No. of Recommendations: 24
Hello folks,
I have tired of copying Buffett, Ted and Todd into picks and I am starting agree with the consensus and Buffett's comments: that their universe is just too small and too picked over in the current environment. I have the largest cash allocation I have ever had personally. But one idea I liked enough to sell some FTSE 100 index and invest in, is Evolution AB. It was recently pitched on the 'We Study Billionaires' podcast. I looked into it this week and agree it looks like a great bet. Here are some of my notes. Let me know what you think.
Let me know your best idea for 2025. It doesn't have to be as long form as this.
Summary
Evolution is an extremely high-quality business, trading at a reasonable valuation (15X) that offers investors a high chance of at least doubling their money over the next 5 or 6 years.
Global market leader B2B online casino services. Attractive growth runway ahead. Impressive financials, high margins, high return cash flowing business.
Arguments can be made that the business model is sustainable for the foreseeable future.
20% insider ownership.
On the We Study Billionaires podcast, Stig summed up the investment with a quote from Willie Sutton, which later became known as the Willie Sutton Rule - apparently taught to medical students. In the spirit of Charlie Munger, I'll let you look that one up yourself, if you are not already familiar with it.
Personally, I'm not sure I am that comfortable owning a sin stock like this. I almost never gamble (other than a small on the Masters to create some interest) for the usual reasons. I tried out one of Evolutions live casino environments this week, as part of my research and it was impressive. I can see how many people around the world enjoy it. Not something I plan to introduce my children to, that's for sure.
Financials
Revenue growth
2024E, 14%*
2023, 23%
2022, 36%
2021, 90% (you can guess what caused this)
2020, 53%
2019, 49%
EBITDA growth
2024E, 13%*
2023, 24%
2022, 37%
2021, 121%
2020, 82%
2019, 70%
EBITDA Margin
2024E, 68%*
2023, 69%
2022, 69%
2021, 69%
2020, 59%
2019, 50%
FCF
2024E, Euro 1.135B*
2023, 1.026
2022, 0.779
2021, 0.528
2020, 0.275
2019, 0.145
* We are 3 quarters into 2024. This is my own 2024 projection. I simply took the YTD and added on another Q3. I think that is conservative, as the business is growing and they had two specific challenges in Q3, which management say are non recurring (strikes in Georgia and cyber attacks).
ROE: 24%
ROE excluding goodwill from acquisition a few years ago: 44%.
Margins, returns on capital and historical growth suggests an incredibly high quality business. Whether that is sustainable is a separate question.
Growth has certainly slowed quite significantly in 2024 due to operational headwinds (strikes, cyber attacks) which would be a cause for optimism in 2025 if non recurring. Or it may indicate it’s getting harder to grow due to size (likely and normal). Or it may indicate they are approaching saturation (not consistent with management statements, industry reports or other factors noted below).
Covid accelerated the trend towards online gambling. This would have made post covid comps challenging. Despite this, the company has continued to grow significantly post covid, which is a strong sign.
Management have increased capital allocation to dividends and buy backs, which on one had suggests the explosive growth of the past is over but it also demonstrates capital allocation that makes sense for shareholders. They don't need much capex to grow and returning capital is better than poor acquisitions.
The business has net cash.
Valuation
Market cap Euro 16.8B
PE 14.1X 2024E
EBITDA 12.0X 2024E
FCF 14.8X 2024E
An investor today might expect a return of 112% by 2030 (before any benefits from buybacks). Assumptions: 2024 base, plus steadily declining growth rates out to 2030 and then an exit at 15x FCF.
FCF growth assumptions:
2025, 15%
2026, 12%
2027, 10%
2028, 9%
2029, 8%
2030, 8%
Capital appreciation return 82% and 30% from dividends.
The dividend pay out ratio of 50%, telegraphed by management, is a large part of the return. These are not heroic assumptions, all things being equal. Although a general market meltdown can of course change things. As could any major disruption from regulators, or competitors.
The current multiples are lower than might be expected, on an absolute basis, for a company of this quality. On a - relative to the market basis, it appears significantly under valued. It may be due to a lack of interest, as not a US company; disappointment after covid explosive numbers; market concerns around recent trading issues; regulatory concerns; or ESG or even index related (not sure about this).
Two questions are critical to an investment in Evolution. They are not knowable with 100% certainty but there is evidence to take a view which provides reasonably high confidence.
1. Are the competitive advantages sustainable?
They have been doing this for several years now and no one has come to threaten them or take their castle.
The business is very difficult to replicate, even with deep pockets. E.g. a large land based casino operator, or private equity, or big tech. Evolution are specialists in the live casino market. This requires a combination of skills and processes: software development, studio creation and operation; studio equipment manufacture; staff onboarding and training; multiple country regulations; established distribution channels; global studio operations; navigation of on the ground country logistics, premises and staff onboarding; installation and configuration with customers. Evolution have built out this complexity over a long period and it would be extremely difficult to replicate and critically, replicate to the same quality of service.
The quality of the service is a key selling point for operators, why would they go for the second best to save 1%. The operators are making a lot of money and they want the best live casino provider.
