Description

The Stars Group was written up a little shy of a year ago in August 2018 by humkae848. That write up was quite comprehensive regarding the history of the company, its management, the transformative merger, and its ability to deleverage. I thought it was appropriate to revisit this stock so soon after the last write up because the stock has been nearly cut in half, despite a number of positive events having occurred since last August. These include:

1.     In November 2018, Stars struck a deal with El Dorado (ERI), which allows them market access in the 13 states where ERI has a physical presence. While the knocking down of PAPSA in May 2018 opened the door to legal sports betting in the US, there is no federal regulation explicitly permitting sports betting, thus the US (at least for now) is regulating as a state-by-state market. In the absence of federal regulation, each state is deciding if they will permit sports betting, and if so, will it be allowed in land-based casinos only, or will online betting be permitted. Most states are giving some preferential treatment to the incumbent land-based casino companies, so as the European sports betting companies look to establish a business here, in most states they are finding it necessary to do deals with incumbent bricks and mortar operators in order to obtain a gaming license. The market access deal with ERI is efficient because it supplants the need to go and cut individual market access deals in each state. Also, the pending merger of ERI with Caesars (CZR) announced earlier this month would only serve to extend ERI’s reach and the value of this deal to TSG.

2.     The Kentucky Court of Appeals in December 2018 reversed the prior $870 million judgment against TSG for illegal poker activities that occurred in KY (and the greater US) from 2006-2011, under prior management. This reversal was worth $3 per share in the valuation due to reduced liabilities. There is a remote chance this case could move to a higher court and TSG could lose, but the probability of this is small, yet the company got no lasting benefit from the reversal of this future liability.

3.     NJ has developed as a robust online sports betting market since its initial launch in summer 2018, giving better visibility into the market potential in the US for sports betting. In the first 5 months of 2019, NJ gross handle (dollars bet) was $264 million and revenue to market participants was $14 million. Looking at the growth of the NJ market, and applying reasonable assumptions to the number of states that will approve and regulate sports betting (am not assuming all states get it in the absence of federal legislation) and importantly, the number that will approve online sports betting, it’s not hard to see the US sports betting market being a $10 billion handle, $500+ million industry revenue opportunity in 5-6 years, with the opportunity for it to grow to multiples of that over time (10-20 year horizon).  While start up costs (technology, marketing/customer acquisition, and regulatory fees) will render the US market unprofitable for entrants for probably the next 2-3 years (or more), over the long-term, this is a huge growth opportunity for companies that manage to secure at least 10% of the market.

4.     Most importantly, Stars struck a deal with (New) Fox (FOX) to form an exclusive gaming partnership. This deal grants rights for TSG to exclusively use the well-known Fox brand to create a FoxBet online sports betting app and website, as well as to create Fox-branded Free to Play non-cash sports betting entertainment games that will be open to anyone in the US regardless of state regulation status, providing a customer list pipeline to mine in the future as states come on board with regulated sports betting. The deal also outlines an agreement to integrate sports betting content into on air and online Fox Sports programming. Fox is the #2 player in US sports behind Disney’s ESPN, and has broadcast rights to, among many other things, the 2020 SuperBowl, Thursday Night Football, and the World Series through 2021. Fox bought 4.99% of TSG in conjunction with this deal, and has an option to buy in 50% of TSG’s US Operations at a future date. This structure was set up to allow Fox’s executives and board to not have to go through the rigorous state gaming license process, state by state, until the business is more established. The attractiveness of this deal, and the market’s lack of appreciation for it, is a big part of why I think TSG is a good investment here. I will discuss the opportunity presented by this deal more below, but it is worth noting that TSG went up around 15% on the announcement of the deal, but has since given up the entire post-deal move, plus a little bit.

