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oelman44
oelman44
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Value Idea Contest: The Stars Group Is Significantly Undervalued

At its current valuation, the market is significantly undervaluing company's growth potential in the online gambling market

January 11, 2019 | About:

At its Thursday price of $18.75 per share, The Stars Group Inc. (TSG) is significantly undervalued, and I am recommending the stock as a long.

The Stars Group is one of the largest publicly listed online gambling companies in the word, and is expected to do revenue of $2.1 billion and Ebitda of $785 million in 2018. The group's revenue is split roughly evenly between its three major verticals: poker (37%), sports betting (34%) and casino games (26%). The Stars Group's core products include PokerStars, the global leader in the online poker market; SkyBet, one of the largest sportsbooks in the U.K. BetEasy, its Australia sports betting offering, and other sportsbooks and casinos.

The company also hosts live-poker events and tournaments under their globally recognized PokerStars brand, but outside of this, the company has no land-based gambling offerings. This makes the company unique from many of it competitors in the gambling space, and them one of the best positioned to benefit from the expanding online gambling market.

The Stars Group trades at an underwhelming valuation for various reasons. First, the online poker industry, while steady, has been in a state of long-term stagnation. The company just recently diversified away from poker, and from my view, the market has been slow to recognize that The Stars Group is no longer a "poker company." Second, it is still dealing with reputation issues due to past management, but these problems should hopefully be and remain in the rearview.

Company history

A Canadian micro-cap formerly known as Amaya Gaming was formed when the group purchased the parent companies of PokerStars and Full-Tilt Poker, the two largest online poker providers in the world, in 2014. The company combined the two under the PokerStars brand, becoming the largest publicly traded online gambling company and taking a dominant position on the online poker industry (currently with a 65% market share).

The company has legacy issues, as mentioned above. When it was still known as Amaya, former CEO David Baazov faced several securities fraud allegations from Canadian regulators. But the company has rebranded and transformed since Rafael Ashkenazi took over as CEO in 2016. Ashkenazi has considerable industry experience; he was managing PokerStars under the Rational Group long before the company was purchased by Amaya, and has come across as competent and measured with a clear vision for the company in conference calls. So far, he has done a great job of rebuilding the repuation of the group's brand, transitioning its revenue profile into regulated markets, increasing compliance and regulatory oversight, forming beneficial media partnerships, and even becoming an industry leader in initiatives like responsible gaming.

The company also recently received a favorable ruling in a pending $870-million lawsuit levied by the Commonwealth of Kentucky back when PokerStars, under Amaya, was operating in America's "dark" market. Kentucky is seeking damages for citizens who lost money gambling on PokerStars from 2007 to 2011, but the Commonwealth’s case has some holes in it. First, its interpretation of the decade-old Loss Recovery Act is a reach, as the court of appeals pointed out. Second, the lofty amount the Commonwealth of Kentucky is asking for consists of net money gambled – not the net amount actually lost.

There is a very low chance The Stars Group pays the full lawsuit, and there is an increasingly good chance it settles out of court for a much lower amount. The full resolution of the liability should represent another potential catalyst for the stock.

Poker

As of the third quarter quarter, 34% of the company's revenue comes from poker. Online poker is a mature industry in a state of low-to-flat growth, and PokerStars' sheer size and market share make it difficult to significantly steal market share.

However, the characteristics of the business give PokerStars a natural moat. Poker websites are largely dominated by traffic; whoever has the highest volume of real-time players has the most cash-games, events and tournaments to offer, and PokerStars has a player pool.

The industry has high barriers to entry. It takes investment and government approval to operate in regulated markets, which is necessary to scale and grow a big-player pool. PokerStars is by far the biggest and most recognized player in the online space, and its size gives it several distinct advantages.

In the past, PokerStars has leveraged its brand to become the first, and sometimes only, beneficiary to "shared online poker liquidity" between countries. This means that PokerStars is able to combine its online player pools between different countries. For example, France and Spain have a shared online poker liquidity agreement, which allows citizens of France to compete with citizens of Spain, with the revenue remaining geography-based for taxes purposes.

