We believe bwin.party is an attractive long investment with very limited downside risk due to a number of overhangs that are poorly understood in the market and in or view fully priced in.

Bwin.party owns and operates some of the best known franchises across the various online gambling verticals including Bwin, PartyCasino , PartyPoker, Foxy Bingo, gioco digitale (Italy). Unlike most operators that license technology from third parties and just apply their own brand skins to it, BPTY develops its own technology platforms and proprietary games. This allows for a differentiated offering to customers ,primarily in casino (the fastest growing and highest margin vertical) and sports betting (including the company’s in house sports video streaming rights unit, sportsman holdings).

Online gambling is an attractive business that enjoys secular growth tailwinds (broadband penetration, e-commerce adoption, smartphone growth, product innovation such as in-play betting, governments looking for tax revenue, growing penetration as % of total gambling spend), low capex requirements (2-3% of revenue), negative working capital and high barriers to entry (large player pools required for poker, casino (jackpots), scale to offset compliance and tax burden in regulated markets, technology, experience in marketing and player appetite for types of games).

The company is expected to earn roughly €165m in EBITDA this year (note that most taxes are paid above the EBITDA line so this is a relatively close benchmark to cash earnings pre-capex).  We estimate the year end cash balance will be around €175m so EV is around €800m or 4.8x EV/EBITDA and roughly 16% FCF/EV. Over the past 12 months BPTY has paid out €30m in dividends and repurchased €70m of its own shares.

The bear arguments:

• Germany is their largest market and they might have to exit which will destroy profitability
• They can’t make money in regulated markets and eventually every country will regulate this industry and they will be out of business
• They are losing market share as peers are showing faster growth, particularly in the past year
• They are desperately shoving money into social gaming
• The U.S. opportunity is gone now that PokerStars has settled with the DOJ.

Let’s take them one-by-one:

Germany

Last year BPTY generated €180m in net revenue from Germany where the Bwin brand is the market leader with an estimated 20%-30% market share. 15 out of 16 German states have agreed a treaty that went into effect in July which bans all forms of online gambling except sports betting for which the states will issue up to 20 licences. Those licenses are likely to go primarily to regional lotteries and the likes. In addition, the national government has adopted an unfavourable tax regime that all sports betting operators are required to comply with (regardless of whether the operator is licensed by the 15 states treaty). It calls for players to pay 5% tax on wagers placed. The above in conjunction with BPTY’s reluctance to single out its EBITDA level in Germany is causing a tremendous amount of anxiety around the company’s share price.

At the moment BPTY has started to comply with the 5% sports wagers tax as this is a federal law, but continuous to offer all games despite the 15 states treaty on the basis that:

1. The company believes the treaty contradicts EU law (the EC has voiced various concerns around the restrictions) which supersedes the treaty
2. The company holds several licenses including an old East German license and a sports betting license from the 16^th state, Schleswig-Holstein, which they believe can be used to accept players from around the country. In addition, despite S-H’s new local government’s desire to repeal the licenses it issued and join the other 15 states, we expect that BPTY will receive a casino and poker license from S-H shortly as the state complies with its existing law (approved by the EC)

The company is currently passing on the majority of the sports wagers tax to players by deducting it from winnings. However, this will impact player activity as available funds for wager recycling are reduced and some players leave bwin to join offshore operators that don’t comply with the new taxes. Therefore, we estimate the current annualized impact from the German situation at approximately €40m-€50m. If for whatever reason the company ends up exiting the German poker and casino market (if somehow S-H joins the state treaty and it is ratified by the ECJ) we estimate the impact to be double the current level. Note that this assumes no change in the company’s cost structure, i.e. all fixed costs are kept (and growing) so that only the variable costs disappear. In 2011, BPTY generated underlying pro-forma (bwin and partygaming merger completed in 1Q11) EBITDA of €200m. This included €23m of the €65m in identified synergies from the merger.  In addition, during its ful year results presentation the company announced that it has identified an additional €10-€15m of cost savings in Germany specifically that will be realised during 2012 and 2013. Therefore, all else being equal, if the company exits Germany by 2014, they should still be able to generate more than €150m in EBITDA before any further cost rationalisation in Germany (which definitely exists if they had to exit the business). Not so far off the current FY12 estimate. However, it is in our view far more likely that they will continue to operate in Germany profitably for a long time and that eventually regulations will adapt as it becomes more obvious that banning offshore operators is simply ineffective. In addition, as many smaller players exit the market (several have already done so) we expect that BPTY will gain market share of the regulated pie which will partially offset the volume declines discussed above.

Other Regulated Markets

We believe regulated markets are attractive over the long-term. Clearly, if you have an established revenue and earnings base and this suddenly gets taxed you take a hit. However, established operators in regulated markets tend thrive over time because:

1. Market shares are higher as small players are squeezed out by heavy licensing, compliance and marketing budgets
2. The market grows as marketing restrictions are eased and the government and operators’ interests are now aligned to grow the market. To illustrate, the Italian market grew fivefold in the first 4 years since it regulated. In France, BPTY’s revenue already exceeds pre-regulation levels despite having had to exit casino (its largest vertical) and a high tax rate driving players to offshore sites.

