EVOLUTION AB-FH24--Just a pit stop?

Understandable business

EVO AB operates a B2B model, EVO develops and sells games to casinos and other operators. The main business is Live Casino, in which EVO is a leader. The second business is games based on  Random Number Generation (RNG), or slot games. These are all delivered online. EVO operates live tables and sells the produce to its customers under various sales agreements, being a profit share, fees or a blend, EVO can badge its product with the customer's name, so white labels.

Some of the customers include Entain, Betfair, Draft Kings,Hard Rock Hotel and Casino, Paddy Power, William Hill and a long list of smaller operators.  The range of customers is from niche operators to the largest operators. There is a host of smaller regional operators given the regulatory environment in gaming usually exists. The last customer announced was BET365, a big operator. EVO states that once-in customers rarely leave, which is understandable, but how many people are playing EVO games through the customer's site is critical. EVO’s size, popularity and scope of games make them a must-have, in live casinos at least.

There are many players in both Live casinos and RNG. The difference is that the Live market is smaller and not as competitive and EVO is the leader, while RNG is very competitive and EVO is one of many. Note ALL competes in RNG, with the advantage of having established land-based games and ALL being an incumbent supplier. EVO acquired the RNG business a few years ago and they have underdelivered ever since. RNG makes up 14% of revenue and, I suspect, less of profit. Pragmatic is brought up as a competitor in RNG and appears to be outperforming EVO. Some believe PG copies EVO games.

 

There are a couple of unusual features that need to be monitored in the EVO business mix. One is the regulated and unregulated mix, which has been around 40% regulated. The unregulated markets are mainly emerging countries and although EVO has said that profitability is about the same for both, there is a risk that as markets move to regulated players change or profits change. There is no real evidence of anything adverse so far. Secondly, although Evo has a very large customer database, there is no real reference to concentration and that could be an issue. That would only be apparent if the large client left. Interestingly, no client has insourced the live casinos, it appears due to the expertise (including regulatory issues) and cost involved. EVO has a scale advantage. If it was discovered that China was a huge part of the business that would be a risk since it is illegal to stream into China. Europe and Asia are the two largest markets for EVO at about 40% each.

 

The growth opportunity is considered large, with the ongoing secular move from land-based casinos to online. About 79% of customers use their mobiles for gaming EVO products. The US is in the relatively early stages of opening up. The US is potentially a very large market. There is little doubt that the TAM is large, the relevant question is the ability of EVO to garner profits from this. Within the RNG market, it is difficult to see that occurring, with EVO as one of many operators. In Live Casino it is different, with Evo the leader and able to reinvest at a greater rate than others. The physical assets are not a huge part of that but having an operating history without issues, in a highly regulated environment, and product development is key. EVO has been a clear leader here. The ability to maintain that lead is critical.

Comments on Last Result—Slower revenue growth across the board. FX -3,5% impact. Large payout in Crazy Time e35m, impacted margins. The heavy expansion phase continues which impacted margins. Lightning Storm launched the biggest launch ever. Georgia strikes are not material. EVO acquired Galaxy Gaming EVUS$124m, equity $85m 1% of market cap. Made to accelerate licencing in the US, they have 28 US state licenses. Tax rate at 15%, Global rate.

Operating History

Not long ago EVO was very small and growing very strongly.  The maturing of the business makes historical growth rates and ROE of less value as it is now a much larger company. The acquisitions of the RNG businesses particularly hit the return metrics.

The historical returns are 5y roll eps growth of 56-78%pa averaging 64%. ROE averaging 39%, with a wide range. However, over the last four years, ROE has averaged 20%, likely comprised of a large ROE from the Live Casino business and very low RNG numbers. The NPM have averaged 41% over the last 10 years, which is phenomenal, interestingly the number is even higher over the last 5 years, 53% despite the acquisition of RNG, as the poor scale benefits of the earlier years fall out.

The reinvestment rate has been 84%, which is a positive, high number. The underlying call on capital is not large, being casino setups, over the last 10 years, 6% of CFO has gone into PPE. 

GM assumed as revenues so is at 100%, being all fees.

Reconciling CFO to NPAT+D&A is good with cash covering reported profits over the last 10, 5 and 3 years.

Comparing EVO to ALL and Playtech.-ALL Orange, EVO blue, PYT grey

Note ALL numbers are AUD rest USD.

Conclusions, ALL is the largest business and has had a successful history of organic and acquisition-led growth. EVO is a more recent story but has a comparable and perhaps better growth rate. EVO is by far the better business on operating margins, driven by the Live Casino and perhaps over all better mix and efficiency. ROE, EVO has recovered from the RNG acquisition dilution. EVO appears to offer better statistics versus the other two but is a younger and more concentrated business. Live casino has been an outstanding business and EVO's future is tied to its success here. The cash generation and growth have been quite outstanding.

However, growth is slowing, Asia Orange, NA Grey, and Europe Blue. These numbers appear not to be influenced by large numbers in the base as the growth rates are falling due to lower new business wins.

While management builds headcount, impacting returns.

There are two ways to take this, one is that management is confident of future growth and is investing for that. The outcome here will be an appreciably higher growth rate in the future. The second is that the marginal returns of the businesses are in decline. Under this scenario the company will grow and do ok but the exceptional growth is behind it.

Management

Management incentives appear to be employee count, table count, EBITDA margins, new studio growth, increased regulated share, increased revenues across all geographies.

The management team is incented, are owners and have a successful track record. There is a key man risk for the CEO and chief product officer, Todd Haushalter.

The acquisition of the RNG business was an error and a dilution of the profitable live casino business. Almost all growth is driven organically, with usually little M&A.

The company has initiated a buyback and a dividend policy, which appears rational.

There was an issue with repriced incentives that the board appeared to handle very clumsily. There did not appear to be nefarious activity associated with it.

Balance Sheet

The balance sheet is strong as the business generates considerable cash, well above that required to drive capex. Net cash US$689m before the acquisition.

CONCLUSION - VALUATION

EVO is a leader with a few mistakes and some operational issues as growth slows into a capex build. The growth has led to a slowdown but not a crunch, due to the outstanding profitability of the underlying business.

The last couple of results have been disappointing in the revenue outcomes. Without a clear reason for the slow down the market is left to ponder whether the market is slowing, or EVO’s position is slowly deteriorating (from exactly what we don’t know). Are there unseen changes in the mix that we are not aware of? Management are, as can be expected, positive on a reacceleration and have kept EBITDA margin guidance well above the current 68%, being 69-71% for the full year, implying a 2H acceleration.

The historical average PE is 41X and that makes sense with the high historical growth. The business's profitability and even downgraded growth outlook imply a premium business. that is, assuming we are not capitalising on unsustainable profit streams.

At 1074e the stock trades at an undemanding PE at 20X. assuming a 12% eps growth, given the buybacks coming, derives a 12% compound return on very conservative assumptions. At this stage I prefer a strategy, maybe being too cautious, of waiting for a stronger quarter to be prudent, to show the last two years have turned around and growth has reaccelerated. Look to add.

 

Please note the disclaimer.

From Ali Gunduz