Two weeks ago the French Government privatized, via an IPO, the majority of France’s monopoly lottery system, La Française des Jeux (FDJ). FDJ provides an opportunity to invest in a growing, recession resistant company with 25-year exclusive rights to operate lottery and retail sports betting services in France at a compelling valuation and an unlevered balance sheet. We believe FDJ will provide a 50%+ return over the next 2 years. Not yet covered by any analyst, we expect an initial re-rating when a range of US and European banks launch coverage in the coming weeks and then a further re-rating as the Company highlights its various growth and profitability initiatives in its first quarters as a public company. 

FDJ has been granted an exclusive right to operate both offline and online lottery services throughout France in exchange for a one-time future payment of €380 million.  Similar to other lotteries around the world, FDJ has grown at consistent low-single digit rates and has been very resilient during economic downturns, as the low ticket, high upside nature of the purchase makes it one of the last expenditures a household cuts even during tough times. 

FDJ also operates a smaller sports betting operation in France via its Parion brand, both in retail, where it has also been granted an exclusive right to operate, and online where the Company is a challenger brand to larger players.   Sports betting is a high growth category as regulation of the space has allowed for increased marketing and deepening penetration, although penetration is still lower in France than European counterparts. FDJ has historically under-invested in this space, providing upside optionality both in higher country penetration as well as improved performance/market share.

FDJ is part of a privatization effort by the French government, seeking to monetize certain state-owned assets to finance a €10 billion government innovation fund. Unlike the typical IPO, we believe the seller (the French Government) has a strong incentive for this IPO to be underpriced given both the large retail French citizen participation and the stated desire to IPO a number of other Government-owned assets (e.g. Engie, ADP).

Moreover, now that the company is no longer under the government’s control, both topline and bottom line growth should accelerate due to increased flexibility to take on debt, increased investment in product innovation and digitization, increased cost cutting and operational right-sizing once out of the government’s control and various other organic and inorganic growth opportunities.

FDJ Business Overview

Lottery Services in France (80% of revenue, 95% of contribution margin)

FDJ has been granted a 25-year exclusive right to operate both offline and online lotteries throughout France, representing approximately 80% of the Company’s total stakes and revenues, and over 95% of contribution margin.  This business is a recession resistant cash flow machine with minimal near-term risks given the lengthy exclusive agreement with the French government.  

Over the last 5 years, French lottery stakes and FDJ net revenues grew at a 3.8% and 2.5% CAGR, respectively. FDJ’s slightly slower net revenue growth rate is due to the fact that historically FDJ’s “take rate” was modified annually via ministerial decrees.  However, now that the company has been privatized, these decrees will cease to exist and any changes to FDJ’s take rate can come only through new laws passed by the French legislature. As such, net revenue growth and stake growth should grow in tandem, likely at least at a 3-4% CAGR rate over the next 5 years. 

FDJ Historical Stake Growth (1999-2018)

France’s higher lottery growth rate relative to other European markets is primarily being driven by higher spend per player (€192 GGR per adult), which remains moderate compared to the rest of Europe (Spain: €223 GGR per adult, UK: €295 GGR per adult). In addition, instant games (i.e. scratchers) have grown significantly faster than the traditional draw games (i.e. Powerball equivalents), particularly as they appeal to a high spending, more regular customer base.

FDJ sells lottery services primarily through 30,000 independent points of sale (PoS), allowing the Company to be within 10 minutes of over 90% of the French population. These PoS’ have historically come from a traditional network of bars, tobacconist and news agents, but increasingly have been coming from hypermarkets, supermarkets, and gas stations.  While these retail outlets will always play an important role in FDJ’s lottery business, there is a real opportunity for FDJ to increase the digitalization of lottery in France given only 5% of stakes are currently digitalized (compared to 10% for Sisal/Italy, 24% for Camelot/UK and 42% for Veikkaus/Finland). As stakes continue to be digitalized in the lottery market, FDJ should be able to expand its customer base, increase usage (and therefore loyalty) outside of its PoS network and drive additional operating leverage in a business that has substantial fixed costs.

Sports Betting Market (20% of revenue, 5% of contribution margin)

Similar to the lottery business, FDJ has been granted a 25-year exclusive right to operate retail sports betting throughout its independent point of sale network via its Parion brand.  The retail sports betting business constitutes ~15% of total stakes, meaning that in conjunction with the 80% of stakes generated by lottery, 95% of FDJ’s business is operated under 25-year exclusive rights. The remaining 5% of stakes is generated by the online sports betting business, where FDJ is 1 of 14 licensed competitors and currently sits in the 2nd tier given a historical lack of investment in product, market depth and technology by the state-owned enterprise.

Over the last 5 years, the sports betting business has exhibited 12% CAGR growth and has accelerated in recent years as mobile penetration in the sector continues to deepen. FDJ continues to grow despite the online sports betting’s market share gains from the monopoly retail market, largely due to the nascent nature of the sports betting market in France.

The online sports betting market is consolidated with the top tier players Betclic, Unibet (Kindred) and Winamax controlling approx. 60-70% of the market, although precise figures are unclear. FDJ’s Parion brand likely constitutes a high-single digit percentage market share. This level of concentration is a bit unusual, and is due to the French government’s notoriously high gaming tax rates.  Online sports betting currently has a 54.9% tax rate on gross revenue compared to 15-25% for other European countries. On the remaining balance, the French government charges 20% VAT; following that, companies also have to pay corporate taxes on profits (28.5% beginning in 2020). With total taxes such a high percent of revenue, the majority are not profitable within France.

