Description

Summary

Flutter Entertainment is a global gambling company focused on online direct-to-consumer. It has a high quality financial and competitive profile with the only major downside being the potential consumer harm of gambling and the fragile regulatory situation that this presents. Online gambling has low penetration into the still growing wider gambling market, and the characteristics of the business tend to create highly capital efficient and profitable businesses and reasonably benign competitive environments over time. As discussed elsewhere on this forum, I used to have more preference for best-in-class B2B operators (Evolution) and perceived lower quality B2C players (GVC, Kindred) but now my preference is clearly for Flutter due to the relative underperformance. Flutter is pretty much the best public B2C company in this space and trades at what I would regard as a modest if not super cheap valuation.

The key geographic segments are the UK & Ireland (31% of revenue), Australia (19% of revenue), US (18% of revenue) and International (19% of revenue). B2C Gambling is a relatively simple business – all games and events offered give a statistical edge to the company, and they can adjust their odds dynamically over time in response to betting trends. Over many events played, this edge adds up to a consistent level of revenue.

There is a pretty clear set of secular trends that they are benefitting from:

·         Gambling continues to be a popular choice for people to spend money on. It’s highly addictive and online is bringing in more and more customers who prefer not to attend a physical site. It’s a $450bln+ market growing above GDP in total.

·         Online is taking share within the overall casino market as well as bringing new customers to the table who prefer online over travelling to a physical location – in many countries physical places where you can gamble are highly limited and far away from the average consumer. In pre-covid figures, online is only 14% (high teens ex-US) of the overall market which suggests substantial room for secular growth even outside the US. 90% of Flutter’s business is online. This means Flutter should be able generate high single digit revenue growth even in mature markets. In Europe online penetration is 33% and still growing which shows the potential for other markets.

·         Flutter has chosen to restrict itself to regulated markets (for good reasons – DTC businesses in unregulated countries tend to carry huge risk if they are not just illegal). This limits the potential for duration of growth overall but provides a more solid and predictable business model.

·         However, a number of markets like Germany and various countries in Asia and Latin America are also planning to regulate (nothing is guaranteed!) such as Brazil, Argentina and India. Flutter may be able to organically build a business or acquire a leader in these markets.

·         Flutter owns the largest business in the nascent US market with an interesting if not yet clear long-term customer acquisition advantage via the fantasy sports market in FanDuel. The US market has potential to be the size of all their other markets combined.

·         Covid has stretched many regional and national budgets around the world which encourages proper taxation and regulation of gambling for revenue purposes.

I can identify limited fundamental downside and a lot of potential upside across my base and bull scenarios. The business trades for 25x forward FCF (fully consolidating US losses, and adjusting for a partial WC reversal in 2021). There are a number of factors which should lead to underlying FCF per share growth in excess of 20%:

·         Sales growth should continue in the MSD range for more mature geographies, with opportunities to expand to new regulated markets

·         US growth should remain high, dragging overall group growth above 10%

·         The US will rise to >25% of group revenue, and US margins should over time get up close to UK levels (although not in the investment period)

·         Next year they should enter the range for buyback to begin (1-2x leverage, 2.3x end 2020)

·         Positive working capital mechanics

With 20% FCF growth and a 4% FCF yield, there is certainly a strong possibility for the stock to compound in the mid 20s over the mid-term. Looking for more margin of safety, we can create the non-US business for 12x forward FCF on relatively conservative assumptions, not adjusting for the WC reversal.

Flutter has underperformed this year due to an issue with the potential FanDuel IPO (addressed later) and concerns about comping strong numbers from last year. In my view, this should not be a concern as

·         There was a relative lack of sporting events last year which should mostly reverse

·         The mix shift towards online gambling is likely to be sustainable and penetration should continue to rise even as casinos and retail shops re-open

I’m not really sure what 2021 is going to look like numbers – I suspect it will be better than consensus fears as I think there will be better online retention but I’m really not sure and I haven’t seen anything concrete to back up my gut feeling. And honestly I don’t care that much – not owning this stock for 2021.

Gambling, due to its potential for consumer harm, tends to be a highly regulated business. This is mostly good for the gambling companies at it provides a stable, oligopolistic market with clear barriers to entry. The only challenge to this tends to be if taxation and regulation are too onerous, in which case a large black market can emerge. In the short term, regulation can also lead to profit warnings and even entire products becoming non-viable (such as the FOBT stake limits destroying most retail locations in the UK) which has always been an issue for many investors. Of course, recent ESG growth also presents a headwind for the multiple of the group and therefore it is prudent to be conservative about potential future multiples.

