Over the past 5 years Ladbrokes has dramatically underperformed its UK retail peers, William Hill and Paddy Power. While its retail performance was marginally weaker than peers, the key difference lies in the online segment where LAD’s revenues were roughly flat and profits down considerably while peers grew at c.30% CAGR. This has resulted in an overall lower earnings base compared to peers and a steep valuation discount.

In March 2013, Ladbrokes announced a new strategic partnership with Playtech whereby LAD’s online division is being outsourced to Playtech (PTEC – has been written up on VIC in the past). Learning from the WMH-PTEC experience and PTEC’s own performance track record we believe this will be a game changer.

Our scenario analysis shows a potential IRR range of between single-digit negative return to >40% over 3 years

Brief Business Description

Ladbrokes’ business can be divided into 2 categories:

• Retail and related: cash cow with attractive fundamental characteristics
  • Gaming Machines (32% of net revenue) : Up to 4 per shop
  • OTC Betting (49% of net revenue)
  • Telephone & high rollers (1% of net revenue)
  • Online: high growth with large untapped opportunity

Investment Thesis

Over the past several years Ladbrokes shares have dramatically underperformed peers. In the past 5 years LAD shares are up 2% compared to 150% for William Hill and 325% for Paddy power. The reason for this is simple: while retail performance has been similar to WMH, online has dramatically underperformed. WMH online net revenue has grown at 34% CAGR while LAD’s has remained flat.

Online earnings fetch approximately >2x the multiple of retail earnings. Therefore the revenue mix change has driven a large valuation disparity between the 3 UK peers whereby on a 2014 P/E basis Ladbrokes (20% of online) trades on 9.6x, WMH (>40% online) is on 13.6x and Paddy Power (70% online) on 18.7x. Therefore, solid performance of Ladbrokes online division would not only increase the earnings base, but also drive a significant re-rating.

William Hill Online JV

In late 2008 William Hill partnered with Playtech to form William Hill Online (WHO). WHO grew its EBIT from £55m in 2008 to £145m in 2012. In April 2013, WMH paid £424m to buy out PTEC’s 29% stake in WHO, implying a total valuation of nearly £1.5bn or 80% of LAD’s current market cap!

Ladbrokes-Playtech

Shortly before the WHO stake sale was completed, Playtech announced a new partnership with William Hill’s largest rival in retail, Ladbrokes. The deal went into effect in May 2013

The agreement is structured as follows:

–      Ladbrokes licenses PTEC’s casino games software and content from PTEC, replacing existing vendors

–      Mobile product to be developed on PTEC’s highly successful Mobenga platform

–      New Ladbrokes-Israel office established with ~100 highly experienced employees

–      Playtech runs the back office and supplies CRM and marketing though its PTTS subsidiary

• Financial Terms:

–      Casino software is licensed at ‘normal commercial terms’

–      Ladbrokes-Israel is full subsidiary so the cost of salaries and fixtures is on LAD

–      Playtech provides PTTS and related services at its own cost with the following incentive:

• Playtech is entitled 27.5% of the incremental EBITDA of Ladbrokes online over the 2012 base (£44m) in the form of a buyout at Ladbrokes overall group multiple at the time of trigger
• The triggers are EBITDA growth of £35m, £70m and £100m by 2017

–      At least 25% of payment will be in LAD’s shares. PTEC has discretion to ask for more in shares

This deal is transformational for Ladbrokes as it fills all the gaps it had in its online segment including a strong mobile product, a single wallet platform and most importantly Playtech’s CRM and customer intelligence.

This will allow Ladbrokes to grow its online segments through the following avenues:

• Improving player yield:

–      While LAD’s number of active players has grown 32% over the past 4 years, its yield per active player has declined 16%

–      Over the same period WHO’s number of active players has increased 39% and its yield per player has increased 69%!

–      As a result, the yield per active Ladbrokes player went from 33% premium to a WHO player in 2009 to a 34% discount in 2012!

–      Reducing player yield discount from 34% to 10% would increase LAD’S EPS by 20%

• Growing with the market: The UK market has grown 11% CAGR over the past 5 years while the global market has grown >20% CAGR. LAD’s has not grown at all
• Gaining Share:

–      LAD’s UK retail market share is 28% vs just 7% online

–      WHO has gone from 8.9% to 19% in 5 years

Earlier this year, Ladbrokes acquired Betdaq , the #2 betting exchange behind Betfair. This will allow it to integrate the exchange with the sportsbook which will offer a differentiated product in the market. Something Betfair is currently trying to build. This is scheduled to be in place by end of the year. Currently, ~30% of LAD’s sportsbook customers already use exchange betting. Keeping those customers on LAD’s site will increase share of wallet + enhance liquidity on the exchange. It also allows Ladbrokes to possibly enter international markets through the exchange and build liquidity as first mover.

Retail

In terms of retail, the business is roughly steady. 2%-3% annual decline in OTC betting due to shift online is offset by growth in revenue from gaming machines in the shops as well as low single digit % annual increase in number of shops. In general the UK bookmaker market has become quite consolidated with the big 4 now accounting for 85% of all shops vs just 40% 20 years ago. The company a 3 year cash payback on new shop openings.

Given the almost entirely inflation linked fixed cost base it is necessary to grow revenues of the retail business low single-digits annually to keep EBIT flat. Bears argue that as machine LFL growth has stagnated this year and OTC betting gross win margins will converge with online, retail earnings will decline sharply.

In terms of machines, we actually think 2014 may see a strong reacceleration as the company is currently rolling a new generation of machines across its estate. The prior 2 roll-outs generated year 1 LFL growth of 22%(2007) and 18%(2011). The company has launched several other initiatives such as loyalty cards to improve utilisation of its machines.

Regarding gross win margins, while online betting has been around for a long time, there is no evidence of any impact on retail gross win margins. That said the argument makes sense. However, market dynamics are such that lower gross win margins tend to drive higher wager activity resulting in a similar net revenue base. For example, Paddy Power matches its online and offline odds which means that their retail gross win margins are far lower than Ladbrokes’. In return its turnover per shop is double. Looking across products and companies, there is a clear negative correlation between turnover and gross win margin. Therefore, declining margins (if it happens) might not necessarily translate into declining revenue. It may well be that this would increase wagers which are currently declining.

Upside/downside

Our base case assumes the online division grows 22% CAGR out to 2017. This would achieve the middle-of-the range for EBITDA targets of the playtech deal. We also assume 4% lfl growth in machines in 2014 and 2% annually thereafter, while OTC gross win margins decline 30bps per annum and wagers per shop decline 1% per annum. Under such a scenario, assuming WMH’s current multiple and taking into account the 4.5% dividend we get an IRR of 25% over 3 years.

A more bullish outcome, achieving the high end of the playtech deal targets can generate an IRR of >40%.

In terms of downside, even if machines don’t grow, OTC margin declines 50bps per annum and wagers per shop decline 2.5%  while the online division grows in line with the market, we get a single digit negative return on the investment. Hence the risk-reward here seems very compelling.

As soon as the online division starts showing acceleration in growth which we think could happen in early 2014 the stock will start re-rating as investors begin to price in the probability of replicating the success of the WHO JV