mission critical 2) they are deeply intertwined with their operators’ platforms and 3) punters are a fickle breed (40%-60% of time, bettors will leave a website after a major content reconfiguration). Over the years, this dynamic has enabled PTEC to maintain its pricing power and lengthen the term of their contracts. The few operators that have tried to gain independence have had little success.
William Hill is one such example. In 2008, the two companies formed a JV (William Hill Online) to revitalize the struggling arm of the retail gambling giant. They signed an 8-year licensing contract, longest PTEC has ever had at the time. From 2008 to 2013, William Hill grew its market share from 10% to 15% as a result of revenues growing at double digit rates since 2010. This was another success story of PTEC’s powerful platform. Despite the achievements, the relationship between the two parties became increasingly tumultuous, arising from strategic and cultural misalignments. In April 2013, William Hill bought out Playtech’s share of the JV, and doubled down on its attempt to decrease reliance on PTEC. By 2016, William Hill had directed 61% of online gaming revenue to non-Playtech software, up from 51% in 2014. In the same year, William Hill experienced a 5% net revenue decline in online gaming, their worst performance in over a decade. Below is William Hill’s management’s account of this in their 2016 annual report:
“After several years of sustained outperformance and market leadership, Online's growth stalled in 2016, with net revenue down 3% and adjusted operating profit down 20%. In January 2016, we changed Online's leadership. We recognised that new customers were generating lower than-expected revenue levels and that our product range had become less competitive.”
Perhaps unsurprisingly, William Hill has since extended its contract with PTEC and has indicated that it looks forward to continuing their relationship for the foreseeable future.
Graph 3. William Hill online gaming revenue
4. Distributor relationship and regional expertise
Unlike the rest of the world, suppliers working in Asia rely heavily on local relationships and key distributors to find clients and navigate the regulatory environment. Playtech has been building deep relationships with Asian wholesalers, operators, regulators and bettors for more than a decade. In addition, the PTEC brand and its games are well recognized in Asia; many operators actually display PTEC’s logo to signal legitimacy and attract traffic. New suppliers without similar background would have substantial difficulties establishing in this unfamiliar environment.
The online gambling industry is expanding rapidly and has been doing so since the beginning of the Internet era. Despite this, the industry is still in its infancy in most regions, with large parts of the world either not regulating or explicitly prohibiting online gambling, even though land-based casinos are ubiquitous worldwide. The contrast between the ~25 countries that have legalized online casino gaming and the 150+ countries that have land-based casinos demonstrates the colossal gap between the two markets in maturity. More importantly, the largest gambling markets in the world are not currently endorsers of online gambling (i.e., China and nearly all of the US), leaving enormous room for industry growth. As these regions become legalized, software suppliers will be propelled forward, in particular those who are well positioned to serve inexperienced operators. Separately, the increasing internet usage and online penetration continue to fuel progress that is independent of any legislation. While Playtech has ridden the coattails of this blooming industry, the majority of its growth has actually been derived from market share taken from its competitors. Since 2008, the Company has posted organic sales growth of 19% p.a., massively outpacing the estimated ~8% p.a from the market (GBGC).
Going forward, H2GC estimates that the online casino market in Europe will grow by 7% annually until 2020, and by 10% globally. But instead of relying solely on third party forecast, the more helpful metric may be the size of the present gambling market, which is fairly stable at ~€400B (GBGC). Online gambling is less than 10% of the total market today at only €35B, indicating an enormous runway ahead.
Playtech capital allocation track record has been mixed. The Company has consistently chosen to pay dividends over share repurchases in order to return capital to shareholders, which has been costly. Compounding this error is the fact that the Company has raised dilutive equity to fund these dividends. The Company has destroyed a meaningful amount of value through this circular capital allocation policy. While we do not factor in any material changes to the Company’s capital allocation framework into our valuation, we remain cautiously optimistic that there may be improvements going forward. The Company appears to be making progress towards more accretive methods of distribution and has repeatedly discussed its intention of optimizing its capital structure since the onboarding of the new CFO in 2017. Historically, the Company has committed to a dividend policy of distributing 40% of adjusted net profit, which is a reflection of the common strategy within the industry of catering to income seeking investors. The result is a 3-4% yield and a total distribution of €820M over last decade (€670M when excluding special dividends). In 2016, PTEC bought back shares for the first time (€50M), evidencing a potential change in capital allocation philosophy.