In summary, the advantages of the online gambling business model are:

·         Predictable revenue and profit due to statistical edge of business over large number of events.

·         Superior consumer experience over land-based betting, with no need to offer perks to attract big customers

·         Migration to online has been accelerated and reinforced by covid

·         Covid has also strengthened the incentives of local and national governments to generate maximum tax revenue

·         Regulated nature of business creates substantial barriers to entry and a relatively unfragmented market

·         Gambling companies are branded and consumers show loyalty and consistent behaviour towards them in mature markets. This gives better marketing ROI, a more predictable business, and pricing power.

·         Online gambling has limited fixed costs compared to landbased gambling which means that higher margins and better consumer prices are possible.

·         Asset light business with limited incremental investment required to scale

UK regulatory discussion

One of the key debates in such companies has been the potential path of regulation in the UK. This is important not just because 25% of group revenue comes from this market (31% UK & Ireland as above), but also because the UK is one of the flagship gambling countries and changes here could easily make their way overseas. There are many things on the table – online slots stake limits, online casino stake limits, deposit limits, affordability check changes, high value customer treatment, tax increases, play time limits etc. It’s very unclear what is going to change.

The Fixed Odd Betting Terminal (FOBT) is a machine where customers can bet repeatedly on low skill fixed odd games. A few years ago, a review began on potential stake limits on these machines as i) it was possible to lose huge amounts of money extremely quickly with little engagement or skill involved and ii) machines outside of gambling shops had £2 stake limits. The gambling commission (GC) at the time proposed a £30 stake limit which was attacked by various focus groups and eventually became the subject of major media scrutiny (the UK media hate gambling). The GC’s role in this and seeming genuflection to the industry caused major change at the GC, and they began to take a much more proactive role in looking at gambling, particularly online practices, where they found some bad behaviour. Moreover, many offshore companies became required to be regulated on-shore and tended to have quite bad practices. The fines issued under this new regime only increased the scrutiny on the sector, and as a result much more aggression is being shown by the UK on this subject.

The UK is currently undergoing of review of the 2005 Gambling Act. This was stimulated by the increased prevalence of online gambling in recent years, increased media scrutiny and focus group activism, as well as the above FOBT events. The profitability and permanently available nature of online gambling has led to ubiquitous advertising in the UK which has led to broad public awareness (and associated opposition). There is a delicate balance to be struck – regulated entities are in fierce direct competition for customer acquisition, meaning that broad co-operation is difficult to achieve on things like customer affordability, and there are many black market operators looking to strike if regulated players are sufficiently weakened by new tax and KYC burdens. Overall, broad bans are unlikely for precisely this reason – people will find places to gamble regardless of legality as it so easy to be anonymous online. There are also GDPR issues that challenge the potential for industry-wide co-operation on this subject.

In general, there are regulatory actions that have a big financial impact, and there are those that have a big publicity impact. The FOBT regulation was a huge shot to the profitability of retail stores and >50% of all UK retail stores are being shut as a result. However, recent credit card bans fit more into the latter category. Credit cards were already largely removed from the ecosystem 2 years ago when banks in the UK started treating gambling as a cash advance and immediately charging interest on credit card transactions for this purpose. As a result, only a mid single digit percentage of transactions in online gambling in the UK now are done on a credit card, and the majority of this even should transition to an alternative payment method – so potential hit from this is limited but it gets a lot of press.

The major discussion point now moves to potential stake limits in online which are really a follow on of the FOBT stake limits which were such a punitive surprise to the retail industry. My point of view is that the mechanical nature of FOBT was the real problem – you could just roll over and over again without even really thinking about it or realising the money you were losing. Therefore, I tend to think that the potential focus on online regulation would focus on slots and not broader online casino where there is more skill and focus required e.g. HoldEm or Blackjack.

The other question is really one of tax rate – there is still substantial room to move up from 21% to rates like those in Scandinavia. The UK government is desperate for revenue after covid and gambling is a very easy place to find revenue politically. That’s why it’s more likely we see significant tax increases rather than stake limits or product bans. And tax rates can generally be managed by the incumbents with large market share. Same goes also for advertising bans – the best brands (who also have retail shops) have the advantage.

