Evolution (EVO)

Lately, I have been busy researching stocks in my portfolio, trying to expand my knowledge faster due to more reading and school, which keeps sucking up wáááy too much of my time.

Last week, I finished writing up this little report about Evolution. I used write-ups from Alta Fox, valuewalk.com, and scuttlebutt.co and EVO's annual report, to write this one. The write-ups can be found here:

• EVO+competitive+advantages+vF.pdf (squarespace.com)

• Evolution Gaming: The Leader In Live Casino - SVN Capital - ValueWalk

• Evolution (EVO/EVVTY) - Part 1 - Scuttlebutt in Europe

• Evolution (EVO/EVVTY) - Part 2 - Scuttlebutt in Europe

I hope you'll enjoy reading and love to hear your opinion.

Company description

Evolution Gaming develops, produces, markets, and licenses live casino solutions to gaming operators in Europe, North America, and Asia.

Live Casino brings the brick & mortar casino experience to a user’s phone, computer, or other streaming devices. Contrary to typical digital casino games which feature no physical human interaction, Live Casino is 100% focused on the seamless interaction between gamblers playing from all over the world and the dealer streaming live from one of Evolution’s 8 global studios.

EVO has around 40 games. Some are well-known games, like blackjack or roulette, and some are less-known self-created games, like Monopoly Live, Dreamcatcher, or Crazy Time. EVO licenses these games to online casino operators but carries the responsibility of running the games themselves through dedicated (unique table servicing one casino operator) and non-dedicated (non-unique tables servicing an infinite number of casino operators) tables. Typical contracts are ~3 years.

The majority of EVO’s games can support a limitless number of players betting at the same time. Therefore, with EVO’s model, the live dealer salary becomes a fixed cost that can be leveraged across hundreds of potential concurrent players instead of just a few players at a traditional casino table. As a result, scalability becomes very attractive. By integrating augmented reality, tactically adjusting bonuses and payouts, and optimizing player-dealer communication, EVO’s offering is more immersive than the experience at a brick & mortar casino.

Due to their superior unit economics and product offerings, EVO has outperformed the gambling industry with a 47% revenue CAGR since 2016 and EBITDA margins of 55% while typical casinos grow topline mid-single digits and operate at 20-30% EBITDA margins.

EVO’s superior unit economics compared to land-based casinos are also due to the fact that EVO has zero customer acquisition costs (which are incurred by the casino operators that partner with EVO). As players bounce between casino operators, they are still playing EVO’s games. While EVO spends next to nothing on marketing, EVO still capitalizes on the upside from newly acquired players.

The vast majority of EVO’s revenue is derived from a ~10% take-rate of all revenue generated by casino operators licensing EVO’s games. For example, if Joe Smith lost $10 last Friday night playing Live Blackjack on Fanduel’s Live Casino product (supported by EVO), EVO would earn $1 in revenue. Note that if Fanduel were to lose money to the customer, EVO would not be responsible for participating in that loss.

The biggest risks B2B gambling providers generally face are customer concentration and regulation. EVO is one of the lowest-risk B2B gambling providers, with their top customer representing only 6% of revenues in FY19, and their top country (UK) representing only 14% of FY19 revenues.

Market opportunity

Tailwinds for industry growth:

• Lower latency internet and broadband

• Better camera and streaming technology

• Improvement of mobile technology

  • In FY14, 13% of EVO’s revenue came from mobile devices

  • In FY19, 67% of EVO’s revenue came from mobile devices

• Regulation of iGaming in various countries expands EVO’s TAM (i.e. UK, Italy, Spain, US)

• Big data utilization allowing casino operators to target customers more effectively

• Cross-selling digital sports betting with iCasino

• General de-stigmatizing of gambling

Regulation is an important driver of the online casino business. There’s a trend of countries/states, especially in the US and Asia, that are imposing regulations on online casinos. More states/countries have big budget deficits and welcome expansion of their tax web. This will expand Evolution’s market drastically.

Europe has been a leader in connectivity and regulations. Approximately 60% of global gross gaming revenue (GGR) comes from Europe, where EVO has about 60% market share. GGR is expected to grow less than 10%.

North America

North America has been slow with internet connectivity and regulation. Only five states currently regulate online casinos. These five account for 11% of the 225 million adults in the US. This 11% has an estimated market size of €1.3 billion and is estimated to double by 2025.

Following the success of sports betting and pot regulations, combined with the shift in attitudes of land-based casinos to embrace online gaming, I expect more states to regulate. Currently, there are proposed legislations in New York, Massachusetts, Virginia, Connecticut, and Kentucky.

Flutter Entertainment, an Ireland-based iGaming company, recently estimated the TAM of the whole US to be €21 billion in 2025. As the current market leader, a lot of opportunity for Evolution Gaming.

