ACTIVIST NEEDED

CryptoLogic is a ridiculously mismanaged company, and an activist is needed to force the company’s chairman to do the right thing and sell to either of two motivated buyers.  At today’s $6.25/share market price, the valuation to a buyer even in a downside case is ridiculously low.

This is a good business, which needed just $1m in founder cash to grow it into a cash-flow rich business worth $450m at its peak, or $30/share.  It has best-in-class software, long term recurring revenue, and is a mission-critical partner of land-based gambling operators who are seeing 20-40% cash margins and 5-10% growth from the spread online of one of mankind’s most enduring businesses.

Each of the two buyers (and potentially a third) sees a $6.25 share price as an opportunity to pay $2.25/share (there is $4.00/share of cash and no debt) for low-risk integration into their businesses of $0.80-2.00/share of cash earnings.

The wide range of potential earnings to a buyer reflects uncertainty over the potential loss of the company’s largest external client, William Hill.  Such a loss may well happen in 2009, and the market is worried that the company will collapse as a result.  But the market is missing two things:  (i) CryptoLogic’s relationship with the Intercasino brand that accounts for 40% of sales is so complete that its loss is not possible; and (ii) the cost take-outs easily available to a buyer will generate ~80 cents a share of earnings, or a cash P/E of just 5x at the current $6.25 share price in a downside case.

Both buyers have privately indicated strong interest in recent months, and one of them (Playtech) has just raised $220m in an equity offering with acquisitions of competitors and affiliates as the publicly proclaimed use of proceeds.

THE CHAIRMAN IS A BAD GUY

The founding Rivkin brothers did a great job, but they left, sold their stock in 2004.  They left the company in the hands of the tax lawyer who helped them structure things.  This man, Bob Stikeman, became chairman, and has run up a record that is staggering for its disregard for shareholder value and lining of his own pockets. 

He has made CryptoLogic into a cash cow of legal fees for his law firm – $935K last year, up from a steady $600K or so annually – while owning virtually no stock and refusing cash offers from competitors to buy the whole business earlier this year at prices north of $20/share.  He has made the CEO job into a joke – three of them in two years – and is a contender for this year’s “PR Like It’s 1999” prize of greatest number of pointless press releases.  My favorite is the recent announcement this week (after the company lost $3m apparently day-trading in the forex markets) that CryptoLogic will be renting a booth at an up-coming trade show.  Alert the media!

As an added bonus to the legal community, the board has awarded additional legal fees to one of Stikeman’s fellow directors – almost $300K in 2007 – and to a firm run by Stikeman’s father (not disclosed, but I estimate at least $100K).

A review of Stikeman’s past reveals directorships at several Canadian penny-stock companies accused by regulatory authorities of improper practices, or bankrupted.  Given the record, it is astonishing to me that there has not been more resistance to him from shareholders.

But the CRYP shareholder base is highly fragmented, except for Mohnish Pabrai, who is not an activist and has been selling (presumably in disgust), some black box houses like Renaissance and DE Shaw that don’t get disgusted, and some huge guys like Fidelity and Royce for whom this is position #700-and-something.  Judging from the Yahoo board, which is non-empirical but fun to read, there are lots of unhappy campers who followed Pabrai into the stock in the 20s, and are likely to welcome an activist.

Given minimal insider ownership, egregious legal fees to board members, the very real buyer interest (easily verified, which I can help you do by introducing you to industry people I gotten to know over the nearly two years I have followed this saga), this is a lay-up for someone willing to embarrass Stikeman, and confront him with what even the most corrupt board member fears – the threat of shareholder litigation if he does not do his fiduciary duty and talk to motivated buyers.

Why am I not doing this myself?  I sold in disgust at $21, and have bought back in recently.  But funds under my control are insufficient to buy more than 2% of the outstanding stock.  And I am not equipped to deal with the multiple jurisdictions (listings on NASDAQ, TSX, and LSE, and domiciled in Ireland) present here.  This situation needs someone with enough ready cash and credibility as an activist to make the board hire a banker and review alternatives.

CryptoLogic has been written up on VIC by Chuck307 and Nish697, and I refer you to those write-ups for some details on the business.  What follows are some summary points you should know.

GOOD THINGS ABOUT THE BUSINESS

There are some great things about CryptoLogic’s business.  Gambling is fundamentally profitable, and the online version has been no exception.  Land-based gaming companies like William Hill and Ladbrokes have found it to be very easy to create fast-growing online casino and poker businesses by getting a URL and doing some incremental marketing.  Even after paying 15-20% to a software provider like CryptoLogic, the online segment of William Hill or Ladbrokes is a 20-40% operating margin business.  And the ability of the land-based companies to do the software themselves is limited – they are good at running networks of casinos or sports betting shops, not writing software.

Revenues are recurring, as operators enter into multi-year contracts with software providers, and predictable, since the business can be tracked literally in real time, and is quickly responsive to marketing dollars.  Incremental margins on new business are very high – CryptoLogic has repeatedly talked about 80-85% – and the same set of casino games can be used at multiple operators, allowing significant leverage of the fixed cost of software maintenance and introducing new casino games.

