32Red - POC Tax Implications

http://www.32red.com/


As noted in the NetPlay TV review earlier this year, online gaming companies situated overseas in tax havens are set to be impacted headed into 2015 by the Point Of Consumption (POC) tax being introduced by the UK government. The tax will undoubtedly set back sector growth companies by a few years as they must now claw back the profit that will be deducted in 2015 and onwards. Whilst I attempted to quantify the impact upon NetPlay, it makes sense to also look at 32Red and how they will be affected given that the comparison earlier in the year was simplistic in nature. Understanding the implications of POC is crucial in deciding whether 32Red now offers good value at circa 50p (much reduced from the circa 90p high), or whether the company is still a value trap.

Technicals


As it stands, the technical position of 32Red is weak with the share price only marginally above the 50p level with a declining overall trend, represented by the falling 50-day and 200-day moving averages. 50p will undoubtedly be a pivotal level given that it generated buying pressure on two previous occasions. However, after forming the second low in July, the next minor high failed to surpass the previous minor high at circa 66p; ultimately that meant there was actually a lower-low in play. For a bullish picture to form, the share price needs to break through the general downward resistance and maintain that break for several trading sessions. A sustained break of 60p would be confirmation that there is a new bullish trend in action. However, it is difficult to see any near-term catalysts that would drive the share price up towards 60p, so the bear case of a fall below 50p remains the more likely scenario at present.

The share register is relatively light on institutions with only a handful holding several million between them; that is because the shares are tightly held as a result of board holdings. Founder and CEO Ed Ware, who was formerly a Managing Director of Ladbrokes, holds around a quarter of the shares in issue with Chairman Fish holding a further 12.7%. Another ~10% of the shares are owned by other directors, which means that half the shares are out of circulation. That does keep the board well aligned, even if it is on the high side.

One point that supports the bullish case is that CEO Ed Ware purchased nearly £50,000 worth of stock in late September. That said, his wages including bonuses and share-based payments totalled over £500,000 last year so it is worth putting the spend into perspective in all cases. It's a sizeable vote of confidence, but shouldn't be considered a 'deciding factor' when trying to form a decision given the wage level last year.

Operations

I won't dwell too long on 32Red's operations given it's the financials that are really important.

32Red is a gaming company that operates an online casino, poker room and bingo platform all branded under the 32Red trademark. Strong growth has been experienced since 2009 with gross gaming revenues more than tripling to £38.8m over the period with active casino players tracking higher by almost 200% to 71,266 at the end of 2013. The company predominantly operates in the UK where growth has been mainly organic, although certain bolt-on acquisitions have taken place.

For example, 32Red acquired Go Wild Malta Ltd. for an unspecified sum in September. Commercial director Mark Booth commented, "This acquisition fits well with our growth strategy for the UK market. The migration of players from Go Wild to 32Red is a low-risk and seamless transfer as both businesses utilise the Microgaming platform and games content. Players will continue to use the same login and passwords to access their accounts and we will be active in showcasing the 32Red experience to these newly acquired players."

That said, sensible inroads have been made into non-UK countries through providing language assistance on their official websites, plus there is an early-stage operation in Italy, albeit this only contributes a low level of net gaming revenues at present (£0.6m in 2013).

One of 32Red's 'tried and tested methods' of marketing has been through football sponsorships, and these have worked to good effect. Partnerships in the past have been forged with Swansea F.C. and Aston Villa F.C, and new partnerships have been created with Italian side Bologna and with Rangers F.C. The company has also been successful with television adverts, notably securing the sponsorship deals for the "I'm a Celebrity...." and Paul O'Grady series' in 2013. Given that the sector does not have high levels of brand loyalty, marketing is a critical factor. Alongside this, 32Red opened a new sports book, 32Red Sport, in June 2014, and greater efforts have been made to drive mobile revenues, which are growing at triple digit rates and now represent around a third of total casino sales.

