NetPlay TV - Quantifying the Point of Consumption Tax

http://www.netplaytv.plc.uk/netplaytv/


Just a quick update on the point of consumption tax. NetPlay (LSE:NPT) announced its final results for the 2013 financial year this morning, and whilst the key figures were very good, as expected, all eyes were focused on the Point of Consumption Tax as the company provided some very useful figures for investors. The market didn't take kindly to them, with the share price closing the day significantly down at 18p, but is that justified? The site closed its position at 20.13p at the start of the day, to allow time to evaluate the point of consumption impacts, without time pressure.

This article is a follow-on from the below post. For full context and information, read these articles first:
http://www.theel1tetrader.com/2013/09/netplay-tv-gaining-traction-and-market.html
http://www.theel1tetrader.com/2014/01/netplay-tv-target-price-upgraded.html

First off, just briefly outlining the 2013 results, revenues jumped by a third, with adjusted earnings per share up to 1.68p, albeit the pre-tax profit figure came in slightly below expectations. The dividend figure came in at the top end of expectations at 0.50p, which provides a solid 2.78% yield. It has been able to do that because of its robust cash flows, which led to the cash pile rising to £13.9m despite £1.2m of dividend payments and the £3.0m acquisition of Vernons during the period.

There were, however, slight concerns over the weak nature of Q1 2014: "Q1 2014 was a record quarter for new depositing players and active depositing players, up 13% to 19,978 and 23% to 37,467 with net revenue increasing by 1% to £7.1m on a very strong Q1 2013 comparative. The net revenue increase would have been more significant if it had not been for SuperCasino's margin reducing to 1.5% in February from an average of 2.8% over the prior 12 months as a result of several VIP winners. The margin has returned to the expected 2.8% in March 2014."

That is a concern given that it could perhaps prompt brokers to reduce their forecasts down slightly from circa £6m at the moment. Dividend payment forecasts should be pushed upwards though, as they appear conservative given the hike in dividend this year. Perhaps Daniel Stewart's 0.6p dividend forecast is closer to the likely figure.

Pushing that aside, and looking at the POC tax alone, NetPlay has demonstrated its strong investor relations by outlining their expected impact based on the 2013 figures.

Against the reported £4.16m profit (£4.87m adjusted), the POC tax will remove 15% of net revenues that NetPlay earns. That means that investors should take the net revenue figure and multiply it by 0.85. Using the 2013 results, the POC tax charge would have been £4.2m. Impressively, due to contractual offsets and cost saving initiatives, NetPlay estimate that they can reduce that charge down by 60% to £1.7m. The tax is slightly worrysome in nature as it punishes any company who have less than 15% in gross profits and who can't boost that gross margin, thus it can be seen as anti-competitive and could lead to some firms exiting the industry.

Taking an example, 32Red (LSE:TTR) does not have the same flexibility as NetPlay with regards to contractual offsets and the nature of the business. Looking briefly at their financial results, their net gaming revenues came in at £25.4m, albeit a small proportion of that can be taken away and attributed to their Italian business. However, the main bulk of their business is from the UK, and the non-Italian net revenues came in at circa £24.7m. 15% of that is a hefty tax charge of £3.71m, which would wipe out their £2.67m in pre-tax operating profits (pre-exceptionals) and send them into loss. This is too simplistic though so I will look at 32Red in the future. Nonetheless, they have a decent cash pile, but the dividend would be at risk, so it is no surprise that 32Red may be forced into taking legal action. Just to operate at breakeven, they would have to shift a substantial percentage of the 15% charge onto third parties or strip out material levels of administrative costs, or embark upon a massive cost-cutting exercise. This demonstrates that other companies could be hit far worse than NetPlay.

The £1.7m charge on NetPlay would drop profits down to £2.46m, which would have meant basic EPS of 0.84p. The more important adjusted EPS would have been around 1.08p, which puts the company on a reasonable trailing PER of 16.7. Accounting for the cash pile, and stripping out 80% of it (defining it as surplus), the share price drops down to 14.2, so the cash adjusted PER drops to 13.1, which is reasonable given the rate of growth, but not outstanding value, which could upon up further downside weakness. There is a risk that advertising in the sector will be ramped up in the lead up to the tax as operators rush to grab market share, so this should also be considered.

Looking forward, net revenues for 2014 are expected to be £34.24m. Assuming that the company is only able to mitigate 50% of the 15% (rather than 60%), and the POC tax charge would be £2.57m. Pre-tax profit forecasts for 2014 are around £6m, but conservatively assuming £5.5m is booked and (given the tax losses), the post-tax profit would be around £2.93m or 1p in basic EPS. Presumably, the adjusted earnings per share will be higher, possibly around 1.2p. The forward adjusted PER would therefore be around 15. The cash pile will have strengthened, but say only to £15.5m to account for the POC tax charge and increased dividend payments. Once again, stripping out 80% of the surplus, and the share price drops back to 13.78p, which puts NetPlay on a PER of just 11.48, which looks good value given the fast rate of growth (albeit at the expense of fast-rising marketing expenses). That cash pile could also be put to good use in acquiring struggling businesses.