Cost and innovation advantages coming from scale. Evolution's customers are large in number covering markets all over the globe. It's far from easy doing what they do and it would certainly not be viable for a small operator. The scale point prevents the operators themselves from taking the service in-house.
Operators core business is dealing with regulators; attracting customers; KYC. They will have already gone through significant pain and cost getting plugged into the Evolution system. Switching providers would be expensive and painful. Developing an inhouse solution would be very challenging.
Evolution’s suite of products in the RNG space provide customers with a huge number and constantly increasing and improving complementary games. Customers like this as it keeps their customers engaged. This complements the core high margin live casino business.
Evolution has brand identity with end users. This is a significant competitive advantage. Customers trust Evolution for quality and security. (Don’t mention the recent security breaches!)
If a competitor spent several billion dollars building a superior or equivalent offering, which is unlikely due to the above, that competitor would then be faced with the significant problem of taking away their business. End users want to use Evolution products. They are trusted. Operators would not want to introduce a new unknown platform.
2. Will the regulatory environment be favourable?
Show me the incentives (taxes) and I will tell you the outcome. Yes, many more governments and jurisdictions will create regulations and laws enabling online casinos as it is in their interests. Land based casinos are permitted with appropriate regulation. It is reasonable to expect the same will apply to online. The global footprint of Evolution enables them to enter and exit markets as regulations evolve. There appears to be a mixed bag currently of standards around the world and they can also change over time with different governments in charge. It is a serious concern that a large element of Evolution’s earnings come from unregulated markets and there is a risk that business in these regions is lost. What is more likely is that some markets will be lost, or negatively impacted but others will become regulated and allow Evolution to operate legitimately. There appears to be an opportunity in the USA, with only 6 states currently allowing online casinos and that this number will increase. Although it will be lower margin business, due to the requirement to have studios in each state. The area of regulation is probably the stock markets primary reason for hating the stock: uncertainty. On balance, this is a risk but one worth taking. It is also worth noting that even if there was a very negative regulatory environment in a large number of markets, there is a stop loss element (zero debt), in that not all of the business would evaporate and it would be partly offset by the favourable industry trends.
Business Model from AR
“Business model Evolution innovates, develops, and produces content for online casino on a B2B basis. Our content can only be played through the interface of an operator who adds important aspects of the gaming experience e.g. authentication of the player, player account management and user interface. The gaming operators then market and offer the products to their end users. Evolution’s customers include the majority of the largest online gaming operators in Europe and North America, as well as a growing number of land-based casinos that have begun to offer games online.”
Revenue model from 2023 AR
“The majority of Evolution’s revenues consist of commission fees for both live and RNG casino. Commission is calculated as a percentage of the operators’ winnings generated via the company’s casino offering. For live casino, the most basic agreements normally include access to, and streaming from generic tables, while more complex agreements can include dedicated tables and environments, VIP services, native-speaking dealers and other customisations to produce a live casino experience that is unique for the end user and helps the operator to stand out from the crowd. Dedicated table fees are monthly service charges to operators who have opted to provide dedicated tables for their end users. Dedicated tables are reserved and used exclusively by the operator and can be customised completely to the operator’s requirements as regards to studio environment, graphics, brand attributes and language. The fee varies from customer to customer depending on factors such as the type of game, number of tables and active hours. In addition to commission and dedicated table fees, there are other smaller sources of income such as set-up fees, which are invoiced to new customers in conjunction with the launch of their casino offering.”
What does the company do?
They build gambling software and run studios for live casino environments delivered online, supplying independent operators. If you havn't used a live casino before, it's basically an app or web browser and you sign up with one of the many operators. Deposit some cash and play. You see the live e.g. roulette table and the human operating it. The user interface is very sleek. You get a strong sense that it's not rigged. It's just like a casino in terms of odds advantage to the house, except you are remote. Evolution own the studios, employ the croupiers and own the user interface. The operators handle the know you client, the marketing, the heavy regulation. Evolution are the market leader and have the best end user experience.
Gambling has been around for probably all of humanity. The thrill, the uncertainty and the chance to win make gambling one of the most powerful forces in human nature, right up there with the craving for food and other human desires. Left unchecked by regulation and discipline, gambling is one of the most potentially destructive forces for humans. But it’s not going away, just like fast food, tobacco and drugs. Of course technology use in gambling is like pouring petrol onto a fire. Regulations are evolving and are the only way to prevent serious damage to societies. Somewhere in between the unbridled attraction of online casinos and regulation, lies the commercial opportunity being exploited by Evolution and others.
The international nature of the business has two huge advantages: scale and exploitation of pockets of favourable regulatory environments. The regulation of the software providers, like Evolution, is less onerous (but still significant) than the regulation for the casino operators.
Gambling has been around for thousands of years and governments, in general, tolerate it. Probably because society wants it, albeit with some guard rails. But governments are of course getting their cut, in taxes.
Operating expenses
The live casino business is highly labour intensive and expensive to run compared to a pure software company. The live environment is highly attractive to operators and consumers but it restricts the capacity of the system and necessitates investment in physical studios and personnel and training. That said, it is a very high margin business but only if you are doing it at scale.