The latest trading update unveiled the following key performance indicators (KPIs):

-  Active casino players in first 6 months up 20% to 50,890 (H1 2013: 42,455)
-  Casino player yield £400 (H1 2013: £398)
-  New Casino players recruited up 35% to 23,566 (H1 2013: 17,459)
-  Casino cost per acquisition: £180 (H1 2013: £159)

These show the continued positive operational performance of the company, with the exception of the casino cost per acquisition. This has risen as a result of 'unsustainably high' marketing efforts in the run-up to the point of consumption tax implementation. Notwithstanding this, the most recent outlook statement from the company noted that the "second half of the year had started strongly...[and] The board believes that 32Red has commercially viable opportunities to grow both organically and by making acquisitions in the sector. As the regulatory landscape continues to evolve, we remain encouraged by developments in potential new markets, both in Europe and the US."

Therefore, on the whole the operational side of the company is in good health and the real question revolves around the financial future.

Financials

Briefly skimming over the recent interim results, these are the key points:

- Net gaming revenues up 20% to £15.2m
- EBITDA up 22% to £2.2m. The adjusted EBITDA is not really relevant in this case as the investment should not be treated as exceptional
- Profit-before tax fell 7% to £1.2m
- Earnings per share fell marginally to 1.63p, with adjusted earnings per share up 8% to 3.32p. Once again, the adjusted earnings per share is not fully useful as it does not account for amortisation. Stripping out amortisation, the EPS falls to 2.25p
- Interim dividend up 25% to 1p
- Trading in line with full year expectations

The balance sheet is in a good state with current assets 1.47x total liabilities and total tangible assets 1.69x total liabilities. As is to be expected with online gaming companies, asset backing per share is low, but the £4.9m cash pile is pleasing, even if it does include a material amount of player balances. Full-year estimates from Numis are for 7.30p in adjusted earnings per share and a 2.20p dividend, which would give a PE ratio of 7 and a prospective yield of 4.3%, which is a decent attraction. However, I would dispute the adjusted earnings per share figure in this case given the adjustments that it accounts for.

Putting that aside, the core discussion point should of course be about the Point of Consumption Tax ("POCT"). After all, without the tax (which is what forecasts are based off), the company appears good value when accounting for the cash balance, growth rates and modest valuation. POCT changes the financial landscape and the lack of guidance from the company is very disappointing in that it does not provide investors a base level for constructing valuations. Therefore, numerous assumptions have to be made; I will look at certain valuation situations.

The first point to understand about the POCT is that it is a 15% tax on net revenues; although this terminology often causes confusion. The reason why gambling is taxed so heavily by the government, it because it is considered a demerit good. Much of the confusion has revolved around certain investors believing that the tax is on profits; that is incorrect. The POCT is a tax on online gaming companies who are situated overseas in tax havens such as Gibraltar and Alderney. In these locations, they can serve online gaming to UK customers whilst paying negligible tax; as low as 1% with a circa £450,000 cap in certain locations. On the other hand, mainland UK companies such as Bet365 pay 15% of net revenues already, so these companies in tax havens (such as 32Red) are effectively benefiting from extremely low tax rates. Therefore, logically it would not make sense if these "bad" companies were taxed at a lower rate than the UK corporation tax.

The POCT changes that; these online gaming companies must pay 15% in tax in any revenues derived in the UK from customers. It essentially levels the playing field and although there are potentially downsides ("smaller operators may be squeezed out of the market by the additional tax burden"), it will generate a revenue stream for the government running into the hundreds of millions. It does also make logical sense, and a recent move by a group of operators to challenge the tax, failed at the High Court on October 10th; this paves the way for the introduction of the POCT towards the end of the year.

As it stands, there are numerous other listed UK gambling companies that will also be impacted with Ladbrokes, Bwin.Party, William Hill and Betfair all set to see their bottom line hit in the near-term. That said, the decreased competition of smaller brands might eventually benefit established and profitable operators as they can take market share from the smaller operators who are forced out of business. Citi Research estimated that circa 15% of the UK gaming market could be left with low or negative margins thus would be forced out of business. After looking closely at 32Red, it does not appear that it will fall victim to that.

Betfair: "This will require all operators selling into the UK market, whether based domestically or overseas to hold a UK Gambling Commission licence to transact and advertise with the UK and pay betting duty at a rate of 15% of revenue generated from UK persons."