On this basis, the drop in relation to today's announcement is more likely related to the weak Q1 performance as a result of several large winners. The company remains on a strong footing and is arguably decent value again at this level. The market is however, uncertain, and that's not helped given the nature of operations. Whilst the company expects to be able to mitigate over half of the POC tax, there is no certainty that it will be able to, and there may be certain repercussions. That said, the calculations above are fairly optimistic (e.g. lower POC tax mitigation in 2014 and a lower pre-tax profit forecast). NetPlay expects to be able to mitigate the losses through taking up market share from businesses exiting the industry, through operational gearing and through pursuing international expansion in the long-run. The situation is certainly not as bad as the market has portrayed, but for now I shall keep NetPlay on the site watchlist. The technical outlook has unfortunately deteriorated, and Henderson Global Investors remain ongoing sellers of the stock. Of course, the POC tax hasn't actually been implemented yet, so investors should keep an eye out for progress on that front.

9 comments:

  1. Hello,
    I've read in numerous reports online about the poc tax that is to be 15% of gross profits. Then i read the npt results where it says its 15% of net revenue (a huge difference). How can they make a tax 15% of net revenue?? It would be an outrageous tax that would punish and potentially bankrupt any business operating on low profit margins. Some businesses have very high revenues yet relatively small profits, these businessess would immediately be loss making. Simon Thompson has referred to the POC tax as based on 15% of gross profits. I think this needs to be clarified for the PI as there is a lot of panic at the mo about this. I just can't believe that a tax could be based on revenue, a companies revenue bears little resemblance to its profit or loss so how can you base a tax on it? Rather confused.

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    1. Hi there,

      It is definitely a tax on net revenues. The plan is to align firms operating domestically and in tax havens such as Gibraltar and Alderney, who are effectively 'dodging' the 15% net revenue tax that mainland UK firms already currently pay.

      Thinking logically, the high tax charge makes complete sense. Gambling is ultimately seen as a demerit good, so tax rates are higher than for other businesses.

      The confusion has come about because of certain balance sheet classifications, and the media using 'informal' language when addressing the issue. The point that they should have made is that the firms will be taxed on all net winnings from UK-based customers. That is the net revenue figure as opposed to the gross profits figure. After all, gross profits accounts for the cost of sales, which a company can directly influence. They can't really evade a tax to the net revenue line. As you say, that is confirmed by NetPlay's assessment which has been very useful in clearing up the matter.

      That does have problems (as you also say). It is likely to shut some firms out of the market and decrease competition. The problem as I see it, is that the politicians will think that these firms have simply been exploiting a 'loophole' and that they shouldn't have been allowed to operate in this way in the first place. Combined with the large players being set to partially benefit from taking market share, the retaliation against the POC tax is nowhere near what it could be if all the major players started to get involved with court cases etc. As it stands, they may benefit in some ways, so that leaves firms like 32Red to fight their own battle.

      Just to sum up:
      - The tax is on revenues because gambling is seen as a 'bad' service so is taxed highly
      - The tax is on net revenues as evidenced by NetPlay's results. There is no chance that they will have misinterpreted the proposed legislation
      - The confusion over profits vs. revenues is derived from balance sheet terminology versus. non-balance sheet terminology

      Final point: The tax hasn't been finalised yet so it could still change. Chances are that it won't because it will provide a nice revenue source for the government and it's seen as being an issue of fairness (why should companies situated in tax havens not have to pay what the UK mainland firms have to pay?).

      El1te

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    2. Thanks for you informative response. After doing more research this morning it appears to be a highly contentious and potentially catastrophic issue for the smaller online gaming operators such as 32red which i happen to be invested in right now. KPMG produced this report in September voicing the concerns of the remote gambling association:

      http://www.kpmg.com/IM/en/IssuesAndInsights/ArticlesPublications/Documents/RGA-UK-Summary-Report.pdf

      It does seem inherently unfair to move the goalposts in such a way as to bankrupt the smaller operators who have fought hard to take on the behemoths of WHill, ladbrokes etc. As you mention the govt is playing right into the hands of the larger operators who can absorb the additional taxes and ultimately hoover up all the market share left over after the smaller gaming operators have gone under. It just doesn't seem right nor fair to me and i can see a lot of common sense in the KPMG report. I assume this will go all the way judicially as this is a game of high stakes if there ever were one.