Given these four positive and significant developments, why is Stars down so much since it was written up last summer? First, it should be noted that the entire industry of UK-based online and hybrid offline/online gaming companies have similar performance over the last year, as the subsector has massively de-rated. The reason for this comprehensive subsector de-rating was really the perfect storm of negative events. What happened was:

1.     Multiples deflated after an unsustainable post-PAPSA euphoria bid,

2.     Adverse regulatory and taxation events in the UK, and to a lesser extent, other jurisdictions,

3.     ESG Initiatives at investment funds.

Regarding the deflation of post-PAPSA euphoria, the stocks in this sector were trading at all-time high multiples last May/June in a fit of post PAPSA giddiness. The US is still the largest gaming market in the world when measuring by country, and we obviously have a sport-obsessed culture. The PAPSA decision was a complete surprise to most market participants and observers, so the euphoria of such a large TAM market opening up unexpectedly led some of these stocks to get out over their skis. There was also a flurry of deals happening between the land-based casinos, the European online gambling companies, the fantasy sports leagues, and the major pro sports leagues, which added to the euphoria. But as the months went on, the market was reminded that regulation needs to go state by state, and that is a slow process because there are a million competing entrenched interests lobbying for their piece of the action, and there are competing legislative priorities to capture the limited time of the various state houses. Finally, legislation can take many forms, and there have been disappointments ranging from states that looked like they might pass quickly not going quickly, gaming tax rates being initially established too high to promote rapid market growth, or the establishment of in-casino sports betting with no provision for online betting. Collectively, the market development is on track, but reality has set in for how long the market will take to develop.

Just as reality began to set in for the fact that the US is going to be a DCF opportunity for a long time, and not an EPS one in the short-term, the stocks also got hit with two very adverse regulatory developments in the UK. One problematic piece of regulation was the reduction of stakes (size of bet) limits at betting terminals in the UK from 100 pounds per bet to 2 pounds per bet. While this didn’t impact TSG specifically, since they are online-only in the UK, it did lead to substantial earnings revisions for peer companies William Hill and Paddy Power (recently renamed Flutter).  Also in the UK, the tax rate on net gaming revenues for online gaming was raised from 15% to 21%, to compensate for the loss of revenue with the reduction in betting stakes. This was obviously a direct hit to TSG, as the UK is their single biggest market and accounts for 38% of revenue and 30% of EBITDA. Some regulatory uncertainty persists in the UK given the direction of the entire UK government is up in the air with Brexit and Theresa May’s resignation. While most market observers think the worst is behind the UK in terms of regulation and taxation, there is some trepidation there could be more adverse actions if the Labour Party prevails. In addition to the events in the UK, there were other negative developments on the regulatory and taxation front, including a tax increase in Australia, and the need to pull out of Switzerland and Slovakia ahead of those countries regulating their gaming market. TSG gets 74% of its revenue (and rising) from regulated and taxed markets. There is inherently more risk on the 26% of revenues where they are operating in a grey area. A market regulating is generally a good thing because it raises the quality of earnings, but there can be temporary hits to revenue and EPS since TSG usually needs to pull out of a market ahead of imminent regulation (legalization) in order to be in good standing to participate in the market post-regulation.  Once back in the market, there will be a one-time step down in profitability, as they will start paying gaming taxes, which they don’t have to pay in unregulated markets.

A lesser factor in the de-rating of the sector, but one deserving of brief mention is the increased focus on ESG by European-focused investors in the last year or so. Obviously any gaming company has the potential to be problematic for a fund very focused on ESG.

In terms of issues specific to TSG that might account for weak performance, they missed their Q1 EPS estimates due to unusually low hold on sports betting in the quarter. The miss blindsided investors since they had held an investor day and given Q1 guidance during the last week of March. There was one weekend left in the quarter, and they suffered a very unexpected blow when all the most popular teams won their matches over that weekend. SkyBet is very deep into servicing recreational bettors (as opposed to experts trying to make big money at it, the punters as they call them). The recreational bettors enjoy playing parlay bets, where there is a big payout if you pick the winners in 3 or 4 matches (but lose all if wrong once). The parlay bets are what allow TSG to enjoy above industry sports betting hold over the long-term…these parlays are low probability bets that favor the house more than just single game bets. But they also lead to volatility in the hold, because when one goes wrong, the house really gets hit, which is what happened in Q1, but not indicative of anything other than bad luck.