Finally, pricing has been stable over the past several years.  In the 1990s, casino contracts were for up to 25% of the house “take” 5 years ago, but have been holding at 15-20%.  This reflects the realization by operators that switching providers is expensive, as this requires changing the “look and feel” of the games experienced by their customers overnight.  Such conversions have tended to result in losses of 20-30% of business (the industry is amazed that Playtech’s takeover of Tribeca lost just 20%), which is very expensive relative to saving 2-3% on the cost of software.  Though customer losses happen (CryptoLogic lost Betfair in 2006, and Littlewoods this summer), they are painful for the operator.

BAD THINGS ABOUT THE BUSINESS

High fixed costs cut both ways.  Each of the four leading software houses – CryptoLogic, Playtech, Microgaming and Boss Media – employs a staff of hundreds of programmers to keep things working and introduce new games to keep players coming back.  Incremental margins are 80-85%, but CryptoLogic’s overall operating margin has fallen from the mid-20s in 2006 to loss today.  This is because the US ban on online gaming in October 2006 ended 30% of CryptoLogic’s business. 

At an 80% incremental margin, this wiped out profitability.  And across the providers as a whole, there is programmer overcapacity, as no one has rationalized their workforce in response to the US ban.   Everyone is hoping to grow out of the problem, but there are only so many clients to go around.

Also, CryptoLogic long followed a strategy of concentrating only on the largest branded gaming operators, like current clients Intercasino, William Hill, Playboy, and World Poker Tour.  While Playtech has 60 licensees, CryptoLogic has 10, and just one, William Hill, makes up roughly 20% of sales. 

The loss of William Hill would be nearly as bad as the loss of the US.  The William Hill contract is up for renewal in December 2009, and William Hill has the right to introduce another software provider as early as January 2009.  Conversations in the industry indicate that William Hill is happy with CryptoLogic’s casino games, but very unhappy with CryptoLogic’s declining poker liquidity.  Playtech and Boss Media are working hard to win William Hill’s business, and this risk is a major overhang on the stock.

The recent decline in the share price appears largely due to the loss of Littlewoods this summer, and management’s barrage of silly press releases in response.  While just 7-8% of sales, the incremental profit of this business is high, and the loss underscores the very real risk that William Hill will go as well.

EUROPEAN LAW

Many investors have worried that a US style ban might come to Europe, but they are missing a clear-minded legal analysis of European court decisions and national politics.  Such an analysis led to Gtech’s game-changing entry into the industry in February 2008, and is important to review.

As opposed to the Republican Congress, one of whose last acts was to attach a ban on online gaming to a port security bill hurriedly signed by President Bush in the last moments before the 2006 election, the European Union has been supportive of online competition.

In a series of court cases – most importantly Gambelli in 2004 and Placanica in 2007 – the European Court of Justice has established that online gambling either has to be allowed on a competitive basis, or entirely prohibited.  This is despite active resistance by Europe’s state-owned gambling monopolies, who have campaigned hard to keep their monopolies in an online world.

Most European countries are now expected to opt for competition, as it is better to tax part of a pie than have nothing to tax.  The UK, Sweden, Austria, Germany and Italy have all chosen this route.  France and other countries are still seeing resistance from its state-owned monopolies, and there is a steady stream of headlines on this subject.  But French prohibition is highly unlikely, since the state needs the money.

In Sweden and Austria, the state-owned monopolies have introduced online gambling efforts, both powered by Boss Media software.  This trend led to the acquisition in February of Boss Media by Gtech.  Gtech views the movement of its state-owned lottery customers into online gambling as inevitable, and chose to acquire rather than build internally.

CONSOLIDATION IS INEVITABLE

Gtech paid $200m for Boss Media, or a multiple of 4x sales, or 40x cash earnings.  Conversations with industry sources and Gtech itself suggest strongly that such multiples were justified only by potential synergies.  Some of these synergies may come from Gtech’s ability to cross-sell into lottery customers.  Others may come from further acquisitions.

The industrial logic underlying both kinds of synergies is simple – high operating leverage.  Incremental margins of 80-85% are quickly achievable if a new contract is won.  They are also quickly achievable if a competing software provider is bought, and its programmers let go.  Customer disruption would be minimal, as the same games would appear on each operator website as before.  But over time, the smaller group of programmers would roll out new games to a larger customer base, and the savings would be big.

How big?  When Playtech bought Tribeca in late 2006, the ~$100m they paid seemed to be a lot relative to $12m of revenue.  But Playtech rationalized the programmers, cross-sold to the customer base, and grew revenues to $20m.  Those revenues come with an 80% margin, or $16m of operating profit.  So rather than paying 8x sales, Playtech ended up paying 6x EBIT for a business now growing at 10% annually.