Overall, my point of view is that even in the UK online is taking share from offline and there’s a good migration effect so there should still be growth even if perhaps it isn’t as significant as it has been in the past. I think big companies are always advantaged by this type of regulation – even if it reduces revenue short term - and Flutter has one of the highest market shares in the UK so I think they will be able to manage for a similar margin to today. If the black market gets too big then that’s clearly a bigger issue and regulations will have to be relaxed. If there's one point in this write-up where my bear case could be too optimistic - it's probably this one - and I suggest you get comfortable with the UK rollercoaster on this subject if you want to own this stock.

FanDuel acquisition

In order to more effectively enter the US market, Flutter decided to acquire FanDuel in 2018 and combine it with the US Betfair business. FanDuel offered an easy way to play fantasy sports online in the US, taking around 10% of the entry fees. They had around 1.3mln active users at the time, who tend to be among the segments of the population most interested in sports. Flutter’s thesis was that this would give them an initial advantage in customer acquisition that would turn into a durable branding advantage as the market grew. Initially this proved to be largely the case with DraftKings and FanDuel having 80+% market share in the early days of the market.

The second part of the equation is experience in running an online gambling company. Over time, this will be a key factor in market share. Whereas DraftKings has lost some market share, FanDuel has managed to largely preserve it. The biggest share taker has been BetMGM which had the strongest management team and technology of any of the new entrants. They have become the new number 2 in the market from a standing start. FanDuel has had the best of both worlds for the most part – a strong existing presence among the most interested customers and wealth of experience and talent from Flutter. This has allowed it to become the stable number 1 player while spending similar money to DraftKings (around $500mln in 2020 for both) - DraftKings have highly amusing quarterly reports btw, and in my view their S&M accounting is probably understating things. The success of BetMGM clearly shows the value of having experience in managing an online gambling companies, underlining FanDuel’s advantage against DraftKings. I expect them to be one of the market leaders for the foreseeable future.

A key source of underperformance this year has been the delay of a potential Flutter IPO due to a lawsuit by Fox. Flutter would likely receive more credit for the valuation of FanDuel if it were publicly traded as it would likely trade at a similar multiple to DraftKings or higher. Fox have the option to acquire 18.5% of FanDuel at some point in the next 10 years at a “market price”. Fox claim that this price today should be set at the Fastball transaction value instead. Flutter claim that it should be set at a market price – either as part of an IPO process or benchmarked to DraftKings. This latter valuation could be 2-3x the Fastball valuation. I have no particular view on this option and I largely view it as an irrelevance so I have chosen to use the most conservative option – that Fox is allowed to acquire the stake at the Fastball valuation. Clearly Fox don't want an IPO yet as that would be a clear mark for their option.

There are a few other minorities to work through but these are insubstantial in the grand scheme of things.

US Market

Note on sourcing: all data below is released by the US and UK economic authorities (as well as those of various states). GB gambling commission + various states gambling authorities are where all the below data comes from.

The US sports betting market was opened up by a supreme court decision in 2018 that repealed a law called PASPA. This law essentially limited sports betting to Las Vegas. In the aftermath of this decision a number of states chose to legalise sports betting in their respective states. A smaller number of states are also choosing to legalise online casino. Currently 22 states offer legalised sports betting, comprising 39% of US GDP, and a further 9 have active legislation to allow it. Covid has accelerated these efforts due to budget shortfalls in many states. However, 10 states comprising 19% of US GDP are unlikely to positive legislate on this matter in the next 25 years. I have identified all these states in the appendix. The addressable US GDP of the 41 states who might positively legislate in the near future is for these purposes is USD18trn.

We know that total handle (the more comparable figure than yield as yield is a feature of market structure) for online sports is around £15bln in the most recent reported period or 0.6% of GDP. We could say then that the potential for US handle at current GDP is USD120bln. In the UK, historical yields on this handle have been in the mid teens (16% in 2019).

Moreover, in 2019 (referring to April 2019 – March 2020 for which the GB gambling commission have provided detailed data), the total online sports GGY in the UK was £2.3bln. The UK is a sports mad country, and it seems likely to me that in the long run the USA will achieve a similar level of total yield relative to GDP or around 0.1%.

This is the most comprehensive report available on historical US sports betting data (and other casino – but can be difficult to parse for those purposes):

https://gaming.nv.gov/index.aspx?page=149

However, Nevada patrons are a different breed to the averaged US consumer so keep that in mind. What these reports show are typical sports yields of around 5-8%. This is much lower than in the UK. Only time will tell whether Nevada or the UK is a better guide but clearly it makes a significant difference. My general expectation is that the DTC companies will manage for more UK like yields and that the Nevada data is skewed by the clientele and huge number of competing companies – the US online market will be much more consolidated than the Nevada market on the ground.