The re-rating of the sector along with the rocky Q1 has left TSG trading at a very attractive level, considering its long term growth prospects (8-12% topline and EBITDA), the optionality on the US, and its recent track record of execution in maintaining global market dominance in poker as well as gaining substantial market share in both sports betting and casino games in the UK. With the stock trading at 9 P/E, 10.5x EBITDA and a free cash flow yield of 9%, one has to wonder if this is the bottom or can the cheap get cheaper?

As for the three industry factors and one stock-specific factor that took it down, the post-PAPSA bubble multiple deflation is certainly played out. While the regulatory situation in the UK is not without risk, the industry is also taking action to improve their prospects by trying to be good corporate citizens. As an example, the entire industry agreed to stop advertising on TV during active sporting matches (they can still advertise during halftime). Prior to this industry pact, the ad blocs on football (soccer) matches were wall-to-wall for betting apps and sites. Removing the ads is a positive for family match viewing, and probably for the companies as well, since that was probably a lot of low ROI customer acquisition spend anyway, but it was too dangerous to be the one company that abandoned it. The companies have also invested in their Know Your Customer (KYC) compliance efforts, in an effort to appease regulators and be good actors within the market. The presence of many, many unregulated offshore gaming operators in Europe should provide some cover against the regulators going too far in the UK. If they continue to chip away at the profitability of regulated operators through taxation or restrictions, then eventually the operators will be forced to reduce the value proposition to the customer – the odds will get worse, the incentive bonusing events will be reduced or eliminated, technology will be less frequently refreshed, etc. If the value proposition to the customer drops enough, the barriers to them leaving the regulated market leaders and going to an offshore player are not that high. These offshore players do virtually no KYC and pay no taxes, so the UK regulators are clearly incentivized to think hard about following up a market disruption with a second one so soon. As for ESG, it’s not going away, but I think it is the smallest of the three industry headwinds, and there are plenty of funds, especially in the US and Canada (where TSG is listed despite the vast majority of its revenues being in Europe) that just don’t care about ESG yet. With regard to the bad hold in Q1, the structure of their business means this will occasionally happen, but each quarter is an independent event. The underlying trends with customer acquisition and retention are good, and there is no reason to think that the hold in the quarter was reflective of bad risk management or betting odds making.

If one can get on board with the thesis that:

1.     2018 was the perfect storm for an industry downward rerating, and that the implied discount for regulatory and taxation risk is probably at a high right now,

2.     The industry is one characterized by high barriers to entry, good cash flow generation, and strong organic growth prospects,

3.     The US market opportunity is extremely large, if not immediate in terms of profitability,

4.     Organic growth prospects in existing gaming markets are attractive for companies leveraged to online/mobile,

then the sector should be appealing at these levels.

So of the list of market participants, why choose TSG here?

1.     The Fox Deal is underappreciated for its prospects to create high efficiency CAC during the land grab that will be happening over the next decade,

2.     TSG’s recreational customer base is higher margin – their sports betting hold in normal quarters is around9% versus industry averages of 5%ish,

3.     Recreational customers may be individually less valuable than the whale punters who bet more, but TSG benefits from playing from people who want to have fun/be entertained more than they want to make money. They are more frequent, and they like to bet on weird things (like parlays), where there is less market transparency so the House can be greedier in its targeted hold.

Returning to the Fox Deal, I think the importance of this deal is underestimated by the market, especially when you see the whole post-deal move has been erased. NJ so far has been a very expensive land grab, with several players pouring ad dollars into the market to get first mover advantage share. This is not a very efficient way to attack the US market, and TSG has stayed out the fray, spending little, and getting marginal market share. They had explained at their investor day that they were not going to spend huge to get early share in NJ, or elsewhere, and were instead holding out for a media deal, which most investors were skeptical that they could get, prior to the Fox Announcement.

