An investment in Playtech offers the opportunity to profit from a regulatory shift in the online gaming landscape in Europe that should increase profitability for the company while also protecting downside through a trough valuation due to misunderstood call options on new business acquisitions and a number of other misunderstandings about the business. PTEC also offers near term appreciation through two related catalysts in the first half of 2011. The company trades at an 11.5% 2012 FCF yield and should trade at 7-8%, offering 50% upside to 550p.

 

Company Description

Playtech is a provider of online gaming software and does not offer its own direct B2C online gaming product. The company offers online gaming companies a completely turnkey Casino, Poker, Bingo and Sports (very recent with only one licensee) product in which operators can effectively scale their backend with other gaming operators while branding the skin of the product themselves. Playtech innovates through new products and its IMS (information management software) which helps an operator manage marketing, products and player retention through CRM tools and individual product/player monitoring to most efficiently provide the best products to different types of players. Playtech has 80 or so licensees and derives revenue through royalty fees from its licensees, usually in the high single digit percent of net revenue with licensing agreements lasting five to ten years.

 

Casino is the company's largest revenue stream. Its product portfolio consists of over 200 downloadable games and 125 flash games. The games consist of online slot machines, card/table games, arcade, video poker and even live dealer games in which dealers in their Estonia facility deal cards to players for a similar look and feel to a casino. The value in their product lies in PTEC's ability to customize games based on languages (30), currencies (50) and cultures-they have agreements with Marvel, Paramount, MGM, Universal and others for licensing games based on movies and comics and also have games tailored to Asian preferences.  

 

PTEC offers poker through its iPoker network, the most liquid non-US facing poker site after PRTY/BWIN. iPoker's scale in combining all of its licensees poker players into a single network adds a significant network effect to the segment, i.e. players in the UK can play against players in Spain regardless of which licensee's site they are on; hence the more players on at a single time, the greater variety a player has in finding their preferred game. However, while iPoker has scale benefits over smaller operators, the site is not US facing like PokerStars and Full Tilt. As such, they cannot compete with the liquidity offered by these two sites given the large number of players in the US. This has been hurting PTEC and each of the other European operators that are not operating illegally in the US (I can get into the specifics here on the message board since there's a lot of details to UIGEA and the European operators pulling out of the US and a current attempt by the DOJ to crack down on PokerStars and Full Tilt's US operations.) The other benefit to PTEC's scale in poker is that it allows bonuses to be pooled among its licensees in order to attract higher stake players.

 

PTEC Bingo product that scales across operators to offer larger prizes and provides a social element to the product with chat rooms. The company acquired Virtue Fusion in 2/2010 to scale its Bingo product across a larger base of licensees and boost its product offering.

 

PTEC just recently launched its sports product and has only one licensee. It is still testing the product before offering it mainstream, which speaks to management's focus on providing products to its licensee base only after they have been well tested internally.

 

PTEC's recently began offering a software product to be used in VLTs (video lottery terminals) which are gaining in popularity across Europe as countries are allowing them in new venues to increase tax revenue. PTEC currently has a large market position in the UK through contracts with Ladbrokes and William Hill. Greece and Italy are both substantially increasing the number of VLTs present which could provide additional opportunities to PTEC.

 

Through its 50/50 JV with Scientific Games, SGMS, called Sciplay, PTEC is looking to offer its software expertise to government lottery contracts in the US, Europe and Asia.

 

The last component to the business is PTEC's 29% ownership in WHO, William Hill Online. PTEC purchased an online gaming company in 2008 which it sold to William Hill for a 29% interest in William Hill Online. PTEC has an exclusive contract to supply software services to WHO until 2018 and an option to sell its interest to William Hill in the future for an undisclosed amount.

 

Why is the Company Misvalued? Question I like to ask of every investment.

 

• Fears of continuing market regulation in Europe

Take a look at BaileyB's PRTY writeup message board for some background on the regulation of online gaming in Europe. As we've seen so far in Italy and France, online gaming is regulating to increase tax revenue for countries while also fulfilling recent rulings by the ECB that countries must allow online gaming companies to operate and cannot let state owned gaming companies run monopolies. As such, Spain, Greece and Germany have all discussed regulating sometime in the next three years. The risk in regulation is that when regulating, countries are adding such burdensome tax regimes that companies that previously operated in a country profitably must now pay such a high tax that EBITDA declines to zero. This has happened in Italy initially (until taxes were reduced) and is currently happening in France. The market assumes that Greece, Germany and Spain will follow France's tax policy which will reduce earnings to zero for each operator.