This leads to the following type of math for sports betting

Handle $120bln (0.6% of 2021 GDP in 41 addressable states)

Low revenue = $7-10bln based on Nevada data

Expected revenue = $20bln based on UK yields.

DraftKings have presented an interesting narrative on this front. They argued at their investor day for the following

·         2018 UK sports betting revenue = $2.5bln (implied by below 2 numbers)

·         2018 UK adults = 53mln (DK don’t give their number)

·         2018 gross revenue per adult in the UK = $48

·         2023E gross revenue per adult in the UK = $88 = $48 grown at 13% compounded for 5 years. 13% is average online growth of the UK market from 2013-2018 (i.e. online only and not per capita)

·         USA GDP per capital = 1.54x UK GDP per capita

·         USA 2023 gross revenue per adult in the UK = $136

·         Adults in the US = 240mln

·         US sports betting TA = $33bln = $136 * 240mln (they claim that the output should be $36bln – I guess they have a different adult number!)

There are a couple of issues with their calculation

1.       Only 81% of US GDP is likely to legalise sports betting whereas 100% of the UK is legalised. This takes their high end estimate down to $26bln

2.       The actual UK gross revenue per adult is very unlikely to grow at 13% compounded over 2018-2023. This includes migration from retail revenue which is the majority and which is flat/declining. They have used the online growth rate over 2013 to 2018 to generate an expected growth rate over 2018-2023 when this migration effect will be much less.

3.       The UK has a highly mature, multi-decade old betting market, with high market share concentrated among few players. This leads to better take for the operators and higher GGR per consumer all else being equal.

For context, my US cases roughly correspond the following top-down situation in 2025 for Flutter in sportsbetting:

·         Bull: 30% share of an $8bln market

·         Base: 25% share of a $6bln market

·         Bear: 15% share of a $6bln market

My view is that this is a pretty reasonable spread, if perhaps a bit conservative on the potential spread of the overall market. The other key flex point in this conversation is of course related to gaming. My general view is that igaming in the US is going to be a smaller market than sports, mostly due to inferior regulatory treatment. This picture is complicated by the acquisition of TSG during which they acquired PokerStars US brands. This temporarily caused the US igaming revenue to be bigger than sportsbetting (also caused by the lack of sports events during covid of course). This trend should reverse as the FanDuel revenues will grow much faster than PokerStars.

One final way to look at it would be to apply Europe’s 33% penetration of online and apply it to the US. Even if this was full cannibalisation of the land-based market (has not been the case in other geographies), this would imply a $26bln total online gambling revenue opportunity.

Caveat to all numbers above – there are lots of different ways to measure things in this sector and it is not that easy to get a really good picture of what the data looks like.

Financials

The general viewpoint I have adopted when modelling is to strike a balance between i) the abnormal results of 2020 both on growth and margin and how much potential there is for reversion, ii) the synergies achievable from the TSG transaction rolling through and iii) the potential for negative regulatory impacts particularly in the UK, where there is also a continued migration effect from offline to online. I’ve mostly ignored the potential of new markets, with the exception of the US– I separated the cases on the US and core parts of the business as they have quite different drivers and outcomes, as well as a different valuation impact and approach.

Flutter has generally shown more M&A ambition (TSG, Flutter, SportsBet, BetFair) than organic ambition and I think this is the likely approach to new markets – you could think of some of the capital from buyback being deployed into M&A instead at 10-15x EBITDA with organic growth in the Intl also trending up with earlier stage acquisitions.

I’ve taken a more granular approach to the US as there is much less historical data on growth and a much less clear competitive environment. I’ve also included wider spreads in my assumptions. I’ve generally ignored external commentary and assumptions and gone with my opinion, while triangulating my final results with implied market share on the basis of third party market estimates. If anyone is interested in specific assumptions on some point happy to share them in the comments - will just share output here

Base case financials:

Risk Reward

Over 4 years I see the following potential outcomes:

Upside PT: GBP 585 (380% upside) based on 25x core FCF/11x US revenue

Base PT: GBP 285 (130% upside) based on 20x core FCF/8x US revenue

Downside PT: GBP 98 (20% downside) based on 12x core FCF/4x US revenue

This is my base case view: happy to share output on bull and bear also but don’t want too much image spam

Catalyst

·         Flutter IPO + minorities resolution           

·         Comping of strong covid numbers and rebasing of numbers

·         UK gambling review comes to an end