Asia

Asia is a big and fast-growing market; much of the region remains either lightly regulated or unregulated. The land-based casino market is €46 billion, 5x that of Europe and second only to North America; but there’s a low online penetration of just 5% (Europe 46%). If Asia would follow Europe and move, in 15 years, from 6% to nearly 50%, then Asia can be as big as €35 billion.

Despite EVO not having any dedicated Asian studios, EVO’s market share is steadily growing in Asia with EVO’s Asian revenue up 115% in FY19. Experts estimate the Asian live casino market to be 10x the size of the European live casino market. This helps validate the view that EVO’s growth is still in the very early innings. Over time is expected that EVO may partner with an existing Asian operator to gain regulatory expertise while utilizing EVO’s superior technology and game IP.

Competition

Evolution Gaming and Playtech were early pioneers in the live casino industry in the mid-2000s. While EVO chose to focus solely on their live casino product, Playtech’s focus was spread thin amongst their many divisions (digital table games, digital poker, sports betting solutions, digital slots, land-based slots, back-end offerings, etc.). EVO significantly outperformed Playtech due to Playtech’s lack of focus and innovation in live casino. Today we estimate EVO’s live casino revenue is 5x Playtech’s live casino revenue.

Since 2006, Netent (a digital slots provider) was the only significant competitor to emerge in the European live casino market, but Netent has been acquired by Evolution in 2020.

During the early days of live casino in Europe, Asian live casino providers attempted to enter the market but could not compete successfully against EVO and Playtech. While Asian live casino providers tried their hands and failed in Europe, EVO has had phenomenal success in Asia in recent years.

Competitive advantage

Evolution has multiple different, but very strong, competitive advantages:

- Scalability

• Network effects

• Capacity utilization

• Best-in-class provider

• Unique portfolio games

• Licensing, regulatory expertise, and security

- High switching costs

- Other

Scalability

• Network effects

As the company releases more attractive games, more operators want to have those games because more players get attracted. Because more people are playing, viewing, and commenting on a live casino game, it enhances the experience for players. More players per game increase revenue for EVO, without increasing costs. This is a virtuous cycle and will lead to more revenue for operators and higher margins for Evolution.

• Capacity utilization

The company offers hundreds of games 24/7 and utilizes its global network to manage capacity. To be a meaningful competitor to EVO, one also needs a global studio presence, unique games that will draw an audience, and the capacity to offer volumes of standard games in multiple languages.

A sub-scale is either have a small number of tables and game offerings which will lead to a bad customer experience (not enough dealers, not enough games, not operating 24/7) or will have more tables than they need which will dilute their ROI on both their fixed cost investment and variable labor. The more scale a live casino operator has, the more it can use its capacity across regions to optimize ROI over time.

• Best-in-class provider

EVO is widely considered the industry leader with the best proprietary game IP. If a casino’s live dealer offering uses a provider that provides a worse experience, the casino risks losing their customer to an alternative online competitor.

• Unique portfolio games

EVO’s most popular games today are their proprietary games that are either enhancements to traditional games (i.e. Lightning Roulette) or entirely unique games (Monopoly Live). If casino operators want to offer these games, they must use EVO’s live casino solution. It is cheaper for EVO to invest in new games on a per-player basis than it is for competitors since EVO has the majority of player traffic on its games. This gives EVO the “Netflix advantage.” Because they have the most users, their spending on new IP on a per-user basis will always be lower than competitors. This makes it very likely that EVO’s game IP advantage will grow over time, creating a virtuous cycle of market share gains.

• Licensing, regulatory expertise, and security

EVO has attained over 10 licenses needed to offer its services in their respective geographies. This process can be expensive and time-consuming, and operators with a poor reputation or no reputation can have a hard time getting a license.

As an example, the growing US iGaming market has a complex state-by-state regulatory scheme. To date, NJ and PA have set into law that live casino studios must be built within the respective state to service residents in the state. This further prohibits competition from entering the market as player scalability will be more limited, making ROIs less certain. This also discourages casino operators from taking the risk of purchasing cheaper dedicated tables with EVO’s competitors. The smaller market sizes will justify fewer dedicated tables and given EVO’s product is known for maximizing casino operator ROI, we expect operators to be even more likely to choose EVO.

EVO also has a 24-hour digital security team that monitors equipment, live dealers, and gaming patterns, aiming to optimize security and prevent fraud. Their monitoring system can be easily integrated with casino operators' existing security platforms.

High switching costs

Dedicated tables with EVO can cost tens of thousands of dollars and the average contract length is ~3 years. If a casino operator were to let their contract with EVO expire, the operators would lose their upfront investment in their dedicated tables.

EVO’s most popular games are proprietary. Casino operators that leave EVO will no longer be able to offer the same games to their customer base. This would cause churn off their platform as those players seek to find their old games by playing on other casino operators’ platforms.

Other

• Industry experts have cited that ROIs for operators on EVO’s games are significantly higher than competitors’.

• EVO has developed a pristine brand amongst both players and their casino customers for offering a high-quality product.