To understand why they wanted this media deal so badly, it’s important to understand both the performance of the UK market and the media dynamics of the US market.  In the UK, the development of an integrated media strategy and branding with Sky (TV broadcaster) has allowed SkyBet to double its share of the UK market in the last 5 years, and become the leading company in terms of number of active players. On Sky Sports, betting information and the promotion of the SkyBet app is native content to the regular programming, not only are ads for SkyBet shown during the program, the sports announcers talk about odds on the app during the course of regular programming. Getting the balance between sports coverage and betting promotion right is key to keeping viewers engaged and not annoyed, as well as maximizing customer acquisition. It’s a skill, and no other company has been able to replicate the success of the Sky Sports platform in terms of efficient customer acquisition.

TSG always said they would pursue this strategy in the US, instead of getting into a spending war. I think this makes a lot of sense because spending wars are obviously expensive and high risk, and TSG (prior to Fox) did not have a recognizable brand name in America, like some other entrants benefit from (large land-based casino groups, as well as the fantasy sports leagues). Additionally, marketing spend is inherently inefficient as long as states are ring-fenced because of US geography. Advertising in Northern NJ meant buying time on NYC-based stations, and paying to reach NY and CT residents who can’t legally be customers of NJ online sports betting sites. In Southern NJ, advertisers were paying to reach the Philadelphia greater metro area, which also can’t play NJ sports. So in addition to avoiding the need to spend large amounts of money to at least partially target customers you can’t reach, TSG is going the route that has been so productive for the company in the UK. Will this strategy translate to the US market? I would argue it may even be a better match for the US market than the UK one given how much American consumers are obsessed with TV, remain influenced by TV, and generally trust the announcers they see on TV (for proof of this, see the current political state of things, on either side). Additionally, Fox will be able to promote free-to-play games on a national level, and therefore will be able to reach and build mindshare with consumers long before their states regulate. The competition will not be spending ad dollars in markets where they can’t collect revenue, so the first mover advantage potential is large here.

If you believe that an integrated media content strategy is a potentially efficient and productive way to reach US consumers, how does Fox rank as a partner? I would argue that they are the best possible partner that TSG could have secured. The reasons for this are:

1.     While Fox is the #2 player in broadcast sports, I think the #1 player, ESPN, may prove to have a smaller commitment to participating in this sector. While ESPN may be searching for avenues of growth and divisional management could be all-in here, it’s questionable whether the parent Disney (DIS) will be all-in. Disney obviously has tremendous family franchises (Pixar, Princesses, Mickey Mouse & Friends, Parks, multiple cable channels to name a few) that could be put at risk if Disney got involved with anything perceived to be shady. They are also in the middle of a massive M&A integration with the studio and other assets they bought from Old Fox, and are getting ready to launch the Disney Plus streaming service, possibly the biggest and most watched new initiative from them since the 1970s opening of Disneyworld. They have larger potential earnings growth drivers than sports betting could ever be, and CEO Bob Iger has been explicit that they will never as a company take a bet, therefore their financial incentives in any gaming/media content deal will be minimized.

2.     New Fox is lacking in growth assets, and it would materially change their corporate level earnings profile/potential if FoxBet took off. They talked about the opportunity at their Investor Day, and their commitment to this initiative was clear.

3.     The Murdochs at Fox already know gaming. Sky is now part of Universal (Comcast) but it began its life as part of Fox, and the SkyBet platform was developed when Fox sill owned Sky.

4.     Given the lack of federal regulation, all operators and all states are proceeding under the assumption, but not the guarantee, that the federal government won’t interfere and decide to crack down on sports betting or online gaming. Without getting too political, it does seem like as long as Donald Trump is President, the Murdochs and Fox are the right media conglomerate to align with in order to be looked at favorably on the federal level.

