Cryptologic CRYP
December 12, 2006 - 12:17pm EST by
nish697
2006 2007
Price: 20.10 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 274 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Cryptologic (CRYP) is a wonderful little business that is trading at under half of it’s 2008 intrinsic value. Holding the stock for 2-3 years is likely to yield a 35-70% annualized return with minimal downside.
For background, it is worth reading Chuck307’s excellent writeup on the company on August 3, 2004.
 
http://www.valueinvestorsclub.com/value2/Members/view-thread.asp?id=1526&more=dtrue
 
Also, the company’s website (www.cryptologic.com) has a wonderful archive of annual reports going back to 1997. Transcripts of all conference calls since 1999 are also archived on the website.
 
Cryptologic is a maker of software for online gaming (poker and various casino games). They are presently domiciled in Canada and are in the process of relocating their corporate headquarters to Ireland. This move affects only a handful of corporate employees. The bulk of the staff (developers etc.) are unaffected and will continue to be based in Toronto, Cyprus etc.
 
On October 13, 2006, the United States government passed the Unlawful Internet Gambling Enforcement Act (UIGEA). UIGEA was tucked into the ports security legislation and took online gaming industry by surprise. While there was always the overhang of the US passing such a low, the speed and timing caught the industry flat-footed. It was the equivalent of a nuclear bomb going off in the industry and a number of stocks, including CRYP sold off as a result.
 
Unlike its competitors, Cryptologic had been planning its business assuming the passage of such a law since 2001. The company used to derive the vast majority of its revenues from US players in 2001. When the law was passed, just 30% of the company’s revenue were dependent on US players.
 
Cryptologic has always stayed well within the confines of the law. The CEO stated on a recent conference call that he visits the US periodically and sees no reason why he would ever be detailed by law enforcement – as has happened to other online gaming operators.
 
Cryptologic stock has always had a overhang on its valuation due to the ever-looming threat of a change in US laws and the precipitous drop in earnings it would cause. Nonetheless, when the law actually passed, the company’s stock got further clobbered anyway – along with all the other online gaming stocks. What the market is missing is that:
 
1.                 US Players made up just 30% of the pie for CRYP.
2.                 The rest of the pie (70%) has strong momentum and is growing at over 20% a year.
3.                 That 70% of the pie in 2 years will exceed the total pie today with 20% annual growth. (0.7 * 1.2 * 1.2 = 1.01)
4.                 The company has always guided very conservatively. Actual growth will likely be far in excess on 20% annualized for the next several years.
5.                 Cryptologic has always had ultra-conservative accounting. They expense everything. A good amount of its large R&D spending for future games, yet all of it is fully expensed.
6.                 The business has very high leverage. Incremental pre-tax profits on additional revenue approach 100%.
 
Under-promising and Over-delivering
 
Cryptologic’s management has consistently under-promised and over-delivered. They expense everything, so net income is fully burdened with all the future growth spending and R&D. Here are some examples:
 
2004 Objectives in 2003 Annual Report:
 
1.                 Achieve 60% of licensees revenue from international sources
2.                 Grow online poker to 15% of total revenue
3.                 Sign 2 new substantial customers
4.                 Continued growth in operating profits
 
Actual Results:
 
1.                 Over 60% of licensees revenue from international sources.
2.                 Grew poker to 20% of total revenue
3.                 Signed 3 substantial customers
4.                 Grew revenues 44% and earnings by 45%
 
2005 Objectives in 2004 Annual Report:
 
1.       Maintain 60% of licensees revenue from int’l sources
2.       Grow online poker to 25% of total revenue & exceed poker industry growth rate.
3.       Sign 1-2 new substantial customers
4.       Continued growth in operating profits
 
Actual Results:
 
1.       Over 65% of licensees revenue from Int’l sources.
2.       Grew poker to 31% of total revenue. Poker grew 126% vs. 86% for industry.
3.       Signed no new customers, but grew in new geographies with existing customers. Solid growth regardless!
4.       Grew revenues 35% and earnings by 50%
 
And let’s take a look at some quarterly guidance as well:
 
2005 2nd quarter guidance (given with Q1 earnings):
 
Revenue: $19.2-$19.6 Million
Earnings: $4.2-$4.4 Million
 
Actual Results:
 
Revenue: $19.9 Million
Earnings: $4.7 Million
 
2005 3rd quarter guidance (given with Q2 earnings):
 
Revenue: $19.4-$19.7 Million
Earnings: $4.5-$4.7 Million
 
Actual Results:
 
Revenue: $21.0 Million
Earnings: $5.1 Million
 
2006 2nd quarter guidance (given with Q1 earnings):
 
