Description

SUMMARY

Thesis: Material margin of safety at the current share price with several ways to win.  M&A is a high probability (WMH was linked to 3 deals last year alone).  If the market does not correct the valuation disconnect an acquirer very likely will.   

•  Valuation is compelling: 10x 2018 P/E for ~5% EPS CAGR over the next 3 years; 9% FCF yield (5% dividend yield); 1.5x Net Debt/EBITDA (arguably underleveraged)
• Capital light business generating high return on capital: 5 year average returns: 14% ROIC; 18% ROE
•  Quality company in a stable/predictable industry: >95% of revenue from regulated markets, Top 3 brand in all major markets
• Several ways to win: FCF generation and capital return provide a downside valuation floor.  The current valuation ascribes zero value to:  
  • (1) M&A: industry consolidation seems inevitable and likely in the short term.  The industrial logic for transactions is compelling, WMH was subject to two approaches in 2016 at >50% vs. the current share price (note: a deal at +50% vs. the current price is >50% accretive for numerous buyers) and WMH’s closest competitor is currently the subject of discussions (more details below);
  • (2) US Opportunity: the US Supreme Court will hear a case on whether to legalise sports betting in the United States in December 2017.  A favourable decision will be game changing for WMH, which currently has a sports betting presence in Nevada & is pre-positioned in other states.  For a sense of impact factor legalised sports betting in the US will likely make WMH a multi-bagger from here (more details below); 
  • (3) Reversion to historical valuation: WMH currently trades at close to historical minimum valuation multiples.  Mere reversion to normalised valuation levels provides a respectable return from here. 
• Why does the stock trade so cheap?  An upcoming regulatory review has the potential to impact profit for one of WMH’s divisions.  However, a close to worst case outcome is currently being priced into the current valuation, assuming zero credit for M&A and the US Opportunity described above (more details below).  The market is over-weighting uncertainty and ignoring the material margin of safety (even assuming a worst case outcome)

BUSINESS DESCRIPTION

William Hill (WMH) is a bookmaker, taking bets on an assortment of sporting and other events.  The company operates licensed betting offices (retail outlets), telephone based-betting operations, and online betting.  Over 95% of WMH revenue comes from regulated markets (theoretically less risky/more stable), predominantly the United Kingdom and Australia where WMH has a Top 3 brand.  WMH divides its business into 4 segments:

• (1) UK Retail (~50% of EBITDA): activity undertaken in physical retail outlets – includes over-the-counter sports betting and gaming machines.  WMH is one of two large players in this market; 
• (2) Online (~40% of EBITDA): online and telephone betting activity outside of Australia.  Includes sports betting and gaming.  WMH is a top 3 player in this market with a strong brand;
• (3)  Australia (~5% of EBITDA): online and telephone betting activity in Australia;
• (4)  United States (~5% of EBITDA): activity undertaken in the US.  Primarily operating sports books in Las Vegas casinos and a joint venture in New Jersey.  WMH’s US operations provide significant optionality if the US sports betting market opens up.  This could be very important and valuable (more detail below).

The sports betting market grows at a multiple of GDP.  The market for UK physical retail is roughly flat (customers transitioning online) and the online market is currently growing at 10-12% p.a.  Based on its most recent announcement (Feb’17 trading update) WMH is growing roughly in line with the market in online and is doing a little better than its largest peer in land based operations.  In aggregate, this should underpin relatively predictable low single digit top line growth.  

WMH has a capital light / high return on capital business that has generated high free cash flow relative to capital deployed / current valuation.

SEVERAL WAYS TO WIN (1): WHY IS M&A LIKELY?

(A) The industrial logic for consolidation in the gambling sector is very compelling

•  Industry Remains Fragmented: The gambling industry is still highly fragmented despite being an industry where economies of scale provide a competitive advantage
  • Top 3 players only account for ~10% of the market – unusually low concentration relative to other industries where economies of scale are valuable;
  • Scale drives organic growth:
    • (i) fixed investment in product & marketing spread over a larger population lowers unit costs;
    • (ii) infrastructure and back-office cost savings can be reinvested in customers leading to a positive feedback loop: e.g. better odds vs. competitors => increased volumes => better unit economics => more customer reinvestment => more volume => etc.
    • (iii) greater ability to weather cost and duty headwinds and use this to gain share against smaller / weaker competitors
  • Unsurprisingly there is a strong correlation between scale and margins in the industry
• Cost synergies in previous transactions have been significant:  synergies from precedent transactions: 4-6% of revenue & ~25%+ of EBITDA.  Recent Examples:

(B) WMH is likely to be involved in industry consolidation:  

• WMH is an attractive asset
  • One of two large/high quality sports betting operators in the UK (the other is Ladbrokes Coral) with a large online presence.  These are desirable assets for numerous acquirers
  • High exposure to regulated markets – regulated markets are considered more desirable due to the higher predictability of returns / lower cliff risk re: regulation
  • The highest optionality on the opening up of the US sports betting market (more detailed discussion on this important topic below).  WMH is the only operator with a meaningful current presence in the US
• WMH has been involved in a number of recent M&A discussions:
  • Aug’16: 888/Rank approached WMH with an offer of ~£4/share (https://www.ft.com/content/7b9ba565-a280-3d2a-918d-a8404de2ae74?mhq5j=e5)
  • Oct’16: William Hill and Amaya consider merger (https://www.ft.com/content/29622d42-94fb-11e6-a1dc-bdf38d484582?mhq5j=e5)  
  • Oct’16: GVC believed to have approached William Hill regarding a potential acquisition
• WMH’s shareholder base is looking for the company to explore a sale
  • WMH’s largest shareholder is seeking to have the company sold (https://www.thetimes.co.uk/edition/business/william-hill-investor-urges-sale-x7cx6l5zk)
  •  An activist investor has recently established a large shareholding (http://www.cityam.com/270611/hedge-fund-silchester-betting-pick-up-william-hill)
• There are multiple potential buyers for WMH.  Highest probability acquirers include:

* Assumes a takeover price of £3.75 / share (+50% vs current)

(C) Comments of potential acquirers regarding M&A

(D) Recent M&A Speculation:  

• Aug’17: GVC approached Ladbrokes regarding a potential acquisition (https://www.ft.com/content/280666e6-8741-11e7-bf50-e1c239b45787?mhq5j=e5)