• Management and the founders are supremely focused on maintaining a product gap vs competition, and frequently refer to it in their earnings calls and updates

• “Evolution’s perpetual mission is to increase the gap to the competition. Already today, Evolution has clear leadership in the Live Casino market and aims to keep its growth momentum.” – 2019 Annual Report

Management

Jens Von Bahr and Fredrik Österberg founded the company in 2006. They remain on the board and control ~13% of the outstanding shares. One of the early backers was Richard Livingstone, a British gaming company operator/investor. Richard’s brother Ian sits on the board and controls ~10% of the company.

The management team has done a great job for now. Widening the moat by focusing on this niche market, developing new games, and gathering new customers. Their performance is great: an average ROIC of 50%, and revenue and earnings growth exceeding 50% per year on average.

Only two things that aren’t great:

• The board and management team has a written policy of paying, over time, 50% of its earnings as dividends. This hurts the compounding of the company significantly.

• They issued ~30 million shares (~17% of shares outstanding) to acquire NetEnt. The strategy is great but cash payments are preferred.

Future expectations

I expect the management to continue executing well, keep the gap between competitors as wide as possible, and increase their market shares. With more and more states/countries starting to regulate online casino, I expect EVO to expand their operating margins to ~62%, continue revenue growth of 30+% per year for 5 years, and expect growth to slow down to 20% thereafter.

Risks

Regulations

Regulations could impact EVO’s revenue, of course. They are able to shut the gambling industry down or remove EVO’s license of operating in that state/country. This will be unlikely because giving people the freedom to gamble online and once tasted, they will protest if their freedom will be reclaimed. For Evolution’s licenses to be removed, their operations should be unsafe to cheaters or hackers, or they should commit fraud. That will be unlikely because management has put a significant amount of their wealth into this business.

Competitors

Competition will enter the market because of the juicy returns. It’s easy to enter the market but hard to be successful because of all the regulations and the dominance of Evolution. As mentioned earlier, it’s wiser for operators to choose Evolution than another firm, because the operators’ returns will be ~10x higher. It will also cost future competitors a lot of time and money to copy Evolution and when they have reached EVO’s current level, Evolution has already improved their operations, games, et all.

Antitrust laws

Another risk could be monopoly antitrust laws. Evolution’s management is probably going to execute well and, as a result of all the scalability advantages, EVO will capture most operators in newly-regulated states/countries and, therefore, is going to keep or increase their 80% market share. It looks like that competing with Evolution is nearly impossible and it’s likely to stay that way.

The likelihood of the government interfering with Evolution’s operations is quite small, I think. First of all, Evolution is operating in a niche market and no dominant company in a niche market has been sued by a government before. Second, even crazy big companies like Apple, Amazon, Microsoft, Google, and Facebook, aren’t split up. The only two companies that have split up are Standard Oil and AT&T, and those companies were way bigger than Evolution will ever be.

Total addressable market (TAM)

Evolution’s growth is somewhat dependant on states and countries opening their online gambling industry. There is a strong trend in America for opening up their states for regulation, but the trend is not guaranteed to remain in the future.

Current valuation

DCF Model

Based on my assumptions from the future expectations, the market opportunity they have, and how the company has done in the past. My median estimation of the company’s value is ~$33 billion with a 15% discount rate (or my required rate of return) and a terminal value of 20 (the multiple I think the company could be sold for in year 10). Because predictions are never accurate my range of value is between $37.7-$29.2 billion. With an enterprise value of $40.2 billion, the company has currently a premium between 7% and 38%.

Here's my DCF model:

The FCF margin is calculated by taking the average of the FCF/Operating Profit over the last years.

I also had a look at what the valuation could be for a DCF model of 5 years:

As we see, I get a present value of $35 billion. If we implement a bullish and bearish view, we would get a valuation of Evolution between $40-$32 billion. Currently, with this analysis, the company is between fair valuation and a 25% premium.

Forward multiple

Another way to value EVO is to look at what the EBIT or FCF multiple is going to be in 5 years with the price paid today. Right now, the company has an EV/EBIT multiple of 89 and an EV/FCF multiple of 109. These multiples are insane, but if we look at the multiple we would get in year 5: ~17x and ~19x. Then selling at a conservative 30x multiple we would get nearly a double in five years and therefore, approximately a 14% return. This return isn’t that far off the 5-years DCF model.

It wouldn’t be too crazy if we could get a 40x multiple for this company in year 5 because of the quality that EVO has. This would result in a double in 4 years and ~19% return.

Why does this opportunity exist?

Whereas the company is a little too expensive at the moment, this opportunity still exists because it’s quite hard for people to see and estimate the value of a great business as Evolution. Great businesses are likely to overachieve and stay around way longer than the average business and are therefore directly more valuable. But the company has a lofty multiple and is in nearly all other cases hard to justify.

This is probably the most exceptional company in the market right now. Because of the industry they operate in, they experience many and very strong competitive advantages. Such strong competitive advantages are nowhere else to be found.