Revenue: $26.4-$26.7 Million
Earnings: $6.6-$6.8 Million
 
Actual Results:
 
Revenue: $30.4 Million
Earnings: $8.2 Million
 
2006 3rd quarter guidance (given with Q2 earnings):
 
Revenue: $26.5-$27.0 Million
Earnings: $6.6-$7.0 Million
 
Actual Results:
 
Revenue: $27.7 Million
Earnings: $7.2 Million
 
This under-promising and over-delivering pattern is important to know because management has made some very specific comments about the future prospect of their business:
 
They have issued the following guidance for Q406:
 
Revenue: $19.0-20.0 Million
Earnings: $2.9-3.4 Million (before relocation and onetime restructuring charges).
 
If we compare this to what the company generated in Q405:
 
Revenue: $25.1 Million
Earnings: $5.8 Million ($4.9 Million net of Interest Income)
 
In 2005, the company did 65% of revenue from non-US sources. Thus non-US revenue in Q405 was 65-70% or $16.3 to $17.5 Million. Assuming Q406 is $20 Million, it reflects non-US growth of 15-23% year over year.
 
On October 2, 2006, the company mentioned the following in a press-release:
 
1.                 The company continues to maintain a corporate objective of growing revenues by 20%
 
2.                 The company’s US revenue loss leads to about an 80% drop in earnings from the lost revenue. So if US contributed $30 Million in 2006 revenue, when it is taken away, earnings drop by $24 Million.
 
Management at Cryptologic “gets it.” This is wonderful high ROE, high growth business. The question is: Will Cryptologic grow at over 20% annual rate for the next several years. I believe the answer is a resounding yes for the following reasons:
 
1.                 Management has directly stated that as a goal they are focused on 20% annual growth. They have a long track record of exceeding their goals.
 
2.                 To get 20% annual growth, they have many different engines:
 
a.      Introducing more games every year.
 
b.     Adding a few more licensees every year.
 
c.      Adding new geographies and languages.
 
d.     Online gambling grows with the popularity of broadband internet. The penetration of broadband outside the US is much lower than the US, but it is growing at spectacular rates. Online gambling will grow as broadband penetrates more deeply.
 
e.      Unusual businesses and brands are keen on online gambling revenues, but have no competency to do it on their own. A good example is Cryptologic’s partnership with Playboy. The Playboy online casino by Cryptologic kicks off in Q107. It is one of the most ubiquitous brands in the world. Recently Ryan Air decided to get into online gaming. I don’t think Cryptologic is involved, but they would be very well positioned to help these great brands with win-win partnerships.
 
f.       This is a recurring revenue business. The gamblers keep coming back and it is not easy for Cryptologic’s customers to wean themselves of the company. These are win-win partnerships for both sides. Cryptologic has 200+ developers who’ve been at it for many many years. It would not be easy for any customer to replicate Crytologic’s offerings in-house at a lower cost or higher quality. Even if they tried, it would take a long time.
 
g.     Cryptologic just opened an office in Asia and are closely studying the Asian online gambling opportunity. It is a question of when rather than if. Macau already generates more gaming revenue than Las Vegas with a small fraction of the gaming square footage of Las Vegas. Longer term, the company is well positioned to benefit from Asian online gaming.
 
h.     More and more countries will get to allowing regulated online gaming like several European countries have already done. Each new country adds millions of potential customers.
 
What is the business worth?
 
On $20 Million of quarterly revenue, the company generates about $1.8 Million of FCF (excluding interest income). About 80% of revenues above this $20 Million quarterly revenue base drops to the bottom-line (per the company). Their effective tax rate is 15% and there are virtually no add’l expenses associated with the add’l revenue.
 
If we look at the 2006 quarterly numbers, we can strip out the US revenue. Then we can add 20% growth and get to a good estimate of 2007 revenues. And adding another 20% to those numbers would get us 2008 numbers. Then we can put some reasonable multiple on its 2008 FCF, add back excess capital and we’d have Cryptologic’s intrinsic value. Note that there is further upside to this with:
 
1.                 Redeploying excess capital on smart acquisitions.
2.                 Generating a greater than 20% annualized growth rate.
 
