Playtech: Betting on betting

A wise man once told me: “Never recommend a stock to anyone. You’re bound to loose. If it rises, they’re brilliant. If it tumbles, you’re an idiot.” In length, I emphasize that the following write-up is not a recommendation. It’s merely a collection of reflections that document my reasoning behind my investment decisions, hence allowing me to go back and learn from my mistakes and successes.

If you’ve read my other stock analyses, you have probably recognized a distinct pattern. Namely, the stocks I find interesting have usually plunged big time before popping up on my radar, e.g. Sports Direct’s 63% slap, Footlocker’s 60% beating and Matas’ 55% drop. Today is a bit different.

I recently ran a screen where one of the criterions was a P/E below 15. Due to Playtech PLC’s (PTEC) recent 15% drop, it appeared as one of the search results with a P/E of 14.35. I decided to check it out. Rarely have I seen a business with such an impressive historic performance as Playtech’s. Now, we need to figure out if the past’s growth is baked into today’s price based on expectations of future growth.

The business
Playtech consists of two divisions: gaming (91.3% of revenues), and financials (8.7% of revenues). Though the latter division is thriving according to the 2016 annual report, I’ll dedicate this write up to the core business. Playtech is supplying the software that online betting and gambling operators base their businesses upon. Namely, Playtech has developed a turn-key platform consisting of i.e. casino games, sports betting, bingo and poker, which licensees can offer their own customers. In other words, if you’re playing poker on Pokerstars (who signed a license agreement with Playtech in 2016), you’re in essence playing on Playtech’s platform. At the time of writing, Playtech has license agreements with 140 operators, including the top ten largest operators in Europe such as Betfair, Ladbrokes and Pokerstars.

The stock
As mentioned above, Playtech doesn’t share the usual characteristics of my stock purchases. This fact is evident in below fundamental metrics as well as the price chart:

• Price/earnings (P/E): 14.5
• Price/book value (P/BV): 2.8
• Price/sales (P/S): 4
• Return on equity (ROE): 20%
• Return on invested capital (ROIC): 14%
• Operating and net margin: 35% and 27%

Despite the rather pricey P/BV and P/S ratios, I found the relatively low P/E multiple combined with the 20% ROE and impressive margins compelling. As you can see, the stock has rallied quite a bit, from around £4 in 2013 to £9.85 on November 1, 2017. On November 2, it traded at £7.7 following a ~20% beating due to an announcement that challenges in Asia would cause Playtech’s earnings to be 5% below market expectations. The price has stabilized in the month that followed, and is now trading at £8.3, 15% below its peak. Though it would have been swell to have bought at £7.7, is £8.3 still an attractive price?

Valuation
Let’s try to answer that question by estimating Playtech’s intrinsic value. The most widely used approach to assessing such a value goes under the banner discounted cash flow (DCF) analysis. The method is outlined in the post How much is LEGO worth?, but let me flesh it out quickly.

You may have heard Warren Buffet say: “Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.” A DCF analysis aims to determine just that. The model seeks to estimate a company’s present value based on the future free cash flows of the business (into perpetuity). In essence, free cash flow (FCF) is the amount that is left after spending the money needed to maintain the operational assets (e.g. property, plant and equipment). Hence, the free cash flow is simply operating cash flow – capital expenditures. FCF is significant, as it represents 1) the cash you could pocket if you owned the entire business, and/or 2) the cash the company can allocate as it sees fit, e.g. reinvest in the business’ growth, pay dividends or share buyback programs. Once we’ve made our projections as to the growth of these free cash flows, we need to settle on an appropriate discount rate based on the investment’s risks. Finally, we subtract the business’ debts (€738 million in Playtech’s case) and add its cash position (€545 million).

To get the discounted cash flow (DCF) model humming, let’s take a look at how Playtech has fared historically. Remember that impressive historic performance I was talking about? Take a look for yourself.

* The 460% jump in income was a result of the sale of Playtech’s stake in William Hill (cf. page 30 of the 2013 annual report).

** Note that earnings are influenced by the sales of stakes in other businesses. For instance, Playtech sold its €64.5 million stake in Landbrokes in 2016, cf. page 104 of the 2016 annual report. The years can be difficult to compare based on these acquisitions and sales.