5.     Fox has a trusted and extremely well known brand in sports and more broadly.

What is success in the US worth? Assuming a US market in 2025 where $10 billion is bet (may prove conservative), if FoxBet can match SkyBet’s UK betting share of 16%, that’s $1.6 billion of bets. At TSG’s typical win margin of 9%, that’s $144 million in annual revenues. At a normalized margin of 30%, that is $43 million in EBITDA, and $39 million of Net Income, or 14c per share. These earnings in a nascent and growing market would likely get a 30 P/E, possibly higher, and therefore be worth at least $4.25 to the valuation, which is equivalent to 25% accretion at the current quote.

I am not putting any of that in my valuation however, although confidence on the US market and TSG’s prospects in it will certainly be a sentiment driver.

To derive my valuation, I put 9x EBITDA on the International business (lower because of regulatory uncertainty in some markets), and 12x EBITDA on the UK and Australia businesses, plus 6.5x on corporate costs. Using 2020 EBITDA and projected net debt of $4.3 billion yields a stock price of $24.05, up 41% from the current quote.

Consolidation remains strong in the industry. I ascribe a 10% probability to that scenario, and to determine a takeout price, I apply 13x EBITDA, on the company level the average price that deals have been going for in this space. This yields a price of $34, up 100% from the current quote.

Blending 90% of $24.05 and 10% of $34.00 gets me to a target of  $25.00, or 46% upside from the last quote.

Please note that I have increased central costs by almost 100% from historical levels to incorporate US investments in 2020, but have added in no material revenue or EBITDA benefit from the new US operations.

TSG will do approximately $1.50 per share in free cash flow this year (9% free cash flow yield) and approximately $2.00 per share in free cash flow next year (12% free cash flow yield). My target of $25.00 implies an 8% free cash flow yield and a P/E of around 11 on $2.30 of EPS in 2020, which do not seem to be overly aggressive targets for a company with 8-12% topline growth and steady EBITDA margins around 31%.

If you wanted to put something in for the US, an additional $1 in valuation would be appropriate. $4 in earnings discounted back at 10% for 5 years, would give a present value of future earnings around $3. Put a 33% probability of seeing that $4 in 2025, and you get your extra $1.

There is some risk to EPS estimates from the investment that they will need to ramp up the US business. I project potential dilution from these efforts of approximately 5% in 2019 and 10% in 2020, but not more than that. The company hasn’t guided on the magnitude of these investment costs for the US, but will on their Q2 earnings call in August.

In summary, I think TSG has suffered the perfect storm, is executing well, and is cheap on the current business, before giving any credit to the enormous embedded call option on the development of US online sports betting. I think their prospects for success in the US have been incredibly enhanced by the Fox deal, and that the Kentucky Court of Appeals decision is unlikely to be reversed.  There’s also a long shot that this company ultimately gets acquired. The consolidation of the UK/European names may be played out, but if sports betting gets traction, TSG could become a candidate for one of the larger land-based casino companies (like MGM or WYNN), or possibly even to big tech, who I suppose will want to enter the sports betting space if the US or Global opportunity looks to be large enough (FB, GOOG, etc.).

Risks to the investment (in descending order of probability):

1.     EPS Dilution because of investments to enter the US is more than I have estimated or the market has anticipated

2.     Regulation process slower than expected in key US states, or online is banned in states that do regulate

3.     Adverse regulations in key markets other than the US

4.     KY Court of Appeals decision gets reversed, recreating a $3 per share liability

5.     Another fluke low hold quarter causes a 2019 EPS miss

6.     US Federal Government intervenes on sports betting in NJ or another state

Catalyst

Catalysts:

1.     Launch of FoxBet Free to Play nationally and FoxBet real money betting in certain regulated states/markets, along with the launch of integrated on air content around football season (Fall 2019) sheds light on the opportunity for TSG to take share in the US with reduced/efficient CAC

2.     Q2 shows a normalization of sports betting hold percentage in the UK and relieves anxiety that something has changed

3.     Labour Party fails to cease control of the UK Government

4.     Additional states regulate in the US

5.     Further market share gains in the UK

6.     Acquisition by a large casino group or consumer-facing tech company (longer-term possibility)