EVGGF - Evolution AB's Unjustified Huge Discount

2023-08-28 05:19:39 ET

Summary

• Evolution AB presents a risk-reward asymmetry and is 40% undervalued compared to my base case scenario with a fair price of €163.
• The company does not have any obvious reasons for its low valuation, making it an attractive investment over the long term.
• Evolution's management has strong skin in the game and has the best CPO in the industry who will continue delivering unique games.

Note: All currencies are denominated in EUR unless otherwise stated.

Usually, when I see a company trading at low multiples or below its average valuation, it can take me more or less time, but I find the explanation. Sometimes it is because of low-quality business, it can also be because of circumstantial reasons, change in expected growth, or management making risky decisions.

In Evolution AB (EVVTY), I can't find any of those reasons, and that is why I am bullish, consider the company to be strongly undervalued compared to its fair price, and believe this is one of those Mr. Market's episodes of madness that presents from time to time.

The company is operating in a growing market and enjoys a leading position thanks to its unique games and innovation, led by great management with high skin in the game that has been able to grow the company since its foundation.

The economics of the business increase Evolution's moat as it becomes bigger and margins are better than ever since they enjoy scale and network effects.

Company background

Evolution AB was founded in 2006 by putting a camera in front of a roulette with a girl spinning it in a small studio in Riga, and the online live casino was born. At that time, online gaming already existed but it was random number generator ((RNG)) games, like slots or roulettes where users press a button and the algorithm produces an output.

With advances in technology, better camera resolution, and online streaming, it became possible to provide a better service for the end users (players) by replicating a land casino experience.

In the following years, the company added more games like Blackjack and Baccarat, signed its first agreements with gaming operators, and in 2009, had to build a larger studio to meet its demand. In 2011 and 2012, Evolution AB became the first online live casino business provider in the newly regulated markets of Italy and Denmark. In 2013, they became the first certified live casino provider in Spain and continued expanding through Europe by opening studios in Malta (2014), the U.K., Belgium (2015), and Romania (2016).

The company went public on the Nasdaq First North Premier in 2015, with an initial market cap of €302M and allocated 43.4% of the outstanding shares from founders, but didn't raise any capital, since as we will see later, the company is asset-light and provide enough cash flow to fund its expansion.

In 2017, they revolutionized the live casino market with the launch of in-house developed game shows with a unique mix of live casino and RNG with augmented reality technology (Dream Catcher), which enabled the company to expand to a much broader group of end users.

In 2018, Evolution expanded outside Europe, entered the Canadian, U.S., and Georgian markets, started an acquisition strategy, and in 2019, entered the Asian market.

The company currently employs over 17,500 people, offers more than 1,000 games (Live and RNG), and is a market leader in the online gaming industry, providing its services in over 40 regulated markets from its studios located in Europe (10), USA (5), Canada (2), and the recently opened small studios in LatAm (2).

Most of their revenues are generated in Europe (39%), but Asia is the fastest-growing market with 66.9% growth during 2022 and currently represents 31% of total revenues .

North America accounts for 12.5% of their revenues, which is also growing significantly faster than average (52.4%), Latin America 7%, and other markets 3% of total revenue, which is mainly Africa.

Business model

Evolution provides its services to online and land-based casinos on a B2B basis, and their games can be played through the interface of the operator who is responsible for KYC, authentication, account management, and user interface.

The gaming operators offer Evolution's games to its customers and pay a fee based on the winnings generated. Evolution signs agreements with gaming operators (currently +700), which include major gaming brands such as PokerStars, William Hill, DraftKings, or 888.

Even though most of the revenues are generated as commission fees for RNG and live games, the company also provides dedicated tables with customized environments, VIP services, or set-up fees in the case of new customers. Fees are generated monthly, which allows Evolution to have a constant cash flow.

Evolution's fee on winnings is ?10% and can vary depending on factors such as the type of games offered, the number of tables, and active hours.

Evolution currently operates over 1,300 live tables. Live tables are streamed from its studios, the main ones, which serve as hubs, are located in Latvia, Malta, and Georgia. Besides its larger studios, Evolution also operates studios in other countries to meet national gaming regulations that require a physical presence in the country.

The company also created its Evolution Job Shop, located in Riga, to produce unique items that are used in their games, like the coin flip machine used in their Crazy Coin Flip live game show.

Main Evolution costs are personnel (53%), which include croupiers and game presenters (87% of personnel costs), IT developers (7%), administration (3%), studio development (2%), and sales (1%).

Personnel involved in their games are trained in their studios, being the normal training period roughly 100 hours, after which a three-month trainee period begins, and are assigned a mentor to minimize the risk of gaming mistakes.

Its business model is highly scalable since some of the games can receive many customers and the marginal cost for a new player is almost zero. Some of the games, like Blackjack, have a limited number of players per table, but once a studio is opened, it can provide its services for many gaming operators.