 
Q106 Numbers:
 
Non US Revenue: $17.6 Million
 
Q107 Estimate:
 
Non US Revenue: $21.1 Million
Non US Earnings $1.8 Million + $0.9 + $1.6 (net interest income) = $4.3 Million
Cash at Beginning of Quarter: $131.1 Million
Cash at End of Quarter: $135.4 Million
 
Q206 Numbers:
 
Non US Revenue: $19.8 Million
 
Q207 Estimate:
 
Non US Revenue: $23.7 Million
Non US Earnings $1.8 Million + $3.0 + $1.7 = $6.5 Million
Cash at Beginning of Quarter: $135.4 Million
Cash at End of Quarter: $141.9 Million
 
Q306 Numbers:
 
Non US Revenue: $19.4 Million
 
Q307 Estimate:
 
Non US Revenue: $23.3 Million
Non US Earnings $1.8 Million + $2.6 + $1.8 = $6.2 Million
Cash at Beginning of Quarter: $141.9 Million
Cash at End of Quarter: $148.1 Million
 
Q406 Numbers:
 
Non US Revenue: $20.0 Million
 
Q407 Estimate:
 
Non US Revenue: $24.0 Million
Non US Earnings $1.8 Million + $3.2 + $1.9 = $6.9 Million
Cash at Beginning of Quarter: $148.1 Million
Cash at End of Quarter: $155.0 Million
 
Q107 Estimated Numbers:
 
Non US Revenue: $21.1 Million
 
Q108 Estimate:
 
Non US Revenue: $25.3 Million
Non US Earnings $1.8 Million + $4.2 + $1.9 = $7.9 Million
Cash at Beginning of Quarter: $155.0 Million
Cash at End of Quarter: $162.9 Million
 
Q207 Estimated Numbers:
 
Non US Revenue: $23.7 Million
 
Q207 Estimate:
 
Non US Revenue: $28.4 Million
Non US Earnings $1.8 Million + $6.7 + $2.0 = $10.5 Million
Cash at Beginning of Quarter: $162.9 Million
Cash at End of Quarter: $173.4 Million
 
Q307 Estimated Numbers:
 
Non US Revenue: $23.3 Million
 
Q308 Estimate:
 
Non US Revenue: $28.0 Million
Non US Earnings $1.8 Million + $6.4 + $2.1 = $10.3 Million
Cash at Beginning of Quarter: $173.4 Million
Cash at End of Quarter: $183.7 Million
 
Q407 Estimated Numbers:
 
Non US Revenue: $24.0 Million
 
Q408 Estimate:
 
Non US Revenue: $28.8 Million
Non US Earnings $1.8 Million + $7.0 + $2.3 = $11.1 Million
Cash at Beginning of Quarter: $183.7 Million
Cash at End of Quarter: $194.8 Million
 
At the end of Q408, the intrinsic value range on Cryptologic is likely to be:
 
Excess Capital: $194.8 Million
Trailing 12 Month FCF: $39.7 Million.
 
Assuming a 15 multiple (on this 20+% grower) would imply $790.3 Million.
 
With 14 Million shares out, this is $56.45/share
 
If they award a bunch of options and the diluted share count is 15 Million then intrinsic value is still above $52. And if the company uses $120 Million of its cash to buy back shares at $30/share, it would reduce the count by 4 Million shares. Now shares outstanding would be 11 Million and IV would be over $60/share.
 
The move to Ireland may lower the company’s effective tax rate. This would allow greater than 80% of future growth dollars to hit the bottom line. Even if one assumes that just 75% of add’l revenues over $20 Million hit the bottom line, the trailing 12-month (2008) free cash flow go down to $38.5 Million (versus $39.7 Million). Under this scenerio, with a 15x multiple on trailing earnings, the intrinsic value is $771 Million. With 15 Million shares out, that’s still over $50/share.
 
The floor:
 
Cryptologic will have $131 Million of cash at the end of 2006. In addition, if they didn’t grow at all and stayed at $20 Million in quarterly revenue, free cash flow would be over $13 Million a year. In 2 years, excess cash would exceed $160 Million and valuing the rest of the business at a 10x multiple yields an intrinsic value of $21/share. The market is pricing the stock with this scenerio. In the extremely unlikely event, it plays out this way, one still has no loss of capital. And this assumes no share buybacks, no smart acquisitions, no Playboy (already in the bag) and no new geographies and no increase in online gaming.
 
The ultra-conservative floor is $21/share.
 
The ceiling:
 
With collapsed valuations all around, Cryptologic could make some very smart acquisitions with its war chest at very compelling prices. In addition, organic growth may be much higher than their sand bagged 20% number. And they could do significant stock buybacks. The stock could trade well about $60 or $70 or $80 a year in 2-3 years under these circumstances. If they are awarded a higher multiple because of their growth (20-25x) then it is even higher.
 
Realistically, Cryptologic is likely to be changing hands around atleast $50-60/share in 2-3 years, if not much higher.

Catalyst

Value is its own catalyst. As the quarters roll-by and they deliver the numbers, the stock will get to its intrinsic value.
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