Description

INVESTMENT THESIS

This is not your typical VIC idea, however, NLR presents a rare opportunity to participate in the high growth on-line gaming space at a reasonable price. NLR is the leading provider of a highly liquid currency used for online gambling in a regulatory environment that prevents major U.S. banks from entering it directly; and you are doing so at a discount of anywhere from 50 to 80% of the company’s intrinsic value. Further, should its international business materialize as expected, our estimate of intrinsic value would grow materially.

SUMMARY

Neteller (NLR) is an Isle of Man-based company that is to online gambling what PayPal, the eBay-owned payment system, is to general online transactions except that NLR has been exceedingly profitable from day one (PayPal does not allow for online gambling). The company provides a secure online funds transfer service that enables gamblers to load, withdraw and transfer funds to and from an electronic Wallet and subsequently use the funds at any gambling site that supports Neteller’s online payment system.

As an example, a Neteller account holder can place a bet on the NCAA college basketball tournament from a sports betting site and subsequently play poker at a different online casino gaming site with ease. Unless a gambler waits 3 to 4 days, when he first puts money in his e-wallet, he pays NLR a fee; and each time the gambler moves between web sites, the hosting site pays Neteller a fee. The company not only has a superior product and reached critical mass with a leading 20% market position, but it will benefit disproportionately as online gaming continues to grow.

There are material short-term catalysts that include: (1) the IPO of Party Gaming (6/24/05), the owner of Party Poker (the largest online poker site), bringing heightened awareness to online gaming from institutional investors, (2) increased wall street research coverage to the space due to recent IPOs of a number of gaming stocks, (3) Potential transfer of 250,000 internal online payment customers from Party Poker to Neteller, (4) the materialization of the expected growth in the 3rd quarter of this year, (5) an alliance with a major European financial institution to protect itself from any potential U.S. regulatory issues, (6) the launch of a Japanese product in June this year, and (7) growth of its recent China-based (Macau) acquisition.

Management has a stellar pedigree led by the CEO, Gordon Herman, whose previous job was as President of GE Capital Leasing Canada, the youngest person to reach such a major role at the company. Gordon is currently building out the management team to handle the rapid growth of the company, including the opening of new markets in Asia – specifically Japan and China this year. Currently, over 80% of the placed bets are by United States citizens, so global on-line gambling expansion should provide exponential growth opportunities for the company as well as diversification away from potential regulatory scrutiny in the US. At the current 15-17 times our estimated 2005 earnings and 10-12 times 2006 earnings, we believe the company is extremely undervalued at current prices and should double in the next 12-18 months.

INVESTMENT HIGHLIGHTS

Attractive Business Model:
The company provides online money transfer services worldwide primarily for use in online gaming transactions. Revenue is generated by charging fees on transfers made between customers and participating merchants. The keys to the revenue model and continued growth are its already sizeable base of customers (gamblers) and merchants (gambling sites), the associated “network effect,” the absolute and relative strength of their product offerings, and the difficulty of replicating their infrastructure and merchant network. This enables NLR to grow average daily signups and average daily receipts at above industry growth rates.

The company makes money in four ways: (1) initial payment to go online by the gambler, (2) transfer of the money into merchant website, (3), use of the float, or the currency that is left online in the Neteller accounts, and (4) foreign exchange.

(1) If a user wants to play immediately and transfers money into his
Neteller account, the company charges an 8.9% fee; however, if the
user will wait two to four days, then there is no charge.
Considering the nature of gamblers, this revenue source is not
going away for Neteller, though it could shrink in time. This
product is called Instacash and represents 30% of Neteller’s
revenues. Merchants will at times subsidize this fee and in these
cases instead of charging 8.9% to the user, Neteller charges the
merchant 5.5%. This product is called direct accept and
represents 15% of Neteller’s revenues.

(2) When the money is transferred to the merchant’s site from the
Neteller account, a 3.1% fee is charged to the merchant for each
transaction; nothing is charged when it leaves a merchant site.
Gamblers tend to move their funds in and out of different gambling
sites. This churn will not go away as different sites offer
different odds, games, tournaments, etc. This represents 45% of
total revenues.