This highly scalable business model has been improving Evolution's margins year-over-year, reaching 63.5% in 1H 2023.

In 2022, the company launched its new smart lobby, with a similar front-end to Netflix (NFLX) or YouTube ([[GOOG]], [[GOOGL]]), that shows recommendations to users and is improved every day by artificial intelligence ((AI)), which uses data to help users find quicker games that they will enjoy.

Gaming market

The total gaming market has an estimated value of €438B in 2022, according to H2GC, and is expected to grow at 11.3% CAGR until 2027 . While land-based gaming represents 77% of the total market, its growth has been significantly lower compared to online gaming. Land-based gaming is mainly made up of state-owned lotteries, land-based casinos, and gaming machines.

From 2018 to 2022, online gaming achieved a CAGR of 19%, while land-based gaming only grew 1.7%.

The expected growth in the gaming market is mainly attributable to online gaming, driven by the increase in legalization and regulation, as we have recently seen in the states of Maine and Kansas in the U.S., and the adoption of augmented and virtual reality, creating an entirely new environment for gambles and the opportunity to create new games, as Evolution has been doing.

Even though online gaming currently only represents 23% of the total gaming market, in the upcoming years, it's expected to gain market share.

Currently, for the online casino market, live games represent 24.5%, while RNG generates 75.5% of revenues. The RNG market is highly fragmented since it is easier to develop compared to live games, and has lower growth rates compared to live games. The expected growth benefits Evolution since 84% of their revenue is generated in this segment.

The revenues for gaming operators and game developers are highly conditioned by regulations. 41% of Evolution's revenues are generated in regulated markets, accounting based on the end-user's location.

In Europe, which is the most mature market ($40B annual revenues), Evolution is growing its revenues 15% YoY (2Q 2023), while in the U.S., where in most states online gambling is still illegal and the online gaming market is half of Europe's, revenues are growing 35% YoY as more states are approving laws.

In Asia, the online gaming market is only $10B, since online gambling is illegal in 48% of Asian countries , including China with the exceptions of Macau and Hong Kong.

In Latin America, most countries have legalized online gaming , which I expect to be an increasing source of revenue for Evolution since it only accounts for 7% of the revenues.

Evolution is clearly the market leader in the global online live games market, having 44 of the top 50 most-played games .

The company is enjoying this leading position thanks to being a pioneer in this market segment, its constant development of new games, and the current size of the company, partly reached by its acquisition strategy, which we will review in the next section.

Since Evolution is able to offer a wide range of games to operators through its One Stop Shop, operators don't have to deal with many suppliers and are able to offer many games with just one platform.

The main competitor for Evolution is Playtech plc ([[PYTCF]], [[PYTCY]]), even though its business model is mainly B2C-oriented, acting as a direct operator, and their B2B revenues are significantly lower compared to Evolution ( €632M in 2022 ) with EBITDA margins of 25%.

These lower margins for Playtech are explained because, in its B2B business, they are not only focused on providing the platform and games to operators, but they also provide many other services with lower margins. These services include hosting services, consultancy, customer support, fraud prevention, and payment advisory.

Playtech is not focused on developing new games as Evolution is doing, and I believe they are not direct competitors since even Playtech can offer a wider range of services for gaming operators, Evolution is clearly gaining the race for creating a leading position as an innovative gaming provider. Playtech still offering the classic casino experience , which doesn't differentiate much from the competition and experience pricing pressures.

On the other side, Evolution offers unique games that other companies cannot provide and creates a moat in the gaming industry. Since they are able to provide these unique games, it creates cross-selling with classic games like Roulette, Blackjack, or Baccarat, as the CEO Martin Carlesund commented in the latest earnings call in July 2023 :

Games like Funky Time truly differentiates Evolution from our competitors, and many of our players play the first ever Evolution game round on Funky Time and after that move on to play also other of our games.

The online gaming market is highly fragmented with many operators since it has relatively low entry barriers, but high success barriers because of scale economies. Smaller online gaming providers include Gamesys, which was acquired by Bally's (BALY) for €2.3B, and Pragmatic Play, which is focused on mobile gaming.

The acquisition strategy

Evolution started its acquisition strategy in 2018, which allowed the company to strengthen its presence in new markets, grow its market share, and provide more services to its customers.

Its first acquisition was the live dealer gaming provider Ezugi in 2019 for $12M in cash plus additional consideration of $6M, of which until now has been paid $3.7M. Ezugi's revenues were €11.9M in 2019 and conducted operations in the U.S., Europe, Latin America, and South Africa.

