He Who Dies Rich Dies Disgraced
Ivor Jones, Director of Leisure and Research at Numis Securities, looks at the year ahead for the iGaming sector. Although wary that the UK point of consumption tax will be introduced at 15% of gross profits, the fact that operators are sitting on piles of cash reserves doesn't mean they are more likely to carry out acquisitions in 2014. Share buybacks and dividends being likelier outcomes.
How times change. Before the financial crisis we used to talk of the ‘efficient balance sheet’ and felt that companies which hadn’t loaded themselves up with plenty of debt were just not trying hard enough. It is not a phrase we have used much since the crisis and the gambling companies we follow generally have balance sheets which are, in theory, ‘inefficient’. This does, of course, have the significant advantage of allowing management and shareholders to sleep easy at night.
In fact, several companies will start 2014 not only without debt but also with very material net cash positions: Playtech with well over €500 million, Betfair on its way to £200 million, Paddy Power with circa €200 million and bwin.party approaching €100 million. bet365, we believe, had well over £300 million of net cash at its March 2013 year end and, despite the cost of its ubiquitous advertising on UK television, we imagine that this balance will have increased materially. This means that these companies alone have a remarkable £1.2 billion to 1.3 billion of ‘spare cash’. If this were added to the considerable amount which they could theoretically borrow, it would create quite a war chest. But in which war might this be deployed: organic growth, to pay the UK government, or acquisitions?
The cash could be used to drive a marketing-led land-grab. However, overall the leading operators appear to have been retreating rather than grabbing new territory. For bwin.party and Betfair in particular, 2013 has been characterised by the financial impact of withdrawing from, or at least cutting off marketing in, several territories. This was on the explicit basis that the revenue from these territories was considered to be of poor quality, although the ‘fit and proper’ requirements of US licensing may have also influenced the decision making process.
The US has the potential to be a potential target for investment, of course, but so far the amounts involved appear to have been modest in the context of the available resources. bwin.party has indicated that it expects total losses in 2013/2014 to fall in the range €5 million to €15 million. We believe that Betfair has spent a similar amount on acquiring a licence in New Jersey, but it has not discussed budgeted initial operating losses. 888 has adopted a business model which should result in an immediate profit contribution from B2B services although it will also report the initial (non-cash) losses of its joint venture.
In theory, regulated territories such as France, Spain and Italy should be at a stage of development post-regulation which would require aspiring market leaders to be investing heavily in marketing to gain market share. However, badly structured tax and regulation, powerful domestic competitors and weak economies have conspired to minimise the opportunities in these markets for licensed operators. The operators are investing in organic growth, of course, but the cost appears to be easily met from operating cash flow and has not required raiding the war chest.
Paying the UK government
We believe that the UK government will fail to introduce its point of consumption duty at the planned 15% rate in December 2014. However, in this regard we appear to be a lone voice and so it makes sense that company management would be planning for the unwelcome arrival of the proposed new duty regime. One aspect of this is the current land-grab represented by the high level of advertising for gambling both online, and very evidently, offline. The threats and opportunities which will emerge if the new regime comes into force are uncertain and unpredictable and the best that companies can do is to be as prepared as possible for different scenarios.
The best outcome for the current UK market leaders would include the disappearance from the market of the long tail of minor competitors accompanied by a rational reduction in the costs of marketing as companies adjust to the lower net value of players. This could create opportunities to buy the brands and customers of the disappearing long tail, which could use up a little corporate cash.
However, it seems optimistic to assume that all market participants will immediately adjust marketing spend to rational levels and to comply with regulation. Other, less appealing outcomes include an increase in the cost of competition both: i) between the companies which choose to acquire UK licences and pay duty; and, ii) companies which decide to continue to operate from non-UK licences. A more competitive market could leave well financed companies dipping into their deep pockets in order to fund the maintenance of market share. They would then have to hope that a profitable new order would establish itself despite increased marketing and duty costs.
Acquisitions of online gambling companies have a mixed history at best. It has proven difficult to reflect regulatory risk correctly in purchase prices. Perhaps the clearest example of this is bwin’s acquisition of Ongame shortly before the 2006 change in US law which resulted in bwin shutting down the majority of Ongame’s business. William Hill, less dramatically, had to turn off revenue from France following regulatory change in 2010 after it acquired businesses via Playtech in 2009.
Success, too, can come with a price. Playtech was surprised by the remarkable increase in profits in what is now Playtech Turnkey Services which triggered the payout of deferred consideration much earlier than expected. Another example of the mixed blessing of success was the ballooning deferred consideration for a very successful Wink Bingo acquisition which was one of the reasons for 888’s share price trough in 2010.
Some businesses have found that due diligence can be a challenge in a sector where the rate of customer attrition is high and businesses typically sit in a complex web of technology, marketing partners and affiliates. William Hill made major acquisitions in 2013 which have not necessarily performed as expected post-transaction. Since acquiring Playtech’s 29% stake in William Hill Online, it has experienced a reduction in the growth of gaming revenue. And the acquired Sportingbet business in Australia appears to have lost customers and key media deals which mean it is going to take longer than expected to make a return on the investment made.
Sometimes, the acquisition process itself creates problems. Managing the integration of merged/acquired businesses is a process fraught with difficulty. Shareholders will feel they have been waiting for too long, but we hope that in 2014 bwin.party will finally begin to realise some of the promise which made the 2011 merger seem attractive.
Better to be a seller?
In fact, the main lesson from the history of corporate transactions in the sector may be that it is better to be a seller than a buyer. Playtech, which made the biggest sale of the year (to William Hill), has been one of the best performing of the gambling shares we follow in 2013 (up over 60%). Shareholders of companies with surplus cash will be rightly skeptical about the ability of management to spend their money on acquisitions and create value and, rather than support acquisitions, may call for a return of a material portion of that cash or be receptive to bid approaches. Early in 2013, Betfair received an approach which appeared to be at least partly based on the possibility of releasing unemployed cash.
A corporate acquirer not only gets the cash but also to set a new strategic course if it chooses to do so. Companies such as bwin.party and Betfair which have withdrawn from, or reduced their activity in, countries with higher regulatory risk, could be attractive to bidders with more risk appetite and a willingness to increase their exposure to those countries. The early signs are that GVC is succeeding with such a strategy with those parts of the Sportingbet business which it retained.
We believe a key sector theme in 2014 will be what happens to surplus cash. Not because of theoretical debates about ‘efficiency’ but because public company shareholders may need a lot of convincing that management have better uses for it than they do. We expect to see more special dividends and share buybacks than mergers and acquisitions.