Aside from dividends, the Company spends most of its earnings on bolt-on acquisitions and R&D (~1/3 of development costs are capitalized) that extend its product offering or generate operational synergies. The Company has been disciplined in the past, purchasing these companies at accretive valuation of less than 8x LTM EBITDA on average (based on major transactions reported, representing ~70% of total acquisition spend), and substantial upside post integration. In general, we believe PTEC has made accretive acquisitions that deepen the Company’s competitive advantage by enhancing their existing gaming platform.
More recently, PTEC expanded into a new market (Contract for Difference (“CFD”) trading platforms) for the first time, through the purchase of an existing operation from its founder, Teddy Sagi. This is a brokerage platform that allows users to purchase securities using very high leverage and typically attracts a similar clientele to online casinos. The rationale was that this market is synergistic to the existing gambling business, and since it is entirely regulated, will reduce the Company’s exposure to regulatory risks. We are cautious of this new business segment due to 1) the uncertainty around operational capabilities 2) regulations and 3) nature of the related party transaction. Consequently, we have assigned zero growth to the existing run-rate of the business and will revise upon greater visibility.
Playtech shares are presently trading at 11x 2017 earnings (excluding cash and investments in public securities) and are cheap on both an absolute and relative (to the market) basis. Our target is £16, which provides ~70% upside to current share price. Our valuation is derived from a discounted cash flow analysis using a 10% discount rate. We assume that the adjusted earnings CAGR for the next 10 years is 16% (as opposed to 19% over the last five years and 17% over the last decade), and is 0% p.a. beyond 2027. We believe this is conservative considering the early stage nature of the industry and the long runway ahead. We assume that for the next ten years the Company continues to distribute 40% of adjusted net profit in dividends while reinvesting the rest back into the business through acquisitions at an accretive yield, consistent with historical average. Investments have been accretive in the past as the Company has been able cross-sell into its client base, achieve cost synergies, and benefit from its low corporate tax rate. Given the fragmentation of the market, we expect there to be attractive targets going forward. If we assume no more acquisitions from 2017 onwards, and that revenues instead grow at 11% p.a. for the next decade, share price target would be £13, which represents ~40% upside.
We feel that the growth and capital allocation assumptions are conservative given the Company’s track record and current trajectory. The goal is to provide us with sufficient downside protection in the case of any unprecedented changes to regulations or competitive landscape as discussed further in the Risks section. In the case that the Company begins distributing cash in the form of share repurchases, we believe there is incremental upside given current share price.
Roughly 50% of Playtech’s gaming revenue is unregulated, and within that the single most important region is China (constituting ~25% of revenues). The rest of the unregulated revenues come from a diversified array of regions such as Malaysia, Russia, and Canada – individually they have limited impact on earnings.
China is a highly contested grey market with very rapid industry growth and high profitability. The Chinese government has banned gambling within mainland (with a few exceptions) for both online and land-based operators; however, it has not enforced these laws on offshore operators. Playtech and its clients are licensed in the Philippines, with all of their tangible assets including employees and servers located outside of China. Based on the limitation of the Chinese government’s jurisdiction and the lack of precedents, lawyers believe that PTEC’s exposure to prosecution is minimal. However, beyond simply relying on the Chinese government’s prior actions, we believe there are factors that structurally reduce the regulatory risk in China for PTEC:
1. Playtech is only a software supplier to casinos, not the direct customer-facing operator. This means the Company is one-step removed with significantly reduced headline risks, as the Chinese government would be much more inclined to prosecute well-known B2C brands than little-known (to the public) B2B software suppliers. Outside of payment processors, we have not been able to identify any prosecution of software suppliers in relation to illegal gambling globally.
2. Playtech’s sales in China are mainly focused on games/content rather than its backend software and services. This means the Company has limited access to player data, payment, and other elements of the infrastructure that have higher compliance risk, and consequently more prone to investigation.
3. Online gambling regulation is decentralized in China, with a significant amount of power held within each province. This means coordination across many agencies would be required if regulators wanted to eradicate offshore players. This is unlikely given individual political agendas and relationships with operators.
4. There are far more salient regulatory issues pertaining to gambling in China such as money laundering, illegal debt collection, and gang-related activities. In order to enhance its image, the government can tackle many lower hanging fruits.
5. Most other international suppliers are either already operating in China or are actively engaged in trying to enter the market (e.g., Microgaming, NetEnt). Playtech cannot be singled out for its risk appetite.