In 2020, Evolution became a complete online gaming supplier by acquiring NetEnt and Red Tiger, adding slots ((RNG)) to their games portfolio. The acquisition allowed cross-selling between both company's clients, a cost saving of approximately €40M annually , and provided a better service by becoming a one-stop shop for online casinos.

This has been the biggest acquisition and the total consideration was €2,280M, which was made through the exchange of 0.13 Evolution's shares for one NetEnt share, increasing the number of Evolution shares from 189M to 220M shares. NetEnt's revenues for 2020 were €202M, with €36.8M in profit after taxes, giving an acquisition price of 11x revenue.

In 2021, Evolution acquired Big Time Gaming, continuing with its RNG acquisition strategy, and DigiWheel, a developer of high-definition spinning wheel.

Big Time Gaming was acquired for an initial consideration of €80M in cash plus €147M in Evolution's shares, and earnouts payable based on EBITDA for 2022 and 2023, which will be paid 70% in cash and 30% in Evolution shares during 2023 and 2024 with a limit of €230M. Revenues in 2021 were €40.2M and net profit after taxes of €16.8M. The acquisition price without including earnouts is 5.6x revenue.

DigiWheel was acquired for €1M in cash and may pay an earnout of five times 2024 profits with a maximum of €250M. DigiWheel's revenues were not disclosed but were less than €1M for the year.

After these two acquisitions in 2021, the company launched its One Stop Shop, enabling its clients to access all of Evolution's games from one platform and facilitating the launch of new games.

The latest acquisition was Nolimit City in 2022, a world-leading producer of online slots with a unique product with provocative themes and a humorous touch. The acquisition consisted of €200M in cash plus an earnout payable based on EBITDA for the years 2022, 2023, and 2024 for a maximum amount of €140M. Revenue for 2022 was €27M and net profits of €12.5M, giving a 7.4x revenue acquisition multiple.

The company doesn't currently disclose sales for the acquired companies, but since 2020, they have disclosed revenues from Live games (Evolution and Ezugi) and RNG (NetEnt, Red Tiger, Big Time Gaming, and Nolimit City).

Even though these acquisitions might seem expensive on a revenue and net profit multiple, I believe these are strategic acquisitions since the company is creating a global leader supplier of online games, and increasing its moat while removing competition in a fast-growing market that hasn't reached yet its maturity phase.

Scale and network effects are relevant in the gaming industry since the economics of the business don't allow the development of innovative games for gaming operators, since the costs would be too high for the number of users they can supply.

Evolution is already the global leader and is gaining pricing power, since operators know they will increase their revenues by including Evolution's portfolio of games in their platforms.

Gamblers will choose the operator that has Evolution's games since gaming operators don't differentiate much from each other, but if the games are fun, they are going to continue on the platform.

Management

Evolution's board of directors still includes both founders of the company, Jens Von Bahr (Chairman of the board) and Fredrik Österberg (Board member). Each of them still owns 5.2% of the total outstanding shares, and they receive annual fees of €400,000 and €100,000, respectively.

Most of the board members were incorporated in 2015 when the company became listed, including Ian Livingstone who owns 0.23% of the company and is the brother of Richard Livingstone, who owned 33.1% of the company prior to becoming public and has been selling over the last years. After the IPO, his ownership was reduced to 16.5% of the outstanding shares, and currently owns 1.9% of the company, since he has been selling shares for the past years and the company diluted outstanding shares through acquisitions.

From the executive management perspective, the current CEO since 2015, is Martin Carlesund, who has been leading Evolution's expansion for the last 8 years and owns shares for a total value of €686M (584,923 shares) and received a total compensation for 2022 of €2.7M. The compensation structure is based on a base salary plus a variable payment limited to 100% of the base salary.

Executive management is also compensated through the issuance of warrants. Currently, Martin Carlesund has 650,000 rights through the 2021/2024 warrant program exercisable until March 2024 for a subscription price of €99.1.

The total warrants that executive management receives are limited to 5M shares (2.35% dilution).

One of the biggest assets of Evolution in my opinion is its Chief Product Officer Todd Haushalter . He was employed in 2015 and has one of the most extensive experiences in the gaming industry. He started making dice games in his neighborhood at the age of 10 and later on, started as a casino dealer with London Clubs International. He has worked in some of the major gaming operators such as the Wynn (WYNN) in Las Vegas (2004-2008), Shuffle Master (2008-2011) in Macau and Las Vegas, and became the Vice President of Business Strategy for Bally Technologies (2011-2014) and the Vice President of Gaming Operations for MGM Resorts ( MGM ) before joining Evolution.

He invented games such as Crazy Time, Lightning Roulette, and Monopoly Live, among others, and I would strongly recommend watching Mr. Haushalter's available interviews. I believe he is one of the main ones responsible for the incredible growth of Evolution driven by innovation.

He currently owns 96,300 shares and rights through the 2021/2024 warrant program for 130,000 shares.

