As the undisputed leader in the high-growth online casino gaming market, Evolution AB (EVVTY, Financial) (OSTO:EVO, Financial) has crafted an ingenious business model that has enabled it to deliver exceptional growth and profitability over the past decade. With its innovative games and strong partnerships with online casinos, the Swedish company's historical valuation has always been high. However, at the current price, a long-term outlook suggests the potential for further upside.
A recurring revenue model that thrives on operator success
Evolution derives most of its revenue from commission fees associated with both live and random number generator casino games. This commission is a fraction of winnings made via the company's casino services. Thus, the company would thrive when its partnered operators succeed. If any operators go bankrupt, the company would be unaffected because of its diverse customer base. Evolution has standard agreements with casino operators, providing them access to generic tables and streaming, but there are more intricate packages that offer tailored tables, VIP services, native-speaking dealers and other personalization. These customized services help their partnered operators provide a unique gaming experience to increase user retention and attraction. Apart from one-time set-up fees, dedicated table fees are charged monthly to operators wanting exclusive tables tailored to their specifications. Fees for these tables vary based on game type, table number and active hours.
Since the majority of Evolution's clientele comprises online casinos—which inherently have lower operating costs, fewer staff and fewer expansion constraints compared to land-based casinos—the company can capitalize on this. Furthermore, Evolution's commitment to innovation ensures its casino games stand out as more engaging than those of its competitors. Their aim is to craft games so captivating that players view them as akin to watching a television game show. Moreover, Evolution's efficient cost structure enables it to offer games with a higher return-to-player percentage, making them more appealing to players. This attracts more users to casinos powered by Evolution's platform, subsequently increasing player loyalty to the company's games.
Impressive growth and profitability powered by a capital-efficient model
The company has demonstrated significant growth in revenue, operating income and free cash flow over the past 10 years. Since 2012, revenue has surged from 31.27 million euros ($33.03 million) to almost 1.46 billion euros, representing a compounded annual growth rate of 41.8%. During the same period, its operating income rose from a modest 9.44 million euros to 908 million euros, a CAGR of approximately 51.45%. Its free cash flow also experienced a substantial increase, jumping 100 times from 8 million euros to nearly 817 million euros in 2022.
Remarkably, Evolution has achieved its results with minimal capital expenditures. Over the past 10 years, the average ratio of capital expenditure to revenue has been a mere 6.5%. Since 2020, this ratio has consistently ranged between 3.12% and 4.16%. Consequently, Evolution has consistently generated a high return on capital over the years.
Between 2012 and 2019, the return on capital remained high, fluctuating in the range of 47.64% and 70%. However, in 2020, it dipped to a low of 10.68%. This significant decline was not due to weaker operating performance, but rather resulted from an increase in shareholders' equity, brought on by the addition of nearly 2.6 billion euros in goodwill and intangibles in 2020. This was a direct consequence of acquiring online slot game supplier NetEnt in the same year. Since then, the return on capital has been on an upward trajectory, touching nearly 25.2% in 2022. This trend highlights the effectiveness of Evolution's business model and the successful integration of its acquisitions.
Furthermore, Evolution has consistently achieved strong profitability over the years with little leverage. Although the Ebit-to-interest expense ratio has consistently remained in the three-digit range, the company has continually increased its cash reserves.
As of September, Evolution held 813.3 million euros in cash and cash equivalents, with no short-term or long-term debt. The company only had minor short-term capital lease obligations amounting to 14.42 million euros and an additional 65.71 million euros in capital leases.
Strong growth prospects in a rapidly expanding market
Moving forward, as the market leader in the rapidly expanding online casino industry, Evolution is poised for further success. Over the last five years, the global online casino market has grown at an impressive annual rate of 20%. Notably, live casino stands out as the fastest-growing segment, boasting a 21.5% compounded annual growth rate. By 2030, the online gambling market is projected to hit $153.57 billion, marking an 11.7% increase from 2023. Riding this upward trajectory, Evolution remains committed to innovation, continuously introducing engaging games to captivate more players, expand its market share and foster greater player loyalty.
Upside potential
Quality often comes at a cost. Overpaying for an exceptional business can undermine the very benefits of the investment. As Warren Buffett (Trades, Portfolio) insightfully remarked in his 1982 shareholder letter, “For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”
Historically, Evolution has carried an extremely high premium valuation. In April 2021, its valuation soared to highs of 53.7 times its revenue and 100 times its Ebit, with average figures hovering around 17.2 times revenue and roughly 39 times Ebit. Currently, an Evolution share is priced at 1,053.6 Swedish krona ($94.21), valuing the entire company at 225.1 billion krona. The market's assessment places Evolution at 10.9 times its revenue and 17.38 times its Ebit, which is only marginally above its record low Ebit multiple of 17.22.
Over the last five years, Evolution has impressively expanded its free cash flow from 82 million euros in 2018 to 817 million euros in 2022, marking an annual growth rate of approximately 58.4%. Projecting forward, if we conservatively estimate Evolution's free cash flow to grow at a rate of 25% for the next five years, and then stabilize at a terminal growth rate of 2%, using an 8% discount rate, we derive a fair valuation for Evolution at 395.4 billion krona. Given that there are 213.66 million shares outstanding, this evaluation suggests a fair share price of approximately 1,850.6 krona, indicating a potential upside of 75%.
Source: Author's table
Key takeaway
Evolution AB has built an extremely successful business model in the high-growth online casino gaming industry. Its recurring revenue model based on operator success, impressive growth and profitability powered by a capital-efficient structure and strong growth prospects in an expanding market all point to continued success. While the company has historically traded at a premium valuation, current prices present a compelling opportunity. The above discounted cash flow analysis suggests the shares could have 75% upside to reach a fair valuation of 1,850 krona.
Given Evolution's business models with innovative games, strong balance sheet and the immense growth projected in online gambling, the company appears well-positioned to continue generating exceptional returns. Investors with a long-term horizon could benefit from seizing this chance to acquire shares in this remarkable company at an attractive valuation.