The bear case rests on all markets regulating simultaneously and BPTY not being able to cope with the initial hit.  The reality however is that post Germany, all BPTY’s large markets are now regulated including France, Spain, Denmark, U.K. (will start paying tax in Dec. ’14) and Italy. The rest will follow over time, but it will come in small, slow increments so the risk of everything hitting simultaneously is non-existent in our view and by the time everyone converges to a sound regulatory and taxation framework (the EU is currently working on an EU wide recommendation) BPTY will have time to grow its already regulated markets into substantial profitability.

Losing Market Share

Over the past year, other listed online gambling firms have been reporting higher growth than BPTY whose overall top line has been roughly flat. This has led many to argue that they are losing market share in key markets.  We believe this is true but only to a small extent and it is likely temporary as management was focused primarily on merger integration and cost cutting during the past year. In fact, in 2010, the year before the merger was completed, net revenue grew 17%

We explain the underperformance as follows:

• There is a major difference in geographic split between BPTY which is well diversified across the world and listed peers such as William Hill, Paddy Power and 888 which generate the vast majority of their revenues from the UK (accounts for ~10% of BPTY).  BPTY has been suffering revenue declines in Southern European markets where the others have little to no presence due to economic hardship rather than market share losses.
• BPTY generates almost a third of revenue from poker where everyone is suffering. Margins in poker a far lower than the rest of the business (14% vs 25% in sports, 32% in Bingo and 35% in casino). Therefore, Poker accounts for only 14% of earnings versus 76% from casino and sports (10% Bingo).  Poker net revenue was down -7% last year and is continuing to decline.
• In sports betting BPTY managed to keep net revenue flat over a 30% comp from the previous year where there was a world cup. This is a good performance but makes overall revenue growth look meagre
• Finally, in 2010 BPTY was the first mover into the Italian Bingo market so it had 100% market share. As other players started to enter this market they lost share and revenue declined -11%
• Casino, the only vertical that was not affected by an inflated base grew 9% last year, despite the fact that the first 6 months of 2010 still included the French casino business which they exited. 

These are clearly many issues, but we think they are mostly temporary and growth may reaccelerate soon.

Investing in Social Gaming

They are investing ~€30m over 2 years (fully expensed btw). This is considerably less than what most participants have spent. In addition, they have hired a seemingly strong team with a proven track record in social gambling applications. They clearly stated that this is a 2 year project. After that, either it generates revenues and covers the costs or it will be shut down. Given BPTY’s experience and expertise in real money games and the millions of people visiting the company’s  various sites that don’t have access to real money play for legal reasons, we think that giving this a shot makes sense.

PokerStars and the U.S. opportunity

This is not the place to open a discussion as to what will happen in the U.S. However, it appears that some people think the U.S. option has become worthless since PokerStars settled with the DOJ. We think this is complete nonsense for several reasons including:

• While PokerStars will be eligible to apply for license, there is no way it can receive one as long as its principals are still being prosecuted (they were not part of the settlement)
• Various state legislation proposals (including the current California bill, the most important poker state) clearly state that entities that accepted U.S. players post 2006 are not eligible for a license
• In the case of state-by-state licensing (as seems most likely) state legislation and application eligibility will be determined by the existing local players who want to protect their turf (see the current dispute between tribes and race tracks in California). It is in no one’s interest to allow PokerStars in as everyone knows that they will dominate that market and hence incumbents will lose share
• Even in Europe, where PokerStars dominates, BPTY generates $300m in annual net revenue from poker. The U.S. market should be at least double this size if regulated and suggested tax rates are half of what they are in Europe.
• Finally, various states (e.g. New Jersey) are considering introducing other games in addition poker such as casino and bingo. PokerStars does not exist in those verticals and BPTY is the market leader

Note that everyone agrees that BPTY’s current share price does not embed any value for the U.S. option. Also note that very few existing operators will play any role whatsoever in the U.S. market as the only ones that have anything to offer to incumbents (the future license holders) are those who have proprietary technology. In casino this includes BPTY, 888, Playtech, Microgaming and maybe 1 or 2 tiny guys. That’s it! In Poker there are a couple more. No one else from the existing players (all trading at premium relative valuations) will be present in the largest online gaming market to be.

Conclusion:

This is a very attractive risk-reward situation because the market seems to significantly overstate the near term earnings risks and completely ignores the possibility that there may actually be regulatory and growth upside in the future. This year, despite paying roughly €50m more in taxes vs last year and spending €15m more in opex for the social gaming initiative, EBITDA will be down ~€30m or half the hit as the cost base continues to improve. If we can add growth into the equation again (as poker plateaus or becomes decreasingly meaningful and newly regulated markets grow) on top of further synergies now that the largest markets are already taxed, then earnings and free cash flow will grow again driving multiple expansion. Note that by next year more than half the company’s revenue will be derived from regulated markets which in itself demands multiple expansion as the story derisks. Also note that Paddy Power which prides itself on being 100% regulated currently trades at 15x current year EV/EBITDA or 3x BPTY’s multiple.

In the mean time, the company is paying a 3%-4% dividend and actively repurchasing stock, further enhancing the future value of remaining holders. We are happy to wait.

• BPTY may receive a poker and casino license from Schleswig-Holstein reducing the risk of total exit from Germany
• Regulations in the U.S
• The sale of Ongame poker platform
• Showing reaccelerating growth rates
• BPTY might be a takeover target for someone looking for an accretive way to acquire top tier online gaming technology