+20% compounded annual growth in revenues, earnings and free cash-flow in both the last decade and over the past 5 years. Now that is a high-speed business. Though it isn’t very conservative to apply a 20% growth to the DCF model, let’s do it anyways! Let’s also feed the model some more conservative outlooks to get a more nuanced perspective on Playtech’s intrinsic value. I’ll present three cases below, ranging from über optimistic to conservative.

NB! The stock is trading in British pound sterling, but the annual reports are listed in Euros, hence the currency conversion.

Über Bull Case: For the optimists among us, let’s speculate that Playtech’s 20% growth in FCF can be extrapolated into the future. Let’s also assume that the perpetuity growth rate is 4% (1% more than the economy as a whole, which is a bold rate that should only be used for moat-protected top-growers). Plotting in those numbers returns an intrinsic value of £27.96-£47.31 depending on the discount rate. Compared to the current market price of £8.3, you get a humongous margin of safety (70-82%) as well as a potential upside of 237-470%.

Bull Case: It probably wouldn’t be prudent to join the über bulls. But, what if we sliced the FCF growth rate in half (10%) and applied a perpetuity growth rate of 3% instead? These – in my opinion – somewhat conservative estimates return an intrinsic value span of £13.72-£22.95. You still get a comfortable margin of safety between 39-64% and a 65-176% upside.

Bear Case: Growth rates of 5% annually and 3% into perpetuity are the most conservative inputs I can allow myself to plot into the model. Still, we get a 21-52% margin of safety, and a potential upside of 27-112% with a share price of £10.5-£17.6.

Regardless of how you slice it and dice it, Playtech appears to be an attractive opportunity at £8.3 in my humble opinion. Personally, I believe the Bull Case is optimistic, yes, but achievable. I regard a 7.5%-12.5% discount rate span as appropriate, thus arriving at an intrinsic value of £15 to £20, indicating a 80-140% upside. Yet, I might be totally off (trust me, that happens).

Though I’m aware that a 10% growth rate is optimistic (perhaps too optimistic?), I turn to the qualitative aspects of Playtech to get reassurance that it might not be that insane to believe in such a bright future for the business.

Moats and other good stuff
I spot quite a few qualities in Playtech and its position in the marketplace. I’ll try to run through some of them, but note that this list isn’t exclusive nor particular in depth, so I (of course) encourage you to research the business on your own.

First, I’ve worked in software company that offered platforms on a license-basis. Having a scalable platform that customers can on-board quickly and effortlessly is a very profitable way of doing business. Though stories from my own career is probably of little assurance, Playtech’s ability to on-board and go-live with around 5-10 new customers a year (including giants such as Pokerstars) – combined with above historic performance – might substantiate the claim. The beauty of getting (big-wallet) clients in the fold on a license-basis is simple: More capital can be allocated to improve Playtech’s value proposition towards new and existing clients, hence making it more compelling for potential clients to sign with Playtech. With each new client, the loop reruns and strengthens Playtech’s position. Though one shall always be weary of the company’s own statements, this quote from the 2016 report says it well: “The rapid growth and increased scale of Playtech has enabled the development of a superior platform, more relevant software and more products than other suppliers. New B2B operators or licensees are not able to undertake significant product development as they lack economies of scale.” (p. 11) One could argue that Playtech is thus enjoying a market leading position, achieved and sustained through a mixture of scale and network effect (read more about the four types of moats here), which has resulted in high barriers to entry. Offhand, it seems to be quite a resistant moat.

Second, due to Playtech’s license-based business model, the company seems to be rather resistant in terms of downside. Long-term contracts obligates the customers to do business with Playtech in the years to come. The 2016 annual report states that the team has been able to “lock in future growth” by successfully signing and extending key contracts. In length, part of the contract with Playtech is a promise from licensees to pay their part of the R&D costs for new games, which is “cost effective when compared to self-development.” Yes, Playtech’s customers pay for the development of Playtech’s platform – a stroke of genius if you ask me. Since the customers become more and more committed for each ‘investment’ in Playtech, I see a fair argument that Playtech might enjoy another moat, namely high switching costs. In my book, this further cements just how well-protected the business is.