      So what to do with my 32red holding. Initially sold my 5k original holding at a nice profit post their results day at 75p. I then read a Simon Thompson article a few days later saying that the results had been misinterpreted and not 'adjusted' to show that they had hit all brokers expectations. Impulsively (and now with some regret, i'm still only 1year in to my investing career) i bought back in after reading the article at 73p for a smaller holding of 3k. Once it started falling i placed a fill order to sell at 70p which wasn't subsequently filled and then found myself watching the share price continue to fall. All the while i have thought that this is a typical stock market over reaction to news and that the poc tax is on gross profits as Investors Chronicle insinuates and therefore not likely to have a game changing effect of the soundness of the investment. Now with the price at 55.5p i'm £808 (25%) down and wondering where to go form here. My head is telling me to sell the investment after a hopeful bounce on mon/tues. My heart is telling me that the govt will see some sense/fairness and the poc tax will be watered down or seen off in the high courts of europe and 32red will prevail largely unscathed and continue on its current growth trajectory, therefore i should sit tight. Anyway sorry for waffling on, time for a morning brew me thinks.

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    3. Fair comment. The KPMG report does outline all the issues and given that it is relatively independent, it does carry weight. Unfortunately, politicians tend to be stubborn when it comes to tax avoidance (probably due to public pressure), so I wouldn't be overly optimistic on the rules being changed. After all, this POC tax has been known for 6+ months now, and there hasn't been any ground made by the betting firms.

      Incidentally, the KPMG report suggests that the POC tax should be no higher than 10%. In other words, in the slight chance that the government do revise it down, the tax will be 10% of net revenues. Looking at the forecasts for TTR next year and making a few assumptions:

      - I'm seeing gross revenue estimates of £38.90m, which seems to suggest that TTR is not a top-line growth stock
      - Assuming a similar translation between UK gross -> net revenue as this year (66%), then the net revenues would be around the same as this year: £25.7m
      - That would create a tax charge at 10% of £2.57m or £3.86m at 15%
      - Pre-tax profits for next year are expected to jump to £5.10m
      - Post-POC, the pre-tax profits are therefore either around £2.53m or £1.24m
      - Taking a minimal tax charge of around 3% away from that gives post-tax profit estimates of £2.45m -> £1.20m

      Taking the basic EPS figures (i.e. using 71.96m shares in issue), you get EPS of 3.4p and 1.67p respectively which would equal PERs of 16.76 and 34.13. Cash-adjusted PERs will be lower.

      Bear in mind that these are adjusted estimates for the impact on the coming year. Seeing as the POC won't come in until December, the figures will be much higher. These numbers show what would have happened if the tax came in at the start of the year. Of course, you can strip out some of the tax (max 20% in the generous case) if they pursue heavy cost cutting measures.

      Even so, there is a huge difference between the net revenue charge being 10% and it being 15%.

      El1te

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    4. Just a point to add. Given that uncertainty, I'd struggle to see it trade at a significantly higher price than currently, for a sustained period of time. That could change once the POC tax is finalised.

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    5. I really appreciate your analysis, its very helpful. I think looking at the estimates for growth on digitallook which are still mightily impressive in respect of profits and eps i'm going to stick with this one and may even add this year if they get too oversold in the poc tax panic. Based on a worst case scenario of 15% poc tax using your 66% ratio gives profit for 2015 of £3.55 million which on a current mkt cap of 41.01 = only 11.57 x profits. My timeframe was 3-5 years and looking that far out the risk/return looks very much skewed to the upside. Interesting to note the figures on digitallook for 2015 for revenue of 33.9 but yet profit at 6.9m. How can they improve efficiencies to such an extent?

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    6. On a seperate point, any thoughts on Monitise? I sold out this week after it came back to break even for me. A billion pound valuation for a model that is now promising profits based on a subscription model further off in 2018, just seemed a lot of downside risk so i got rid. Its been a steep learning curve this first year of investing. With hindsight was sitting on a 40% gain a few months back...wouldn't have been a bad time to press the sell button.

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    7. Hi there,

      Yes - I was also a little surprised about how they plan to ramp up profits despite suffering the revenue hit in 2015, but I'm sure there must be good reasons for that. I'll try to find out as that would definitely help in terms ot mitigating the POC tax. With respect to TTR, it's definitely that the 80p+ valuation was simply too high, given the POC tax, so it should stabilise at a lower level.

      I briefly looked at Monitise the other week and thought it's grossly overvalued. It's not set to be profitable for many years, so people are paying for that profitability up front, which is a dangerous move, especially since the market is valuing is so extraodinarily highly. Anything can happen between now and the time of anticipated profitability, and competition will almost certainly increase.

      It has been suffering from the US tech market sell off recently, hence the slump. I don't see a credible reason why it should demand such a high valuation compared to other companies. Yes, it should have an above average rating due to the nature of the company, but where will the market stop if its seen as a completely blue-sky company? 20* revenues? 30* revenues? It becomes extremely difficult to put a valuation on a company such as Monitise, so whilst it looks grossly overvalued now, its really difficult to see where it will be in 3 years time, so for that reason it doesn't interest me. Those are the sort of stocks that will be hit hardest should the market turn bearish.

      Hope that helps,
      El1te

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  2. Indeed it does, have a great weekend

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