(3) The cash that sits in wallets unused can be invested by
Neteller. That figure is now over $110 million and rapidly
growing. Though this money sits in a trust, the company makes
money on the interest and can invest it within certain parameters.

(4) The company generates additional revenue from other fees,
including a 1.9% charge for a peer-to-peer transaction and a 2.0%
charge on foreign-exchange (FX) transactions.

Substantial Customer Base:
Neteller’s customer base has grown from 100K members in January 2002 to over 1.5 million by the end of Q1 2005 and is expected to grow to 2.5MM by the end of the year. Current daily added subscriber rates are 2,800 per day and expected to increase to 4,100-4,200 for the last four months of 2005 as football, hockey and basketball seasons begin and the outdoor summer season ends. This increase, which occurs during the fall sports season, historically has been a permanent jump. New member signups should receive an added boost from new growth from Asia – primarily Japan and China.

The existing base of customers is safe as well. Neteller is reliable and trusted by gamblers and currently there are no other real options that offer the same capabilities as Neteller. Firepay recently launched an indemnified product (e.g. instant access to funds by the user) but it is restrictive as to the total amount that can be deposited ($300 maximum per week) and the cost is $6.99 per deposit. Further, Firepay is not affiliated with nearly as many sites as NLR.

Value to Merchants:
Neteller differentiates itself by offering merchant operators 100% guaranteed non-refutable funds from customers. The value proposition for the merchant is that this enables them to outsource their credit risk operations and focus on operating the gaming site. Consequently, the merchant does not take any credit risk associated with bad accounts. Either the merchant or the gambler will pay for this indemnification – at the choice of the merchant.

The additional value for merchants is that they have access to over 1.5MM Neteller account members out of an estimated 6MM online gamers in over 100 countries.

Another advantage for merchants is Neteller’s ability to settle in multiple countries and currencies. Merchants can market their games to different countries and enable play in various currencies. For poker games, this enables merchants to attain critical mass by enabling players from different countries to play against each other.

Finally, merchants are exposed to new regulation from the UK that creates a legal requirement to prevent underage gambling. With Neteller’s screening process, the company could add controls in their systems very easily to help prevent underage gambling. It would be much more difficult for the merchant to screen for this – i.e. a 15 year old with a debit card can directly transfer money to the website without going through any type of identity check. A Neteller account cannot be opened by a 15 year old because the company checks credit history (which a 15 year old will not have).

Value to the gambler/customer:
From a user’s perspective, there are many advantages to Neteller. First, because a majority of online gaming sites (1,500 out of 1,600 sites) support Neteller’s online payment system, a user can easily jump from site to site with his money to find the best odds for a sports bet or play in specific tournaments offered by different operators. Second, money can be transferred in by credit card, ACH (automated clearing house) or bank transfer and can easily be withdrawn using a debit card provided by Neteller instead of waiting for a check to arrive in the mail. Finally, Neteller users avoid bank rejection from certain types of transactions. Due to the combination of an uncertain regulatory environment, high bad debt risk, charge backs and difficulty executing two-way transfers, 70% of banks routinely reject internet gaming transactions (e.g. transactions that are specifically coded “7995”). Neteller avoids the regulatory risk as they are an FSA authorized e-money issuer which essentially means that Neteller sells e-money to their users which is a legal transaction. Subsequently, the customer can use that e-money for online gaming transactions which is also legal because the e-money was issued at the Isle of Man, where online gaming is legal.

Significant barriers to entry:
Technically, developing a basic online payment system focused on the online gaming industry is fairly simple; yet it is far from easy. There are four main barriers to entry. They are:

(1) Arranging licensing agreements with 1,500 individual merchants
who trust the reliability and credibility of the system. And, by
having these arrangements in place, gamblers are more apt to use
NLR’s payment system which in turn reinforces each site’s need to
offer it. Gamblers, like most people, are creatures of habit and
rarely switch from a product that works as well as NLR’s. This
network effect is similar to that experienced by the likes of
PayPal.