Playtech is deeply worried about the entry of Gtech into the business.  Playtech was the clear #1, and seemed likely to become the dominant software provider to the industry.  But Gtech’s deep pockets and customer relationships put this in jeopardy. 

Gtech has approached CryptoLogic at least once in early 2008, and offered to pay $20+ per share.

Playtech approached CryptoLogic at least twice in between fall 2007 and spring 2008 to discuss a possible acquisition, and was willing to pay $20+ per share.  Stikeman’s response was to put them off and try to buy Boss Media in order to gain scale.  When he was outbid by Gtech, Stikeman then told Playtech that he would not accept their stock as a seller.  CryptoLogic’s CFO tells investors these days that Playtech is interested, but not at “fair market value”, whatever that is.

In July, Playtech raised $220m in an equity offering, with the use of proceeds specifically targeted to make cash acquisitions.  In Playtech’s earnings call on September 3, their management discussed a transaction in process for an affiliated business, which almost certainly is not CryptoLogic.  But they clearly mentioned their desire to another purchase, preferably of a competing software company.

There are three meaningful competitors to Playtech:  (i) Boss Media, which is now owned by Gtech; (ii) Microgaming, a private company which has continued doing business in the US, and therefore cannot safely be owned by a public company like Gtech or Playtech; and (iii) CryptoLogic.  There is a tiny Canadian company called Chartwell, but it is an also ran in the industry.

Finally, there potentially is a third buyer – IGT, which owns a US facing software provider called WagerWorks.  Clearly the US online market is no longer addressable, but IGT does have some European customers for its land-based slot machines.  Owning a bigger software provider could be helpful as their land-based customers in Europe increasingly go online, and in case the US ban is ever lifted, as Democrats like Barney Frank would like to do.

VALUATION

CryptoLogic had roughly $4.50/share of excess cash at June 30, and has presumably lost some of with botched forex management and operating losses this quarter.  At a $6.25 share price, we are paying $2.25 for the business or an enterprise value of about $32m across 14m shares.  All options are out of the water (note that Stikeman and other board members have been buying in the market recently at $8-10 – about $250K worth of stock).

Second quarter 2008 revenues were $17m, and the second quarter is seasonally weak (lots of time outside means less time gambling in front of a computer).  So annualized revenues are about $75m.  If you assume the loss of Littlewoods, which is 7-8% of revenues, and some growth, we are looking at run rate sales of about $70m assuming no loss of William Hill or other licensees.

Second quarter loss was $1.5m, or 11 cents a share – the business is not profitable on a status quo basis, and the loss of Littlewoods will make this worse.  But the status quo is not how a buyer will view the business.

We are told again and again by CryptoLogic in its earnings calls, and by other industry players, that incremental margins are 80-85%.  If we assume that a buyer sees the potential for incremental margins of 40-60% (i.e., some of the programmers and other fixed costs are retained), then the cash EPS possible is as follows

 

Note that Playtech’s Vice Chairman and deal guy has told me that he expects at least 50% incremental margins from integrating CryptoLogic.  And Gtech’s deal guy suggests that $20-25m of synergies are possible in a combination of Boss Media and CryptoLogic.

Now let’s assume that William Hill goes away, and that all of the other outside licensees also leave.  It turns out that CryptoLogic effectively controls the Intercasino brand, which makes up 65% of casino sales, or 40% of sales.  The company denies that this is so, but CryptoLogic owns the Intercasino URL, and sublicenses the trademark to an affiliated entity for a nominal fee.

So the “every customer leaves and the poker room collapses” scenario still has CryptoLogic doing $28m of casino sales.  This is subscale on a stand-alone basis, and would likely be unprofitable, but to a buyer would look as follows:

 

One might assume $10-20m of costs for a buyer to achieve these cost savings.  And one might also believe that a buyer would be unwilling to pay a market multiple for cost-savings which their hard work will enable.  But relative to even downside EPS, CryptoLogic is very cheap at $2.25/share net of cash.

RISKS

Stikeman is a bad guy, and has demonstrated willingness to screw shareholders.  It is possible that he does a dumb deal in order to entrench himself and enjoy another $5m of legal fees before he retires.

Gtech buys Playtech.  It’s possible to imagine, but highly unlikely due to valuation.  Playtech’s market capitalization is more than $2 billion, or 12x sales.  CryptoLogic’s market capitalization is $90m, or 1.3x sales.

A regulatory change in UK or Europe that impairs online gaming, as in the US in 2006.  Possible, though highly unlikely due to clear legal precedent, and greed of national operators.

Buyers don’t show up.  Unlikely, given industrial logic of removing fixed capacity, and the desire of both Gtech and Playtech to dominate the space.  Whoever buys CryptoLogic will add the #2 provider to their roster, and therefore become the clear #1.  For Gtech, missing this would be expensive, as the combination synergies would justify the 40x multiple they paid for Boss Media.  For Playtech, missing this would be dangerous, as a 12x sales multiple is not likely for a #2 player.