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Playtech - Undeservedly Sold Down and Glaringly Cheap

October 18, 2011 | About:
Price – 266p

Market Cap
– £647m

2011 EPS
– 31p

2011 P/E Ratio – 8.5x

Div Yield – 3.5%

2011 Rev – £171m

2011 EBIT - £42m

2011 FCF- £53m

Net Cash on B/S – £85m (13% of market cap)

EBITDA Margin – 60%

Playtech Ltd. is the market leader in providing online casino, poker and bingo betting software, operations and marketing services to the global online betting industry. PTEC is the dominant player in the field with their “one-stop shop” turnkey service of hosting, Client Relationship Management, Support, Finance and Software proving very attractive to new entrants to Online Gaming. PTEC’s customers get to share back-end support functions which allows them to leverage scale. Furthermore PTEC customers get to share “user liquidity”, i.e., customers of ALL PTEC customers, whilst branding the software skin with their own content giving the impression of a unique product to end users. For clarification, it is quite possible you could be on Betfair Poker playing against someone on Paddy Power Poker without knowing it and vice versa – all thanks to Playtech’s smooth intermediating.

Since inception PTEC has only had one customer leave their services for another provider. It is very difficult for an online casino to leave PTEC’s software without materially affecting its own customers due to the complications of switching back office services and online “fascias” smoothly without disruption. This powerful market positioning, along with it’s prodigious FCF generation justifies it’s historical valuation premium to the sector – a premium which has now been eroded and more. In addition to its main business PTEC also owns a 29% stake in William Hill Online.

Industry

The industry has been under pressure as Europe, the source of the majority of industry revenue, has been gradually regulating online gambling one country at a time. As a country moves from unregulated to regulated, two shifts occur:

1) The profitability and market share of the pre-regulation leaders falls.

2) The existing land based casinos join the online fray and establish new meaningful market share positions.

While most of the listed online casino firms are clear losers due to regulation and markets opening up to more competitors, PTEC is able to gain new customers as the software provider to the new entrants that have no software development abilities. PTEC will be able to maintain its overall market share in an industry that will continue to grow at attractive rates, well in excess of GDP, for the foreseeable future due to demographics (I’ve never been to a betting shop), broadband penetration and increases in televised sports.

PTEC is the market leader – they provide services for a dazzling array of the big names (Paddy Power, Betfair, William Hill (where they own a stake)). However, there are competitors. Bwin Party Digital Entertainment are the biggest but they are not a pure services play – that company also owns PartyPoker the website. 888 Holdings also offers B2B services through its Dragonfish platform.

One of the most instructive points I’ve heard on this came from my discussions with a sell-side analyst. He said that it is incredibly sticky business, PTEC clients DO NOT leave, it is just too difficult to do without disrupting (and angering) your end customers.

Variant Perception – It is always encouraging when you can define where/why your view differs from the market and why you might be right. I think PTEC has been unfairly marked down with the rest of the gambling industry due to the overhang of regulation in much of Europe. Markets HATE uncertainty and this ongoing sage provides it in spades. What I am choosing to focus on is that PTEC doesn't necessarily need to suffer from an increased number or participants in online gambling but instead benefits from new potential customers

Business

PTEC has very high EBITDA margins (50+ %), minimal capex (capex/sales circa 5%), and pays minimal taxes of around 1% per annum due to Isle of Man base. Thus, FCF conversion is extremely high (often in excess of 100%).

PTEC has materially better prospects than the traditional gambling companies. PTEC derives revenue through a revenue share agreement with its circa 80 customers. There is, however, a fairly strong concentration of these revenues with the top two producing 39% of revenue and the top 15 producing 74%.

As a free option, the opening of the U.S. online gaming market would be a huge catalyst for PTEC. As firms rush to establish first mover advantage, PTEC would most likely pick up large market share position as a third party provider of gaming software to the U.S. online industry. Before the U.S. Justice Department shut down online gaming in 2006, the U.S. online gaming market was estimated to be 40- 50% of the global online industry. There is nothing for the emergence of the U.S. market in the current price. Longer term we could also say there is a lottery ticket for online gambling in Asia too. If you were an Asian casino operator moving into a new unregulated online gambling industry, it would make sense to look to team up with the incumbent market leader for software and support services for efficiency, user liquidity and professionalism's sake.