Gaining regulatory approval to legally operate in a country is a barrier to entry. Gaining approval for shared online poker liquidity is an even more ardous barrier to entry. As stated earlier, online poker is a "winner-take-all" market, where players will naturally migrate to the website that hosts the most active players. Italy, a market in which The Stars Group has a 9% market share, is set to join the France-Spain shared liquidity agreement, which represents another growth opportunity for its poker wing.

Still, regulation remains an overhang for The Stars Group and the larger online poker industry, as PokerStars could be forced to exit markets due to adverse government rulings which has happened in the past. However, The Stars Group is transitioning most of its operations into regulated markets (over 70% in the last quarter, a far cry from a couple of years ago), which should be a positive for the company’s long-term earnings health. The Stars Group's poker vertical should remain a steady cash generator and low-cost acquisition tool, as the company can easily cross-sell its casino and sportsbook products to its massive poker customer base.

The company forecasts mid-to-low single digit poker growth going forward, but with the possibility of a large-scale expansion into the emerging American market, there is potential for higher upside. The Professional and Amateur Sports Protection Act's recent reversal of the U.S. federal ban on gambling has opened the door for PokerStars to re-enter the American market, where it still has decent brand awareness (24% of American “sports fans” polled were familiar with the brand despite the company not operating in the states since 2011).

PokerStar has a reputable, well-known brand globally, and its poker products are upper-echelon compared to its early American competitors. With the right moves and partnerships, PokerStars has the best chance of all The Stars Group's products to emerge as the dominant market leader in the emerging online gambling market in America. Full discussion on The Stars Group's plans for American expansion below.

Sports Betting

The Stars Group's recently transformed the company in April 2018 by acquiring SkyBetting and Gaming for $4.9 billion, again making The Stars Group the largest publicly traded online-gaming company in the world and diversifying the company's portfolio away from the stagnant poker industry. The company also purchased William-Hill Australia and CrownBet-Australia, integrating the acquired customers into its self-created sportsbook, BetEasy. The Stars Group also has BetStars in its aresenal for the expanding U.S. market, which has soft launched and New Jersey and is set to launch in Pennsylvania in early 2019.

SkyBet currently has a leading 13% share of the $6.5 billion online gambling market in the U.K., and is poised to take an even more commanding position due to its unique brand. SkyBet has a content partnership with SkySports, a branch of SkyMedia, which allows the company to stream SkySports channels on the SkyBet website. Customers are able to watch sports live as they wager on them, which is a pretty unique feature for the industry; most online sportsbooks tend to be simple and bare-bones.

Through the BetEasy brand and accompanying casino products, The Stars Group has a 16% market share of the $2 billion online gambling market of Australia. BetEasy has a similar partnership with SkyRacing, which allows Australian gamblers to watch live horse racing events on the sports book website. Building partnerships with massive media brands has given The Stars Group tremendous visibility in these markets, and goes a long way in establishing itself as a trusted, reliable vendor.

Other important markets for The Stars Group are Germany, Italy, France and Spain, among others. In the U.K., nearly 50% of gambling revenue comes from online/mobile. In the other major countries mentioned in which The Stars Group operates in, that number is below 20% across the board. Based on where the industry is going, I expect brick-and-mortar action to gradually transition online, and The Stars Group estimates that these countries' online markets should grow at CAGRs between 6-17% from 2018 to 2021. The Stars Group is one of the few sports books without a land-based presence, which should allow it to uniquely benefit as the gambling industry continues to transition to online and mobile.

Casino

The Stars Group offers accompanying casino products with each of its sports books. Its casino vertical accounts for 26% of the company’s revenue, and represents a low volatility, low maintenance revenue generator.

The Stars Group's strategy in the casino market has been to offer a safe and reliable product with a wide amount of offerings. The casino branch has over 300 different types of games, a unique feature in the industry.

The same regulatory concerns exist for the casino branch, but it would be safe to assume this wing of the company should grow at a rate roughly in line with the sports books, as the industry continues to transition online and The Stars Group enters new markets.