William Hill: "This has the potential to radically change the shape of the UK online gambling market and we are confident William Hill can, over time, take more market share as a result."

Since the POCT covers all fixed odds/pool, non-fixed odds betting and remote gaming (e.g. casino games and bingo) that is served over the internet, the entirety of 32Red's UK-derived revenues will be hit as they do not have bricks and mortar presence. To re-iterate the point, current 32Red forecasts do not account for the POCT as the brokers have yet to adjust their forecasts post the court case. In particular, an analyst at Numis commented that he excluded the POCT from Betfair forecasts because he did not believe it would be introduced; this hardly gives investors full information!

To start to be able to quantify the impact, we need to know roughly what proportion of the revenues described as 'underlying' in the 32Red financial statements are generated in the UK. Unhelpfully, the company ceased geographical splitting the revenues after 2009, when the UK and Ireland figure was 74%. That figure is not particularly useful either unless you know the Ireland split. However, in the 2011 Annual Report, the company commented that over 75% of revenues originated from Britain. Given that the split is unlikely to have changed drastically, we can take 75% as a base percentage estimate of UK derived revenues, as a percentage of the 'Underlying' figure. This is likely to be out by a few percentage points given the age of the data, but given that the UK remains their core market, it's a sensible estimate to use.

First we can back-apply the tax to see the implications had it been in place during 2013. Net gaming revenues for the underlying business totalled £24.76m. At 75% of that being UK, the taxable net revenues total £18.57m with a tax at £2.79m at zero percent offset. The offset represents any costs that the business can strip out elsewhere to restore profitability. We can use that to derive POCT adjusted estimates for 2014 to generate a theoretical earnings multiple. The table uses annualised H1 results and ignores tax charges for simplicity.

The table shows sample income statements for annualised H1 2014 results, with different offsets applied. In reality these offsets (i.e. cost savings) would be derived from either lower costs of sales or lower admin costs, although I have not specified where from in this table and have simply adjusted to include a lower POCT figure.

What becomes immediately clear is that the level of offset is hugely important; without any offset at all, the back-adjusted 2014 POC tax outflow stands at a hefty £3.41m, which would reduce adjusted EBITDA to just £0.96m. That EBITDA figure would fall further if depreciation, amortisation and share option costs were included, and probably would tip unadjusted EBITDA negative. However, we can ignore that for now, and £0.96m of EBITDA translates through to a PE Ratio of 38.5, which is far too high. Stripping back 70% of the cash from the market cap (not 100% as part of the cash is held in player accounts), and the PE Ratio still stands at 33.6, which would be far too high for a company in this sector. After all, the gaming sector tends to trade at a modest average multiple of low double digits, as this reflects the substantial regulatory risks.

You can however upward adjust the PE ratios by 8% to match Numis' forecast 2014 figures. In that instance, the Adjusted Basic EPS figures are 1.40p, 2.16p, 2.91p and 3.65p respectively, giving PE Ratios @50p of 35.7, 23.1, 17.2 and 13.7 respectively. The latter figure represents decent value for the sector, whereas the rest arguably do not. Given the definition of adjusted EPS it's not clear-cut in this case.

So what level of offset is sensible? I would suggest that somewhere between 15% and 30% is reasonable as this would reflect cost savings of between £0.51m and £1.02m on an annualised basis. It is perhaps harder to cut those costs back whilst a company is growing so aggressively as cutting back on marketing costs tends to be an unwise move; therefore, any such cuts are likely to be largely derived from administrative cost reductions than improvements in the gross margin.

On one level, the amount of costs that need to be stripped out to offset 30% of the projected cost are not substantial at just over £1m, but it is also possible that 32Red may just run with the costs this year and seek to benefit from operational gearing later on. That operational gearing is generated from growth filtering through to the bottom line. The table to the right shows a TTR-unrelated example of how operational gearing kicks in despite the presence of POCT. A 25% in UK net revenue can generate a 44% rise in EBITDA.