(2) Recreating the extensive credit risk analysis systems to manage
the bad debt expense. The company has a three year head-start
over its competitors in developing and fine-tuning these
systems. The process involves a 49-point check on customer’s
details with third party databases, a confirmation phone call and
a micro payment made to the customer’s bank account. If the
customer is unable to provide details about the micro payment,
then Neteller assumes the customer is not in control of the bank
account that has been linked to the Neteller account. This would
be an indication of fraud or identity theft.

(3) Building the extensive systems required to handle thousands of
simultaneous transactions at low failure rates. Not only is it
difficult to do operationally, but it is also difficult to
convince merchants that your systems can handle high volumes of
transactions. Partygaming, the largest online poker and gaming
site, is in discussions with the company to turn over all their
customers to Neteller. They obviously have the confidence in
Neteller as a premier payment provider with the reliability and
capability to handle the additional volumes should this happen.

(4) The complex and uncertain regulatory environment makes it
difficult for new providers to enter. The UK gambling bill has
been passed legalizing and regulating the online gaming industry
while new US bills threaten to restrict Internet gaming. If the
US follows suit from the UK, this would allow PayPal and other
entrants and would reduce the barriers to entry. However,
despite the improbability of this occurring, should it happen we
believe that Neteller would be acquired at a significant
premium. On the other hand, if the regulatory environment in the
US becomes more restrictive, there would be a lower threat of the
entrance of any large financial institutions into the market.

Excellent Management Team:
Gordon Herman, the company’s CEO, began with the company in September 2002 bringing significant operational and management experience, including being the past President of GE Capital Leasing. He hired the rest of the senior management team and has created processes with near-term and long-term goals to manage growth. He has unbelievable foresight and a longer-term strategic vision that we believe will greatly benefit shareholders.

The Strategic Vision / Plan:
The plan to joint venture, acquire, or be acquired by a bank is simple yet brilliant on many levels. It costs Neteller $2.99 to acquire a customer while banks customer acquisition costs are in the $200 range. For a major European or other non-US bank, access to inexpensively-acquired Neteller customers provides a great opportunity for up-selling other banking products including mortgage, credit cards, brokerage, etc. Given the favorable customer demographics for a Neteller account holder – a 35 year old educated male with $60K in income, this would certainly be of tremendous value for any bank and could be significant incremental revenues for Neteller.

Early stages of fast growing on-line gaming:
Online gaming is the fastest growing industry and only represents 4% of all of e-commerce. The market was over $8bn in 2004 and some industry experts estimate this will be $23bn in 2009. The share of the total global gaming market is 3.4% in 2004 expected to grow to 8.1% by 2009. Sportsbetting accounted for $3.4bn while casino was $2.2bn in 2004. Sportsbetting and casino games are expected to grow to $5.9bn and $5.6bn by 2009. Surprisingly, while online poker has been a tremendous catalyst for online gaming growth, it still only accounts for 12.7% or $1.0bn – growing to $6.4bn by 2009. For Neteller, online gaming accounts for 90% of the revenues with poker at 40%, casino at 32% and Sportsbetting at 28%. The other 10% of revenues comes from foreign exchange, peer-to-peer transactions and interest from the float on the money left in trust.

Asia First Mover Adv. Represents Significant Longer-term opportunity:
The company generates 80% of its revenues from the US. However, through its (recent acquisition of) Macao based Quick Access, a debit card payment processor, the company expects to launch an Asian Instacash (Indemnified – 8.9% fee) product. They are using the acquisition to gain an understanding of Asian customer behavior so that they can better be equipped in identifying potential bad debt exposure. The company also launched in Japan in June of 2005. Asia represented $1.3bn (15%) of the market in 2004 and is expected to grow to $5.7bn (25%) of the total market by 2009; however, Asia represented less than 5% of NLR’s revenues in 2004.