 

While this is a risk to each of the B2C facing sites, there are a couple reasons why the market is overreacting for PTEC. France was PTEC's largest regulated market at 10% of revenue before regulation. We saw this decline in 2010 and result in 4-5m gbp in EBITDA losses in 2010 that we won't see in 2011. Germany, Spain and Greece represent 5-6%, 2-3% and 1-2% of revenue/EBITDA for the company, so our worst case outcome is 10% of EBITDA is at risk in total sometime between 2012 and 2013, assuming all of those countries introduce a tax at the same rate as France. Nevertheless, while France structured its tax to protect its local monopoly for the first year to transition into a competitive online gaming company, the German, Spanish and Greek regulators have given hints that they will structure their tax to increase tax revenue (from France's tax, online gaming declined 50% in the country, thus the high tax put them far from the point of revenue maximization on the Laffer curve). Also, while the initial business decline results in lost revenue for PTEC, they derive revenue as a % of their licensees' revenue, hence while licensing fees might contract through a reduction in the licensing rate and lower revenue from operators pulling out, there is no risk to negative margins from regulated markets. Finally, PTEC benefits from their business model in regulated markets, which is the key benefit here. RAY, the local monopoly in Finland that had no online gaming offering recently signed up for PTEC's service and now has a robust offering that should add 2m gbp in incremental EBITDA for PTEC. Similarly, in anticipating the market opening up, Casino Gran Madrid began using PTEC's products for their online offering. Similarly, Titan in France (offsetting some of French decline) and SNAI in Italy have done the same. I will get into specifics in my valuation section, but I believe PTEC's position as the only software provider offers significant benefit to monopolies in regulated markets with no expertise in online gaming.

 

• Declines in Poker from US facing sites

This risk is real, but has recently been partially stemmed by regulation. The US facing sites have many more customers (can be monitored at pokerscout.com) and this presents a real risk as European customers shift off of iPoker onto PokerStars to take advantage of the greater player liquidity. As such, poker revenue has been declining over the last couple years. However, while we expect these declines to continue, ceteris paribus, regulated markets are ring fenced, meaning players in Italy cannot play against others worldwide. This has resulted in some reduction in players in regulated markets attrition to US facing sites. iPoker has decent positions in Italy and France.

 

• Affiliate Call Options

Perhaps the greatest reason the stock is down recently and heavily undervalued is the misconception behind a call option PTEC has to acquire certain affiliates by March 20^th. When PTEC initially did its IPO, its bankers suggested that the software only piece of the business would receive the highest multiple, the it should be separated out from other interests within the company and the software business should just be floated with a call option to potentially add the other businesses with a five year expiry. There is very little known about these affiliated businesses, thus the market is afraid that they are B2C businesses (which would create a conflict with PTEC licensees) and that they will be purchased at such a high price that PTEC will have to issue shares and dilute equity holders. Moreover, the market is afraid that PTEC will overpay because these affiliates are owned by Teddy Sagi, the founder of PTEC who has a shady past and is PTEC's largest shareholder.

 

In terms of debunking the misconceptions, I would say, first, that the only affiliate previously acquired was the only B2C business which was merged into WHO (described above). The was a great deal for PTEC shareholders since the business was acquired for 187m gbp and is adding 30m gbp in pre-tax cash flow to PTEC in 2010 or a 16% yield and is growing significantly. Moreover, none of the other affiliates are B2C facing, they offer network management services, payment processing services, call center services and affiliate marketing. Moreover, many of PTEC's currently licensees are already using these services and they add a more robust offering for PTEC's gaining new customers in regulated markets. While we don't know the exact purchase price, management has mentioned in the past that these options are structured to purchase the affiliates for 5-6x EBIT and for 200-300m gbp total. While the company does not have enough cash on the balance sheet to fund these purchases, we do not know if they will acquire all of them, could easily issue a small amount of debt for payment or structure an earnout. There's no certainty that they will issue equity and if we are correct on the multiples to be paid, even if they did, it would be accretive to earnings. While Teddy Sagi has a sordid past, he is not involved, day to day, in the business (no board seat) and as we've seen with the affiliate purchased in the past and put into WHO, the price paid was very profitable to PTEC shareholders.

 

• Technical Factors

Because of the rumors surrounding the above information, many UK hedge funds which tend to play momentum and jump on herd short trades in small size have been shorting the stock and spreading unfounded rumours about the company. Moreover, from a trading perspective, we've learned that there was a shift in personnel at Fidelity in London and while their former media analyst liked online gaming, the new one does not and has been selling the stock, hence additional mispricing of the equity.