Macro, American market and beyond

The global gambling market does an estimated total of $311 billion annually, with the online segment representing just $43 billion of that. The online segment is expected to grow at a CAGR of 8% from 2018 to 2021, and due to The Stars Group's internet-heavy asset profile, the company should uniquely benefit.

Another major area of expansion for The Stars Group is the American market. In May, the Professional and Amateur Sports Protection Act of 1992 was overturned, essentially opening the door for states to legalize all forms of gambling as they see fit. So far, three states (New Jersey, Pennsylvania, Delaware) have officially legalized online gambling, with West Virginia set to join the market in 2019.

Many other states have introduced sports-betting legislation, including potential revenue heavy-weights in California and New York. You can track gambling legislation and an overview of the legalized American market here. The Star’s Group has existing market access deals in New Jersey and Pennsylvania, and all three of their verticals are live in New Jersey.

The American Gaming Institute estimates that $150 billion is gambled annually in the U.S., with most of it done in the black market. This represents between about $7 billion and $12 billion in annual revenue. There is some fear that a portion of this will remain in the dark market despite legalization, but I think these worries are overblown - the legalized, regulated sports books should largely make the local bookies and offshore bookies obsolete. The convenience from betting mobile/online simply can't be beat (and if it were to be, the brick-and-mortar casinos will need to spend a lot to attract physical customers), and legitimate, reputable local brands will have several distinct advantages over their offshore rivals.

For one, customers can rest assure that their deposits will be safe in American books, as the same will never quite be true for offshore books. These companies operate from areas of low regulation and oversight, and if the company goes belly up or freezes a gambler's account, their deposit and winnings are gone. There is not much the gambler can do about it.

Second, anyone who has dealt with offshore books know how big of a pain depositing and withdrawaling can be. The easier payment platform alone is a a major reason to choose an American operator over an offshore one. The only advantage offshore books may retain over their regulated counterparts is better "juice,” especially if professional sports leagues seek an integrity fee (which seems increasingly unlikely, or at-least much smaller than originally imagined), but this should only make a difference to "sharp" sports bettors, the exact type of gambler The Stars Group would prefer to avoid. So far, at least, American books have been able to offer competitive if not jaw-dropping odds and highly competitive sign-up bonuses, as the companies have vied for early customers.

Bulls will tell you sports betting will boom in America. Morgan Stanley projects that $216 billion will be gambled in American annually by 2025. If the Stars Group can capture just a piece of that pie, that represents significant revenue growth potential. If it can capture a big piece of the pie, which doesn't seem impossible given The Stars Group's industry expertise, strategic partnerships and portfolio of top-notch products, it is trading at an exceptional discount.

Sports betting is beginning to spread state to state faster than cannabis legalization is, yet, unlike stocks in the cannabis industry, sports betting companies have not been bid up to ridiculous valuations. In fact, the entire industry has surprisingly been in somewhat of a bear market (before the recent market struggles) since the PASPA reversal, even though the reversal is the single best news the industry has had in a decade.

One reason for this is that American sports betting companies like MGM Resorts International (NYSE:MGM) are large, diversified behemoths, with a large portion of their overhead and earnings being tied down in real estate and resorts. Brick-and-mortar casino operators already have high costs – they rely on huge televisions, upscale bars and lavish atompsheres to compete for customers. The Stars Group is the biggest gambling company in the world that is enitrely concentrated online. As a result, The Star's Group is one of the companies best positioned to benefit from American legalization and the overall expansion of the online gambling market, as it has a highly scalable platform.

My early sense is that American brick-and-mortar operators do not have much experience or expertise when it comes to the online space, as early reviews and industry sentiment indicate that these casinos' early internet forrays have been sub-bar and missguided.

In its latest third-quarter conference call, CEO Rafi Ashnekazi said he believes the U.S. has potential to be the biggest gambling market in the world. The Stars Group is investing heavily to establish itself as a major player in the space.