Third, one could worry that growth might come to a halt, since Playtech has already signed ‘the big 10’ in Europe. However, the online gambling industry has grown ~10% annually during the last five years, and is expected to continue doing so. One might speculate that such a trend lures in additional operators (read: Playtech leads) and increases existing operators’ businesses and thus their willingness to expand the assortment of offerings (read: increase Playtech’s revenues). Furthermore, new licensee opportunities arise continuously as markets ‘open up for business’ through regulation.

Fourth, Playtech has been rather aggressive in their acquisition strategy, buying up lots of businesses that seemed to offer synergies. In 2016 alone, Playtech spent €240 million on acquiring BGT, Quickspin and ECM to their gaming division, and CFH plus Eyecon (February 2017) for the financial division. I’m usually weary of acquisitions, as it’s difficult to assess whether they’re value adding or value destructive. From what I have been able to deduce, Playtech’s past acquisitions seem to have been value-adding. Speaking of capital allocation, management has consistently paid out dividends, and increasingly so (0.04 per share in 2007 vs. 0.33 per share in 2017). However, doing so seems inexpedient given the rates at which Playtech can compound capital at. I hope that the €50 million share buyback program Playtech announced in 2016 is the ‘new norm’ for returning excess cash back to shareholders. Regardless, management appears to be shareholder friendly.

Fifth, though these acquisitions have resulted in €1 billion of goodwill/intangibles on the balance sheet (of €2 billion in total assets), Playtech is still a financially healthy business with €693 in current assets (of which €545 million is cash), and ‘just’ €998 million in total liabilities (of which current liabilities are €260 million).

Risks
For a comprehensive review of the risks (as the company presents them!), I’ll refer the reader to p. 44-47 of the 2016 annual report. I’ll merely highlight a few:

When I read-up on Playtech’s business model, I was surprised that these giants of the digital gambling industry such as Pokerstars or Betfair don’t have their own in-house platforms, but rather choose to ‘share’ with their competitors. Next to regulatory risks, I thought that a movement towards customers developing their own software was a key risk. Management says: “The single most realistic alternative to partnering with Playtech is for operators to utilise their own proprietary platform. […] This is an increasingly unsustainable and costly business model.” Sure, they must say so. However, William Hill attempted to cut-off Playtech in 2016, which resulted in immediate revenues decline. Naturally, they changed their mind and have just signed a long-term contract with Playtech once again.

Other risks concern regulatory interference such as higher taxation or bans on gambling. Say that the Chinese government shuts down all gambling operations; with one blow, one of Playtech’s key segments constituting 10% of the global market is gone. These ‘Grey Swans‘ are impossible for your’s truly to account for. To me, this is the greatest concern, as the impact of such regulatory actions would be immediate and probably quite extensive.

A short-term risk worth re-mentioning is Playtech’s troubles in Asia. Management has said that the challenges in Asia (which caused the saddening earnings announcement, cf. above) are temporary. But, if the troubles turn out to be permanent, it could be a growth hindrance as well as a source for unfortunate headlines, which (again) could pull the stock price south.

Catalysts and conclusion
Say that the intrinsic value span of £15 to £20 is somewhat accurate. Why should a market leading billion pound market cap growth story be this undervalued? One explanation is that I’m dead wrong, and the intrinsic value is nowhere near these estimates. Perhaps the regulatory risks are keeping the price down? Maybe the growth prospects are drained now that Playtech have secured ‘the Big 10’? Perhaps it’s just unrecognized by the market? Finally, why should an aspiring hobby investor be able to spot something that ‘Wall Street’ hasn’t? I don’t know, and that is a bit frightening to be honest.

Regardless, I chose to invest in Playtech given its impressive quantitative showing and qualitative qualities. I have no expectations of Playtech’s stock price to spike in the near future. This is definitely a long (+5-10 years) bet for me, and is thus not in the same category as i.e. Footlocker and Sports Direct where contrarian investors could pick up stocks that were probably oversold due to exaggerated short-term issues. Hence, if the stock price ever reaches £15-£20 I expect it to take time. But that’s fine with me, as I believe Playtech is a great business, and you know what Warren Buffett says about those, right? “Time is the friend of the wonderful business.”