 

Because of each of the reasons above, the stock is misvalued. However, PTEC is in a pretty good position to benefit from regulated markets and offers the best service/products in online gaming and has virtually no competition from anyone offering a full spectrum of products/services. They have a great base of licensees, Titan, William Hill, Paddy Power, bet365, Betfred, Betfair, Virgin, SNAI, Centrebet and Sisal, among others. The common thread is that each of these operators are very successful in their own proprietary products/brand names but recognize the value in offering additional products to capture the cross selling and further recognize PTEC is the best in these tertiary products. Of the list above, William Hill, Paddy Power, bet365 and Betfair are all some of the best online sports companies in the world but supplement their offerings through PTEC casino, poker and bingo products. Similarly, some of the others are the most well known land based operators in their countries but recognize the value of outsourcing online to PTEC.

 

Further, while I am not looking at the valuing the US market in my price target, I believe it offers a massive free option. Each bill in the US, Reid's federal bill, Lesniak's NJ bill and Wright's CA bill all ensure US based operators are given preference for licenses. This puts the European B2C operators at a disadvantage, however PTEC's robust software offering brings them the same value in a regulated US market as it does in regulated European markets. If offer the ability to provide a seamless backend integration for any US operator looking to offer online gaming products.

Valuation

From a valuation perspective, I can get into specifics on the message board, but I am assuming continual declines in poker along the lines of the last few years, mid single digit annual revenue declines, but, as discussed above, we might see some relief from regulated markets being ring fenced.

 

In casino, we look for low double digit revenue growth (12%) along the lines of H2 Gaming estimates (this is conservative because casino is expected to grow faster than sports or poker).

 

The bingo market is small and growing rapidly, so we assume 20% growth in 2011 and 9% growth in 2012 in bingo.

 

For WHO, we assume 11% revenue growth in 2011 which drops to 9% in 2012.

 

From an opex perspective, PTEC has never disclosed its fixed vs. variable cost basis and this is one of the issues we've felt has been a risk for the company. While we would assume the engineering base is fixed, the company has increased the number of engineers so we haven't seen much leverage of the fixed cost base in the past, which is a concern. However, management has said the increase in the past was due to a few acquisitions as well as tailoring their product offering for regulated markets and we shouldn't see more of an increase in the number of engineers going forward. As such, we assume slight incremental EBITDA margin benefits of 70% vs. current 59% EBITDA margins in the business.

 

This gets us to 206m gbp in 2012 revenue and 125m in EBITDA. In terms of regulated market risk, we assume that by 2012, 10% of revenue/EBITDA is lost through Greece, Germany and Spain. However, aside from our revenue growth from existing licensees (factored in above), new licensees recently announced will add additional incremental EBITDA for the company. Based on discussions with the company, we expect RAY in Finland to add 2m GBP, the addition of Italian casino games and cash poker (being introduced in March/April 2011) to add 5m gbp, new services sold to Betfair to add 2m gbp, Scandinavian bingo being sold to Unibet to add 1m gbp and new business to Titan adding 1m gbp or a total of 11m gbp from new licensees that should offset regulated market declines. This only includes signed contracts and does not include additional new licensees the company should add from regulation in Greece, Germany and Spain.

 

With 3m in taxes and 6m in capex, we get to 114m gbp in FCF, not attributing any value to the Scipplay JV or the videobet business. This a 11.5% yield on EV for a business that should be trading for a 7-8% yield given the lack of competing products, great placement in regulated markets and growth from current licensee revenue and incremental revenue from new licensees. A 7.5% FCF yield on EV would put the business at 550p or 50% upside. However, we are not including the purchase of affiliates in our price target or financials because we are not fully sure of the size and whether or not the company will actually acquire them before March 20^th. We believe that's a bet on management's ability to allocate capital, which through the WHO affiliate acquisition, they have shown to be savvy.

 

Catalysts

The company is currently looking for a new CFO. Our checks show they are very close to finding a CFO which is their last constraint before moving from the AIM to the main market. Their re-listing will allow them to be included in the FTSE index and should cause certain large mutual funds that are unable to invest in the AIM to invest in PTEC. If we look at SBT as an example, their move to the main market and inclusion in the index resulted in a pretty significant stock price move at the end of September 2010. 

The company is currently looking for a new CFO. Our checks show they are very close to finding a CFO which is their last constraint before moving from the AIM to the main market. Their re-listing will allow them to be included in the FTSE index and should cause certain large mutual funds that are unable to invest in the AIM to invest in PTEC. If we look at SBT as an example, their move to the main market and inclusion in the index resulted in a pretty significant stock price move at the end of September 2010.