SEVERAL WAYS TO WIN (2): US SPORTSBETTING OPPORTUNITY

• The US sports betting market is potentially one of the largest in the world.  Estimates vary but most believe the market size is hundreds of billions of dollars 
• Sports betting is currently illegal in the United States with the exception of 4 states (licenced sports books in Nevada and sports lotteries in Oregon, Delaware and Montana)
• There are three key pieces of legislation that are important:
  • Professional and Amateur Sports Protection Act of 1992 (“PASPA”): this is a Federal law that effectively outlaws sports betting, with the exception of the four states listed above (which were grandfathered when this Act was passed);  
  • Federal Wire Act of 1961 (“Wire Act”): this is a Federal law that prohibits the operation of certain types of sports betting business activities across state lines.  The Wire Act makes it an offence to use a wire communication to transmit bets or receive money from bets or information regarding bets across state lines.  This effectively makes online sports betting offered from one of the 4 states above across state lines illegal in the US;  
  • Unlawful Internet Gambling Enforcement Act of 2006 (“UIGEA”): The UIGEA was the law passed to effectively outlaw online poker in the US.  The UIGEA "prohibits gambling businesses from knowingly accepting payments in connection with the participation of another person in a bet or wager that involves the use of the Internet and that is unlawful under any federal or state law."  The act specifically excludes fantasy sports that meet certain requirements, skill-games and legal intrastate and intertribal gaming.
• Some states believe PASPA is unconstitutional and are challenging the law – New Jersey has been the leader
  • In 2012 the NJ legislature enacted the Sports Wagering Act, allowing sports wagering at New Jersey casinos and racetracks (i.e. creating a conflict with PASPA)
  • Shortly after the Sports Wagering Act was passed in NJ five sports leagues filed suit seeking to have PASPA enjoin the Sports Wagering Act.  To date the sports leagues have prevailed
  • The Supreme Court of the United States ("SCOTUS") has agreed to hear the case.  Oral arguments are scheduled for 4 December 2017 and a decision is likely in early/mid 2018 (http://www.scotusblog.com/case-files/cases/christie-v-national-collegiate-athletic-association-2/)
  • The SCOTUS’s interest in the case is regarding the matter of state’s rights
    • The plaintiffs argue that Congress exercised its authority under the Commerce Clause of the constitution to enact the legislation
    • New Jersey argues that the Tenth Amendment of the U.S. Constitution reserves to the states all rights not explicitly granted to the federal government—such as gambling regulation – and therefore PASPA is encroaching on state’s rights
• If the SCOTUS decides in favour of NJ (striking down PASPA) it would allow each state to legalise sports betting
  • In addition to New jersey approximately a dozen other states are progressing legislation and are looking to act quickly post a favourable SCOTUS decision
• Each state would determine its own framework but because of the Wire Act sports betting would need to be restricted within state borders and cannot use telecommunications.  This is important because it will require operators to have a physical presence – incumbents have an advantage & a mass market online offering likely will not work
• WMH is very well placed to take advantage of a favourable SCOTUS decision on PASPA
  • WMH currently operates over ½ of the sports books in Nevada (generally a JV with the casino operator).  This model will likely be rolled out across other states if/when sports betting is legalised
  • WMH has a 50 year agreement with Monmouth Park Racetrack in New Jersey – i.e. it already has a physical presence in the NJ market
    • NJ will be the first state to open if PASPA is overturned
    • NJ has estimated that in year 1 there will be $1 billion of bets if PASPA is overturned
• Given: (i) the size of the market; (ii) the number of states that are seeking to allow sports betting if PASPA is overturned; (iii) WMH’s significant experience operating sports books (this is not something a small casino can necessarily just do themselves and there are scale advantages as discussed above); and (iv) WMH’s established presence in the market; WMH is very well placed to benefit significantly from any favourable SCOTUS ruling.  There is no value currently ascribed to this option in WMH’s current market value
• How probable is a favourable SCOTUS decision?  This is difficult to handicap.  However, the following factual background might be worth considering:
  • The most recent decision, a decision from the Third Circuit Court of Appeals, upheld the decision of the lower courts and ruled that PASPA was not unconstitutional.  If SCOTUS had chosen not to take this case that ruling would have been final and PASPA would have remained the law of the land
  • Following a routine conference where the Supreme Court justices determine which cases to hear, the Court issued an order inviting the Acting Solicitor General to file a brief "expressing the views of the United States" concerning the federal prohibition of sports betting (https://www.supremecourt.gov/orders/courtorders/011717zor_5h26.pdf)
  • The Solicitor General filed a brief stating that SCOTUS should not hear the case (http://www.scotusblog.com/wp-content/uploads/2017/05/16-476-16-477-CVSG-Christie-AC-Pet.pdf) 
  • Despite the direction from the Solicitor General above SCOTUS decided to hear the case.  This is unusual as the court generally gives great weight to the SG’s input
  • SCOTUS clearly has something to say about this issue.

SEVERAL WAYS TO WIN (3): VALUATION

• WMH is currently trading at 9.8x 2017 P/E & 7.0x 2018 EV/EBITDA – well below historical mean valuation levels and close to historical lows
  •  5 year mean/median P/E: 11.3x (min: 9.3x; max: 14.3x)
  • 5 year mean/median EV/EBITDA: 8.8x/9.1x (min: 6.9x; max: 11.1x)
• WMH is also currently trading at 69% of the P/E of the FTSE Index – also well below historical mean valuation levels and close to historical lows
  • 5 year mean/median Relative P/E: 87% (min: 66%; max: 114%)
• Normalising WMH’s valuation level suggests at least 25% upside 
• This valuation ascribes zero value to M&A and zero value to repeal of PASPA
  • M&A is highly strategic & >50% accretive for multiple parties at 50% above WMH's current price (see above)
  • Repeal of PASPA has the potential to make WMH’s US business more valuable than all of WMH’s assets combined (i.e. the US operations alone could be worth materially more than WMH’s current EV).  In this scenario WMH also becomes an attractive acquisition candidate for numerous US gaming companies

WHY DOES THE STOCK TRADE SO CHEAP?  REGULATIRY REVIEW: BACKGROUND & POTENTIAL IMPACT

Background

In October 2016, the UK's Department for Media, Culture, and Sport (DCMS) announced a new Triennial Review of the gambling sector, initially seeking views on maximum staking levels on B2 gaming machines, allocations of gaming machines, and advertising.  The major potential issue for WMH from this review is the potential reduction in staking limits for Fixed Odds Betting Terminals (FOBTs). 

There  has  been  a  widespread  campaign  lobbying for a reduction  in  the  maximum stakes placeable on B2 FOBT machines from £100 (the current maximum) to £2, in-line with other gaming  machines in the  UK.  On one side of the debate anti-gambling groups argue that limits should be reduced to the minimum.  On the other side of the debate the industry argues that retail outlets are large tax payers (both machine level levies/taxes and corporate taxes) and employ tens of thousands of people.  The horseracing industry is also aligned with the bookmakers as they stand to lose funding in the event industry profitability is reduced.  Any decision is required to be evidence based and look at social harm caused by the machines – in particular whether they contribute to problem gambling.  In reality, this is a political decision so there will also be a political overlay. 