Operating Momentum - Two recent “wins” include the purchase of Mobenga, which provides sports betting services for mobile phones. This will be a new avenue for growth and broaden/deepen their product offering. They added a long-term license with Gala to their list of customers. This will become a top 5 contract as of next year – the share price reaction has been negative! On October 3, Playtech announced that Paddy Power has migrated its casino gaming to PTEC to join the existing Poker and Bingo provision contracts already in place. Amazingly, all this operating momentum seems to be doing little for the share price!

Valuation

Despite this attractive positioning the equity is priced for disaster. At today’s 266p they are 8.5 times 2011E with the earnings growing conservatively at high single digits per annum. They are paying a 3% dividend which is covered 4 times. (There is an interesting story to this covered below.)

There is circa 25p a share of cash on the balance sheet with zero significant debt outstanding. This strikes me as an exceptionally cheap price for a company with a track record of EPS CAGR at 30% since 2004 and a whole bunch of structural growth catalysts on its near-term horizon.

Conservatively, if we were to imagine that PTEC returns to a very undemanding 10 times earnings over the next year:

2012E should be 35p x 10 = 350p plus the 25p net cash takes us to 375p which is 41% above the current share price.

Of course, with the power of buybacks being correctly utilized at these rock-bottom prices, there could be some serious long-term value creation and earnings enhancement. At the current price, I believe Playtech offers a very attractive skewed risk/reward investment. It could, in fair weather, easily be a 500p stock.

Recent Results -

Cash flow was strong, but PTEC has chosen to defer a decision on the interim dividend, to conserve cash given “exceptional joint venture and near term acquisition opportunities currently under discussion in certain key markets,” particularly in the context of weak financial markets this could prove long-term value accretive (although I would prefer a buyback or increased dividend). If they were to pull off another William Hill Online type deal then this could be very beneficial for the stock.

The problem here is the confused message from management: Previously they indicated at 307p that they thought the stock was substantially below intrinsic value and would look to repurchase circa 10% of shares. Now there has been a volte face and attractive opportunities lie elsewhere. Now we might discount this under Keyne’s “When the facts change, I change my mind, sir; what do you do?” but under most circumstances the market prefers a consistent message from management.

Recession Proof? -

PTEC is relatively defensive because its revenues are linked to the pre-marketing revenues of its competitors; this makes it immune to competition within the industry between companies. If they wish to scrap it out for market share by spending on advertising that doesn’t affect PTEC revenues. Furthermore, the gambling industry itself is defensive, whilst revenues were dampened online during the recession, the structural growth of increased broadband penetration and more televised sport are still coming through.

Ownership

Teddy Sagi, the founder of Playtech, still owns 40% of the shares outstanding. I love it when I can invest alongside an owner-operator, as you know interests are aligned. However, with Teddy it’s not quite so simple. Teddy Sagi was convicted for his part in the 1996 “Discount Affair” stock manipulation case. Sagi is also involved in the credit card clearing business, in particular for casino and gambling sites, as well as adult content websites. He is, however, a proven entrepreneur at No. 993 on the Forbes Rich List and also owns instant messaging service Messenger Plus. There are worries amongst some institutions that “Teddy” uses PTEC to do what is best for him and not what is best for shareholders in general.

Far more encouragingly, a glance at the shareholder register shows David Einhorn's hedge fund, Greenlight Capital, owns 3.6% of the company. Now although David Einhorn is a known Poker lover and this may be somewhat of a pet project, we can take comfort that if it’s in the Greenlight portfolio it must look very attractive to him. His purchases were made circa 300p. Other owners I'm aware of are, or have recently been, Odey Asset Management and Teton Capital Partners.

One potential reason for the sharp share price decline over the last 12 months was apparently the gambling analyst at Fidelity changed from someone who was pro PTEC to someone who hated it, resulting in the stock being sold down across their funds. I can’t substantiate this, but it might go some way to explain it if they were liquidating what would have been an insignificant position for an institution of that scale.

About the author:

Kelpie Capital
UK based value investor. Law Degree, Investment Management Certificate, Completed all 3 Levels of CFA, will complete Practical History of Financial Markets at Edinburgh Business School in 2012.

Visit Kelpie Capital 's Website


Rating: 3.4/5 (9 votes)

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