How big might the market get and where are we now in that journey?
One online research report suggests the industry will grow at 12% CAGR from 2021 to 2030, from $75 billion to $206 billion. There has been a lot of growth to date and there are a lot of factors that should drive future growth. Internet penetration in emerging markets; more and more digital orientated young people grow up and begin to earn; advances in technology and game quality.
The annual reports do a great job setting out the market opportunity:
Global Casino Market 2023
. Land-based casino 78%
. Live casino 5%
. Random Number Games 17%
CAGR industry revenue growth 2019 - 2023:
. Land-based casino 0.3%
. Live casino 23.9%
. Random Number Games 20.8%
How sustainable is the business?
Of course it’s hard to know the answer to that. The casino games have been around in different forms for hundreds of years. The live performance is an important psychological trick using social proof, liking, attraction. How will AI performers affect this. AI might be too polished and might be noticed. Live is by definition full of subtle flaws that might be hard to replicate. If it did happen, Evolution could adapt but it could be a competitive threat. Having used the sites, I think end users would not trust AI and that is significant. They would assume it was rigged. Regulation tightening in big markets, or outright bans could harm the business but the global footprint helps counteract that. New technologies and better games could become easier to develop which could be a threat but also a cost advantage. It’s perhaps highly likely there will be gambling in some form out into the distant future but it is harder to predict how it will be done and who the beneficiaries of the technology might be. But over a shorter period of time, of say 10 to 15 years, its maybe reasonable to believe that Evolution, with all its scale, current lead, expertise and financial strength will continue to be a major player and beneficiary of the industry tailwind.
Big tech may not want to enter the market due to the regulatory challenges and being associated with a toxic product, due the effect that could have on their core businesses. The business may not be big enough for them either.
Maybe the immediate growth, ROIC and business performance compensates for the lack of really long term sustainability of something like Coca-Cola.
Competition from the 2023 AR
“The strong growth trend over recent years for live casino has encouraged more systems providers to develop live casino solutions. The barriers to entry are relatively low, while the barriers to success are considerably higher. Live casino is a highly complex product that, in addition to a technical solution, requires both a certain volume and outstanding operational excellence to be profitable and perform satisfactorily. Our perpetual mission is to extend the gap with the competition and strengthen our market leadership. This is the common thread in our studio expansion as well as in product development, operational excellence and recruitment. We have a leading position in RNG, offering an award winning portfolio of games. The market is more fragmented than live casino with many other suppliers in the marketplace.”
How is the business currently performing?
In 2023 achieved revenue growth of 23.5% compared with 15.0% for the total online casino market.
Q3 2024 revenue growth 19% in constant currencies.
“Very successful launches of new products and the opening of two new live casino studios.”
Q3 2024 EBITDA margin 69% negatively impacted by strikes and cyber attacks.
Negatives: strikes in Georgia. Company was able to down size and move operations to more favourable locations. Cyber attacks. Company has tightened defences. The cyber attacks are significant. Regulators and law makers have tight guidance around protecting consumer data. Company has access to large amounts of consumer details including card details. This is a significant threat and potential competitive advantage. Operators and regulators will be monitoring this carefully and will need to be reassured of the safety for end users.
New product innovation continues.
The 2021 numbers show the exceptional increase in trading during Covid, which would have made future year comparisons difficult. It may also have created strong investor enthusiasm and subsequent disappoint as growth slowed and the stock price followed. However, the business continues to grow like a weed and has become cheap.
Capital Allocation and Balance Sheet
Evolution is buying back its own shares 40% of 2023 earnings. No debt. Insider ownership 20%. Dividend pay-out ratio 2023 50%, taking 2023 returned to shareholders to 90%. Opening at least 4 studios in 2024. Currently demand exceeds supply.
The RNG business was purchased around 2020 at mid 20s x EBITDA and has not performed as well as management might have hoped. The Random Number Generator business is 14% of revenues. Despite the high price paid, it may have still been a useful acquisition, as the games compliment the core high margin live casino business, which helps keeps end user engaged.
Conclusion
There are sustainable competitive advantages. There are incentives for governments to allow the activity to operate and the geographical market diversity mitigates the regulatory risk. All investments involve risk. It is rare to find something growing like this, at this price. The 50% dividend pay-out partially mitigates the risks here. One final point not mentioned above is management. The guy in charge of game development is originally from the land based casino market and is apparently regarded as the Steve Jobs of the casino world. I don't know if that is true and only discovered the company earlier this week but I did watch an interview with him and he certainly seemed genuinely passionate about leaving his mark on the industry through innovations. Of course having a super star on board, is also a risk, as all Berkshire Hathaway shareholders know.
I appreciate this is a long post but if you got this far, thanks for reading. And it goes without saying, do your own research. The good thing is there is a lot of great material on the company in their annual reports and online elsewhere. It was an interesting company to research but also a little bit of sadness in how it makes its money. I have bought it but don't know if I'm okay with it. I guess we are all involved to some extent indirectly through our governments.
Let me know, especially if you can see any major holes in the investment idea.