Interested parties have been making submissions and lobbying since the review was announced.  An announcement regarding next steps is expected by the end of October / early November.  The likely next step is a 12 week period where interested parties will be invited to make submissions.  At the end of that period DCMS will likely make a decision.

Potential Impact on WMH

• It’s very unlikely that the maximum bet level does not get reduced.  The range of potential outcomes are between £2 (worst case) and perhaps £30-50 (a realistic best case)
• Approximately 20% of WMH’s revenue is derived from B2 gaming machines
• However the impact of a reduction in maximum staking limit is not a simplistic linear reduction in revenue (i.e. a reduction in the staking limit by 90% to £10 will not reduce machine revenue by 90%) because:
  • (1) Staking patterns are not linear:  ~40% of total bets are <£10, 60% of total bets are <£20 and 90% of total bets are <£40.  As such, an optically large reduction (say a reduction by 50% to £50) will impact a disproportionately small amount of staking (i.e. only 3% of bets are >£50);
  • (2) Machines contain multiple games: the machines are electronic (think an electronic version of the old ‘one armed bandit’ – google image search ‘FOBT’ and you will see) and have multiple games.  The so called “B3” games are not impacted by the review.  Only “B2” games are impacted.  As such, regardless of the outcome of the review for the B2 machines the staking limits of the B3 games will not change.  Punters can therefore elect to play other games – i.e. any ‘leakage’ from reduced stakes on B2 machines will very likely be less than 100% due to ‘recycling’ into other games;
  • (3) Punters don’t only bet on machines: a retail outlet is not a ‘machine only’ venue.  In fact a shop is prohibited from having more than 4 machines.  A typical retail outlet offers a variety of gambling options (horse racing, sports betting, etc.) as well as machines.  The typical punter in a retail outlet will spend on a variety of options (many ‘pass time’ between horse races, etc. by playing the machines).  As such, it’s very unlikely that ‘lost’ revenue from any reduction in staking limits on B2 machines will not be recaptured in another form in the retail venue.  Thought of another away, if a punter enters a venue with a certain amount of money to spend the exact way the venue takes that money is less relevant than the amount the punter spends (same way a casino takes money from punters in a variety of forms).  This is a long way of saying that it’s unlikely that the venue doesn’t ‘recapture’ some of any lost B2 revenue in another form of gambling – i.e. there is likely some ‘recycling’
• The various ‘recycling’ & behavioural impacts above are difficult to estimate with precision.  However, I think even in the worst case outcome (£2 maximum) it’s too draconian to assume that there is no mitigation
• In addition to the non-linear nature of staking (described above) and recycling (also described above) operators also have cost mitigation potential.  Specifically, store closures
  • Approximately 90% of profitability of the WMH estate comes from the top 70% of shops (the bottom decile are already borderline profitable with some already slated to close).  In the event of an adverse FOBT outcome material cost reductions will come from closure of stores from the bottom 1/3 of the estate (without a linear impact on profit as these stores are lower profitability)
• What’s currently priced in? Based on my modelling I believe a 90%+ reduction in B2 staking limits is currently priced in (i.e. a reduction from the current £100 limit to <£10 limit).
  • Again, this is based on the stand-alone business only and assumes zero value for M&A and the US opportunity
• It's also worth highlighting that there will be an implementation period for any decision.  Even if a decision was announced tomorrow it would likely be 9-12 months before it was implemented.  WMH will retain current cash flow levels during that period
  • WMH has indicated that they will be in a position to recommence their buyback program once the regulatory decision has been announced
• From my discussions, I believe many investors do not want to deal with the uncertainty of this regulatory issue.  As a result many are allowing the uncertainty of the situation to drive decision making.  However, I believe the combination of what's currently priced into the valuation (close to worst case outcome when that worst case is far from certain) + the asymetry of the upside / multiple ways to win makes this situation highly convex / very attractive. 

Catalyst

• Resolution of uncertainty from the Triennial review – announcement expected regarding next steps in late October / early November
• M&A - highly likely there will be deal activity.  The Triennial review is likely the only thing that has prevented M&A in the last 6 months
• US Supreme Court decision on PASPA