Reasons 3-5 also apply to PTEC’s Asian operators, who face higher regulatory risk, but historically have not undergone significant scrutiny. Despite the various mitigants mentioned above, it is difficult to handicap the probability of a material reduction in PTEC’s Chinese revenue. Therefore, we modeled the hypothetical scenario where the Chinese government decides to buckle down on its gambling regulations and PTEC’s clients are forced to exit the market. Based on conservative assumptions, if this event were to occur tomorrow, we estimate ~25% of the revenue and ~50% of net profits would be reduced due to the significant fixed costs of the business. In the near term, this will obviously have a material impact on the business; however, due to the rapid growth within other regions, we expect Playtech to be able to rebound within 3 years. Its valuation in this case would be close to today’s share price, implying that the market may be assigning little if any value to PTEC’s business in China.
Competition / Exclusivity
Despite constant competitive threats from new and existing B2B software developers, Playtech has managed to maintain its undisputable leadership in the space. This is because most competitors are focused on game production, and like most forms of entertainment, content is a commodity to a large extent, with low barriers to entry. With some creativity and good luck, even relatively unsophisticated developers can build an addictive fun game (just take a look at your app store), but it’s much more difficult to build a comprehensive infrastructure to support this content. We believe that in the short to medium term, its breadth will remain Playtech’s largest value driver, and it will allow the Company to continue to capture significant share globally especially with newly regulated regions and inexperienced operators.
At some point, however, as the market matures, the growth of the industry will stabilize and operators will become more consolidated, sophisticated and cost efficient. An example of this is PTEC’s UK clients, who are far more developed than operators in other regions. In comparison to an inexperienced operator like Caliente, who sources casino products exclusively from PTEC, these operators typically use a range of suppliers and insourcing, with PTEC as their primary vendor. Over time, these operators have been adding more frontend content from non-Playtech sources in order to differentiate from one another. While PTEC continues to have an exclusive “tab” (page on the operators’ websites that usually takes precedence over other casino products) on all clients’ websites, PTEC has recently begun offering operators the ability to develop games in-house using PTEC’s tools. This trend demonstrates how PTEC can lose some of its leverage and exclusivity as operators gain expertise and scale. This negative impact is typically offset by the material growth achieved during this process of maturation. In addition, as demonstrated in the William Hill example, PTEC’s key differentiator is its backend solution while content is more of a commodity. Therefore, its key value proposition does not experience significant deterioration even when they have less exclusivity over frontend games. We believe that PTEC’s unmatched financial resources will likely to allow it to maintain its product leadership, and a world where PTEC’s quality can be challenged is many years in the future because regulatory approvals within each region will cause long delays in the natural advancement of the industry.
The founder and largest shareholder of the Company is Teddy Sagi, a successful but highly controversial entrepreneur within the industry. Prior to starting Playtech in 1999, he had a short stint in bond trading that ended with a jail sentence for insider trading. According to the Company, Teddy was young (22 at the time) and was coerced into insider trading. He became a whistleblower, pleaded guilty (with a plea bargain), and consequently received a light sentence of only 9-months. We do not gain meaningful comfort from this explanation.
Since 2014, Teddy has been gradually reducing his stake in the Company from 49% to 6% today. We believe Teddy likely sold down due to a combination of regulatory pressures and his own desire to diversify his net worth. Two of PTEC’s CFD acquisitions in 2016 failed to receive regulatory approval (the ruling for the larger of the two deals was later overturned), allegedly in part due to Teddy’s reputation. Separately, like many serial entrepreneurs, Teddy may enjoy the process of building companies far more than waiting on the sideline for them to compound at favorable rates. Since 2014, Teddy has redirected his attention to London real estate, where he initially purchased Camden Market (later taken public) for £500M and more recently, Holborn Links for £300M and Brack Capital Properties for £260M. Prior to this, Teddy was kept busy by founding many business ventures such as SafeCharge and Crossrider (both IPOed on London AIM) in addition to Playtech, his biggest winner. It’s clear that as the largest shareholder of four public companies as well as many private ventures, Teddy has an extremely wide range of interests. Overall, we view Teddy’s disengagement as neutral for PTEC as any negative impact from losing Teddy as an advisor should be offset by the Company’s ability to refresh its image and reduce its regulatory risks. The current CEO, Mor Weizer, has been at the helm of the Company since 2007 and has an impressive command of the operations.
 For poker, the liquidity of PTEC’s network (iPoker) is the largest amongst suppliers, but smaller than a couple of B2C poker operators (i.e., Pokerstars and Party Poker). Despite this, iPoker still offers substantial value for its clients as the poker product is nearly worthless without a sizable liquidity pool and these clients have no access to the larger B2C networks owned by competing operators.
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