Description

Netent AB

NetEnt AB is a Swedish supplier of online gaming technology used to operate and monitor gaming transactions. The company has an impressive track record of revenue growth and a consistent history of profitable operations. Its 10yr median revenue growth rate is about 12%, and the 10 yr median EBIT margin is just above 32%. 10 yr median ROE is an impressive 56%. Its main customers include among others Betsson, PokerStars, William Hill and Lottomatica. 85% of revenues are generated in Europe, but it is increasing its presence in other parts of the world as well. In 2019, 92% of revenues were generated from slot games and 8% from table games. FY 2019 revenues and EBIT were about 1.8 Bn and 530m SEK respectively. 

The global market for online casino gaming is about 14 Bn EUR, while the total gambling market was estimated at 400 Bn EUR in 2019 (H2GC estimates). In Europe, the market share of online is larger than in the rest of the world, at roughly 25% of the casino market. This grew by low double digits in 2019. This market is generally believed to grow by mid to high single digits going forward. 

One may then reasonably ask why NetEnt is available at such an attractive valuation (P/E ~13) if growth potential is good and the margins are high. What's the catch? There are several.

The reasons include decreased growth rates and increased regulatory pressure over the last few years, and increasing competition in some of NetEnts most important markets. This has resulted in massive multiple contraction in the Swedish-listed gaming companies and very reasonable valuations. In NetEnt's case, that has meant a contraction from 48x EV/EBIT in 2014 to roughly 16 now (on a T12 basis). Several of these companies are cheap, I prefer NetEnt because it has no sportsbook exposure, which is beneficial in a world with virtually no ongoing sporting events, however I am also looking closely at Betsson. I believe these pressures are unlikely to go away and will stay a major risk factor for NetEnt and the online gaming business.

As a result I also believe it is realistic to believe that sector margins will continue to contract somewhat (though not at the same pace as previously) from current levels going forward, just as it has over the last ten years: T12 EBIT margin for NetEnt is still high at nearly 30% (2019), but in 2009 it was as high as 40%. Note though that the 5 yr median EBIT margin is at 35%, higher than the 32% median for the last ten years. Other important risk factors in this investment case includes exchange rate risk, customer concentration and possible (though not known to me at this point) disputes over intellectual property rights.

I don't believe that these pressures will stop revenue growth and profitability for NetEnt and the sector more broadly, however. One of the reasons is that the increased regulatory scrutiny will lead to the exit of smaller and less profitable players, another is that NetEnt is present in several different geographies/countries and I believe they will continue to navigate legislation successfully overall. Furthermore, increased regulatory scrutiny will probably mean moving toward licensing systems in regulated markets and put major pressure on unregulated/illegal online gaming, which will favor the incumbents and increase barriers to entry in the future. Finally and most importantly, I believe COVID-19 will prove a catalyst for increased online casino activity over the long term. This is already happening, but the virus will probably accelerate the process. In the short term, the company appears to be benefitting from increased appetite for digital content as well judging by their march numbers (see Q1 report).

NetEnt operates in a fragmented market, which means there should be possible to grow through acquisitions as well. This could be important, as organic growth rates have been poor recently, most notably in Norway and Sweden. NetEnt has already made what looks like a good deal though. To accelerate growth and strenghten its market position, NetEnt acquired Red Tiger, a fast growing online slot provider in September, the first major purchase they have made. They paid around 220m GBP for the company, which generated an EBITDA of roughly 18m GBP in 2019. This was an all cash deal financed with bank loans and a small equity issue, leaving NETB with a Net debt/EBITDA of 2 on a T12 basis and a very managable 1.4 in 2020e using FY consensus EBITDA. Hence, I view balance sheet risk here as very low, and expect the company to be able to service this debt comfortably and pay out dividends around 4-6% annually should they not go for further acquisitions. 

NetEnt believes the acquisition will help in creating new an exciting content and capitalize on what they refer to as a scalable global platform that has been built over several years. They also claim the deal will lead to annual cost synergies to the tune of 150m SEK. Going forward, NetEnt appears to have decent growth potential both inside and outside Europe (Croatia, Switzerland) and both North and South America. They are now present in several US states (Pennsylvania and New Jersey, where they're seeing solid growth, and soon Michigan (2021)) and are also moving into Colombia. Mid single digit revenue growth therefore seems realistic. I'm assuming mostly organic growth here with further acquisitions as a bonus. 

What's NetEnt worth? Certainly more than 13x current EPS. 

Trying to be precise is always difficult, but I'll give it a shot. I think the company will be able to grow its top line by 5% annually over the next few years (using a estimated 2.2 Bn top line in 2020 as the starting point) without doing further acquisitions. I further assume the EBIT margin contracts from a median of 35% over the last 5 years to 30% in 2024. I'm assuming assuming tax rates, D&A and capex as a % of sales stay in line with historical norms and I'm not making any explicit assumptions about working capital changes.

I think a 6% FCF yield is a fair target valuation for a capital light, highly cash generative company like NetEnt, i.e. a terminal FCF multiple of 16.7x. This is only slightly lower than the current valuation multiple using last years FCF figure.

Hence, in a base case scenario this company is worth around 49 SEK, compared to a market price today of roughly 35 SEK.

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Catalyst

Earnings boost from Red Tiger deal, entering into new jurisdictions, structural trend toward more online gambling accelerated by Covid-19