Compelling Valuation:
The company generates very strong operating margins and given the low capital requirements for this business, net income is a close reflection of free cash flow. This company appears very cheap considering it is growing revenues 100%, has 69% gross margins, 59% EBITDA margins and 41% net income margins and is trading at 16x this years FCF and 11x next years FCF estimates with no debt at the current 660p price.

For reference, when Paypal was acquired by EBAY for $1.5 billion (transaction multiples of 9.9x BV, 10.4x EV/Rev, 279.8x EV/EBITDA) in October 2002, the company had LTM revenues of $140MM and EBITDA of $5.2MM – a 3.7% EBITDA margin versus Neteller’s 59.4% margin. Our price target is 1,100p – 1,300p based on 20-24x ’06 estimates of 55p. Yet, we expect to revise this price target upwards over time as the industry and the company continues to grow. Despite the recent run-up to roughly 650, the long-term prospects for this company are incredibly bright and there is at least a 50% chance that we are underestimating the potential growth for this company. Further, recent strength in the US dollar has made the stock price more attractive.

COMPETITION

Neteller has a dominant 20% market share among all payment processors. The next largest player solely focused on the online gaming space is Firepay with an estimated market share of less than 10%. Only this past December (3 years later), did Firepay create a competitive product to take on the credit risk and indemnify the merchant. Firepay supports approximately 600,000 members and 60-70% as many merchants as Neteller. Two other much smaller competitors have also recently launched an indemnified product: Navaho Networks and Click2Pay. Navaho has approximately 50,000 members and Click2Play has even fewer. The key issues for competitors are distribution and managing credit. In the case of Firepay, we have tracked the history of the company and spoken with the CEO and CFO (of its parent company) and believe that they are not of an equal caliber to Neteller’s team. The mere fact that they were the first company in this space five years ago yet greatly lag NLR is enough evidence.

Other major payment processors include credit card companies (e.g. Visa, Mastercard, Diners Club) and Western Union. However, for credit card payments, the issuing banks routinely reject about 70% of internet gaming transactions. The largest issuing banks including Citibank, Bank of America and Wells Fargo will not let their credit cards be used for online gaming. Visa and Mastercard have also issued statements to their cardholders about the legality of internet gaming in certain jurisdictions including the US. Western Union also has said that it will not permit the use of its internet service for illegal internet gambling. These payment processors pose little competitive threat as long as the US regulatory environment remains uncertain which should be the case for many years to come.

RISKS
• U.S. Regulation of online gambling – this may be the biggest risk and is a wildcard. It is more likely that nothing will be passed in the US especially given the difficulty in prosecuting
• Slowed industry growth – online gambling is in the early stages of growth. Online gaming still only represents a very small percentage of total gambling revenues when including land-based casinos
• Competition – although much smaller competitors have entered with their versions of an indemnified product, we believe that with 1.5MM users and growing, the network effect will make it difficult for those competitors to detract materially from NLR’s current growth rate. The company’s proprietary credit-checking system is superior and cannot easily be replaced given its 3-year headstart and the management talent from GE Capital that was involved in its creation
• Macro-economic conditions curb consumer spending/playing – historically, in an economic downturn, land-based casinos typically still perform well. We have no information that leads us to believe online gambling will be impacted any differently. Additionally, the average customer for Neteller is male, age 35 with an income of $60K and therefore may be less susceptible to the macro-environment

Catalyst

• Rapid industry growth continues; Christiansen Capital Advisors forecasts that the online gaming industry, will grow an estimated 40% in 2005, to $10 billion; (Bear Stearns estimates for 2006 are $15bn)
• Partnership with a major European bank will allow cross promotion of a suite of financial services to global member base
• They recently acquired a small company in China and are rapidly expanding in Asia, which should eventually spur growth dramatically
• A Japanese language version is expected to be launched by early June; it is already the 5th largest market
• Generation of significant free cash may be used for a dividend or share buy back
• Party Poker, the largest on-line poker web site and a major source of business for Neteller, is expected to go public this summer, which will generate significant investor interest in this space
• Operator consolidation continues (1,600 sites down from 2,000 in the past two years) leaving leading payment providers disproportionate gains in share