Therefore, the question is whether the POCT will be a one-time hit to 32Red's financial statements, with operational gearing allowing the growth play to continue thereafter. It does increasingly look that way as they have noted expansion outside of the UK in recent news statements. However, that does not mean that investors should avoid the fact that the rating in 2015 is likely to look on the high side (barring an unexpectedly high offset). That is even more so the case since the EBITDA figures used in the earlier table to not account for depreciation, amortisation and share option costs. Excluding amortisation is unwise given the continued investment into intangible assets (£328k during H1), hence the important figure is the Basic EPS with that included; this would only succeed in increasing the PE ratios, meaning that a larger offset is required to obtain the EPS figures pre-amortisation.

Investors should also not forget the costs of expanding into new markets (as can be seen with their Italian operation). Marketing is the core method of establishing brand presence, and this is costly with start-up ventures tending to run losses in the intermediate term whilst critical mass is gathered. Therefore, it's difficult to be excited at the current valuation unless either taking a long-term viewpoint or if you believe that 32Red will be able to strip between £1.25m and £2.50m from their cost of sales/administrative expenses. That's not an assumption that I find particularly favourable in terms of risk/reward.

Although the dividend could theoretically be under threat next year if the offset is low because of a low cover, the cash position should ensure that it is not reduced, and the progressive dividend policy is continued (albeit potentially at a slower rate).


Purely out of interest, it's worth looking at a potential long-term (multi-year) upside case for 32Red. If gross gaming revenues reach £60m and the relationship with net gaming revenues continues to be 67%, then net gaming revenues would stand at £40.2m. It assumes that a high level of focus still remains upon the UK, but that natural diversification occurs and the NUR drops to 68% of NGR.

Gross profits come out at £13.3m. Assuming that 32Red has been able to offset 30% of the POC costs through decreasing its annual admin costs, then adjusted EBITDA comes out at £3.87m giving EPS of 4.97p. In this scenario the PE Ratio is very fair with a single digit ex-70% cash PE using a cash balance of circa £6.7m. However, this potentially underlines that even a material rise in net gaming revenues over the next few years and using a 30% offset would generate a set of valuation metrics that are attractive (and this still does not include amortisation. For that reason it can still be argued that the market is valuing current prospects relatively highly and that a lot of the post-POCT upside is factored in at the current price.

A Value Trap?

The bottom line is to consider whether 32Red is a value trap based on the uncertainties arising as a result of the POCT, and the board's failure to give the market guidance as to the impact that can be expected. In my opinion that does not necessarily make it a value trap given that the hit is likely to be one-off in my opinion, with operational gearing kicking in thereafter and driving higher EBITDA. That said, I also see little attraction in investing prior to the POCT given that next year's figures will almost certainly be hit by the tax, barring a significant offset (watch for company guidance on what can be achieved).

The sole point that does make the sector interesting at the moment is that industry consolidation looks inevitable. After all a company can acquire another, strip back the fixed costs, cross-sell the products to customers and therefore eliminate the bottom-line impact from the POCT. Those companies who struggle to make a profit can essentially be absorbed into a larger company, and with lower administration costs, it can be turned into a profitable business. It is probably more likely to be the case that 32Red is the acquirer rather than the acquiree, but it does set up an interesting dynamic that could prop up share prices if the POCT cannot be offset materially.

At the same time, the POCT has effectively re-warned the market of the risks of involving with gambling companies and how the regulatory risk is substantial. After all, there is nothing to stop a further regulatory decision being announced in the future; a blanket ban on gambling company TV sponsorships for example. At the current point in time, the risks remain material and without the company providing clarity on the level of offset that can be achieved, there is little attraction in taking a risk heading into what could be a 2015 in which the financial figures for profit are lower year-on-year. For that reason, I have put a No Rating tag on 32Red.

3 comments:

  1. THANKS. THIS IS VERY USEFUL

    sorry for caps lock

    ReplyDelete
  2. This is a time when the management need to come out and clearly state what their projections show. How is the market meant to value 32 if we can only have a rough idea what will happen. My hope now is that sometime acquires them at 75p
    Steve

    ReplyDelete
  3. Call and a half. Below 50

    ReplyDelete