For one, The Stars Group has entered into strategic partnerships with the National Basketball Association and Ultimate Fighting Championship. The Stars Group was only the second sports book to partner with the NBA, giving it media exposure and the ability to use the NBA's likeness within its products, giving BetStars further legitimacy, visibility and credence. The Stars Group also partnered with the UFC through PokerStars in a co-promotional agreement, another step to re-building brand awareness for the its products in America.

In the U.S., Nevada and Delaware have been sharing online poker liquidity since 2015, with New Jersey joining the fray in 2017 to start the Multi-State Internet Gaming Agreement. Pennsylvania is also expected to join once online gambling launches early 2019. This adds a much-needed influx of real-time players to populate the online poker lobbies in the nascent American online poker market. So far, only competitors 888 Holdings PLC (LSE:888) and Caesars Entertainment Corp. (NASDAQ:CZR)'s WSOP.com have received the go-ahead for inter-state liquidity, and have since vaulted towards the top in American online poker traffic.

PokerStars had the early market lead in the online New Jersey poker market, and once it receives inter-state liqduidity permission, it should be able to regain it. Given PokerStars' track record, I do not foresee this being an issue for the company. PokerStars is only running in New Jersey, so expect this to become a bigger priority once Pennsylvania online gambling officially goes live and the state joins the shared market agreement.

Out of The Stars Group’s entire portfolio, I believe PokerStars has the best shot at becoming the go-to provider in the U.S. By all reviews and accounts of people I have spoken to, PokerStars has far and away the best product in the U.S, as it does globally. The numbers show PokerStars dominated the early online poker market before 888 or WSOP's shared liquidity agreements flooded both sites with an increase in volume, and once PokerStars spreads to more states, I fully expect them to regain their position at the top.

The Stars Group's path to state-by-state expansion as it rolls out legalization is becoming clearer; it recently reached an agreement with Eldorado Resorts, which holds properties in 13 states. This offers The Stars Group an entry point to offer its products in many different states, and eight of the states Eldorado currently operates in have shown "legislative interest" in legalizing online gambling.

Valuation

During The Stars Group’s third quarter conference call, management estimated that the company would see $2.1 billion in revenue during full-year 2018 and generate between $755 million and $810 million in Ebitda. The Stars Group trades at just around 6.7x Ebitda and 9x earnings at the lower end of forecasts, below its 12-month average price-earnings ratio of 11.5.

The company's closest competitor is likely Paddy Power Betfair (PDYPY), a company similarly concentrated in online gambling assets. Paddy currently trades at multiple of 14.3x 2018 Ebitda and has a price-earnings ratio over 27.

Paddy trades at a premium for several reasons. It owns BetFair, the largest betting exchange in the world; Power Paddy, the largest sportsbook in Ireland; and it recently purchased FanDuels, a popular American brand. FanDuels, one of the two giants in the daily fantasy sports market, recently opened an online sports book that is jumping out as an early leader in the nascent online betting markets in New Jersey. Still, the disparity between The Stars Group's and Paddy’s premiums are extreme, and in my view, The Stars Group has the stronger portfolio of products, better market position and as much, if not more, growth upside.

Expecting a modest 10% revenue growth rate and given stable margins, I expect the company to generate roughly $2.34 billion in revenue 2019, netting $940 million in Ebitda and $2.90 in adjusted earnings per share. Assuming The Stars Group's multiple stays constant, this represents a base one-year target price of $26.10. If The Star’s Group can resolve some issues and regain its "median" valuation, this represents a one-year target price of $330. In a bullish outlook, in which the market gives The Stars Group a loftier price-earnings of 15, the company could trade at a price of $43.50, which is not much higher than the stock’s 52-week high of $38.95. No matter how the market opinion on The Stars Group continues to develop, any entry price below $19 represents an adequate margin of safety.

Stock market stabilization, a full year of synergies and a clearer earnings picture should give the market a better picture of The Stars Group "story." This is not a profit margin growth story. The house "take" should remain relatively flat in the long run. It's a revenue growth story, and I think The Stars Group's strong portfolio of online assets uniquely positioned to continue to gain market share in the expanding online gambling market.

Disclaimer: The author holds a long position in The Stars Group at the time of writing.

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