We believe Parion has the opportunity to become a premier online sports betting brand, leveraging an omnichannel strategy similar to UK counterparts like PaddyPower, Ladbrokes and William Hill, given brand awareness for Parion will naturally be much higher than any online counterpart. Now privatized, the Company should be able to invest more heavily in their online capabilities and create a more efficient marketing strategy to grow market share in the online business, while still supporting retention in the offline business.  The retail monopoly will allow them to maintain profitability for the overall sports betting business while in investment mode for online. And given the minimal contribution margin from this business, coupled with a high growth outlook in an immature market and the potential for share taking, we believe there is opportunity to rapidly expand profitability in this business.

For even further optionality, it was rumored last year in the press that the owner of Betclic, which is believed to be the #1 operator in the online sports betting space, would be interested in selling to FDJ once privatized. Such a transaction would immediately bring significant scale and expertise to FDJ’s online business, allowing for an immediate expansion of profitability for their platform. 

Adjacent Activities

Although currently small as a function of revenue, FDJ has developed plans to leverage existing infrastructure into additional revenue and profit streams. We currently assign no value to these plans, but they do provide additional drivers of potential upside for the business. These plans include:
-  International B2B Services, whereby FDJ would provide turnkey solutions for sports betting operators as well as distribution of online games and software solutions for point of sale equipment in the lottery space. There have been some early wins, signing the Portuguese lottery, the Israeli sports betting operator, the three Scandinavian lotteries, etc.
- Payments and Services, whereby the Company will leverage its footprint with their 30,000 PoS network of bars, tobacconists and news agents to position themselves as a collections service on behalf of third parties and payment solutions, as well as develop their own payment solution for their gaming customers.

Capital Allocation and Management

As a government run entity, FDJ remained mostly unlevered. Now that the Company has been privatized, it should begin to add some leverage to its balance sheet; 95% of the business is a recession resistant monopoly and lower quality international counterparts such as IGT or TabCorp employ 3.5x – 4.5x leverage.  FDJ Management has indicated it is open to a 2.0x Net Debt/EBITDA ratio, which considering where rates currently are in Europe, implies they have significant firepower to make value accretive deals in the future.

Additionally, given that the French government maintains a ~20% stake of the public company, dividends will continue to flow as the Company has indicated returning ~80% of net income to shareholders annually starting in 2020. Currently, the dividend yield on the stock is 3% but that understates two factors: 1) corporate tax rates in France are set to decline to 28.5% in 2020 and continue down to 25% in 2022 and 2) as part of the privatization, the government has written into law a more favorable gaming tax regime, implying on pro-forma 2019 numbers, the proposed payout ratio is only 65% compared to the indicated 80% going forward. . Given these factors, we project dividend yields of 5% in 2022 based on the current stock price, too high for this quality of business.

We do not know too much about Management although our checks on the current CEO, Stéphane Pallez, have been very positive. Pallez became CEO on 21 October 2014 and has previously had a lot of senior government experience (including Deputy Director of the World Bank) and senior corporate experience (including CEO and Chairwoman of CCR).

Valuation

FDJ currently trades at a 6% 2020 FCF yield for a business that is 95% growing monopoly / 5% ultra-high growth online sports betting operation, with upside optionality to expand both growth and margins through the continued digitalization of the broader business.  Additionally, a government-owned entity likely has excess to cut from its operations that may provide even further upside to the margin story. And while we do not assume that the company will take on debt for M&A purposes, that remains a distinct possibility and provides further upside to our numbers above.

All together, this is a business that on conservative assumptions should be able to grow top-line revenue at mid-single digit range (LSD for lottery, HSD for sports), and with operating leverage (40% of costs are fixed) grow EBITDA/FCF at a high single digit to low-double digit CAGR. Therefore, at the current price, we are getting a very stable, growing business at a reasonable valuation with multiple paths to meaningful value creation for shareholders. As such, we feel that a 5% FCF yield reasonably captures the upside optionality from prudent capital allocation, while also being quite reasonable for a business that should be growing its FCF at a HSD/LDD CAGR over the coming years.

Moreover, while we aren’t major proponents of relative valuation, it is worth noting that the closest comparable to FDJ is Australian-based TabCorp, which has a virtual monopoly on lotteries/keno, a monopoly on retail sports betting/horse racing and a competitive position in online sports betting/horse racing.  Relative to FDJ, the mix is much heavier toward the sports betting side of the business (~42% of revenue), where TabCorp has been struggling to maintain share in the online space against the global gaming peers Flutter, TSG and GVC. This is a problem FDJ need not concern itself with given that abnormally high French gaming tax rate dissuades new entry. Compared to FDJ, TabCorp is projected to grow much slower (~1% CAGR) with modest margin expansion, and yet still trades at a 4.5% FCF yield and 12x EBITDA.  It is also relevant to note that in 2017, Tabcorp purchased Tatts Group, which has a 98% market share in lotteries in Australia in addition to a small betting business for ~14x EBITDA, once again despite the lower growth and lack of optionality on the margins and capital allocation.

Technical factors and government incentives

Risks

Regulation

The French government / regulator determines the return to player ratios (total prize payouts relative to total stakes) for all games offered in the country, as well as controlling the gaming tax rate, so negative movements on those factors would be the primary risk to the business. That being said, return to player ratios in France are already much higher than other countries (68% for FDJ/France vs. 58% for the cumulative European lottery market), and the gaming tax rate as we stated before, is multiples higher.

Sports Betting Failure

While the retail sports betting business continues to grow both revenue and cash flow, investment to get the online business to scale may be substantial. If the company fails in creating a strategy that has worked for UK counterparts, then eventually the retail business will begin to decelerate or shrink as the online market continues to capture share and FDJ does not participate in the share-taking.