Regarding the other members of the executive team, the CFO and CHRO have been in the company since 2016, the Chief Strategy Officer since 2008, and the COO since 2006. All four combined own 0.38% of the company.

One of the most positive aspects I see from management is that are strongly qualified to continue with Evolution's growth as they have been demonstrating for a long time and the fact they are still in their positions, which means they believe in the company. They have strong skin in the game, owning significantly higher amounts in shares compared to what they annually receive as base salary.

Financials

Evolution reports its revenues separated between Live games and RNG. The core of Evolution's business is Live games, which represent 84.2% of total revenues for 2Q 2023.

Even though the company doesn't disclose the margins by segment, RNG margins grow along with volumes, since the company doesn't need to hire as many staff with more customers playing the game, while in Live games, the number of players per table is limited and they need to open new studios and hire staff.

At the time of the RNG supplier's acquisitions, NetEnt had 18% net profit margins, Big Time Gaming 41% , and Nolimit City 46%, which on average were already tighter than Evolution's margins during the previous years.

Since they have been able to include these games in its portfolio, the number of players increased, increasing Evolution's net income margins overall. Even though this is a segment that is growing at a slower pace compared to Live games, they contribute to increasing margins, as the CEO commented on the latest earnings call:

We're very happy with the brands that we have acquired. And don't forget that it's highly accretive to margin, and it's contributing a lot to Evolution.

As we can see in the chart above, the RNG segment has not been growing significantly and all of the growth is from acquisitions, while the Live segment has been growing at 40% CAGR. Anyway, I believe Evolution's strategy of including more verticals on their games offering by acquiring RNG providers contributes to Live games revenue growth and I believe this capital allocation is appropriate.

The company has generated a strong free cash flow of €954M (57.6% margins) for the last twelve months and has a solid balance position, with a total debt of €868M while owning €541M in cash.

Its balance mainly consists of capital contributions because of the NetEnt and Red Tiger acquisitions in 2020, and goodwill for an amount of €2.2B, which lowers significantly its ROIC, which is still outstanding at 25%.

The current tax rate stands at 6.7%, but it is expected to rise to 15% from the 1st of January 2024 because of legislative changes related to Pillar 2 , which will raise its effective tax rate to 15%.

Evolution has almost no CapEx since the costs for setting up the studio and producing the material involved in games have low costs, and currently represent 4.1% of revenues, including the costs of the new studios opened during the last year.

Since the company is generating huge free cash flows, they are not able to reinvest in expanding because it is an asset-light business, Evolution distributes a minimum of 50% of its net profit in dividends and repurchased 1.9M shares during 2021 and 2022 (1.24% of total outstanding shares).

Even though I am aware some investors prefer to receive dividends from their investments, in my opinion, this is one of the negative points of Evolution, since I would prefer the company to keep the cash to finance its acquisitions instead of paying part of the amount in new shares or allocate the capital paid on dividends in share repurchases instead.

I don't see this as a major deal, but I believe this strategy would be more effective for shareholders to avoid being taxed when receiving dividends, and just being taxed when shares are sold. I believe Evolution is not going to be able to cut the dividend, but I see some changes since the company is limiting the dilution and even reducing outstanding shares slightly over the last couple of years.

Expected growth

Evolution has been growing significantly faster than the online gaming market, with a 53% CAGR revenue growth over the last 8 years. The company is currently undersupplying in Europe, their activity on the network is growing, which is measured by game rounds, and more than half of the game releases are expected during the second half of 2023 (over 100 games).

The company is expecting double-digit growth for RNG games towards the end of the year and 2024 and Live games are expected to grow at similar rates. The recently launched Funky Time has been one of the most successful launches ever for Evolution, and the management doesn't expect a slowdown for 2024:

We're already working on our road map for 2024, which will be the best one ever. We want to be better every day and further strengthen our market leadership by continuous focus on the best games experience. Investments for the future will continue in form of new studios and in constant innovation of new products.

Even though the European market is expected to grow at a 15% rate, the less mature markets in the online gaming space like the U.S., Asia, and Latin America are expected to grow at significantly higher rates.

For 2023, I expect growth in revenues of 21.5%, mainly driven by Live games. For 2024 and 2025, I expect RNG growth to be in the low range of management guidance with a 10% YoY growth, while Live games continue to grow at a 30% rate.

For the next years, I expect lower growth rates of 25% for Live games and 5% for RNG during 2026 and 2027. In 2028, as the markets that are currently growing faster slow their pace as they mature, I expect Live games to grow at 10% and RNG at 3%, which I believe is a conservative scenario.

Assuming a 10% discount rate, a 4% perpetuity growth based on a 3% inflation, and 1% population growth , my fair value is €154. From a multiple perspective, using a 20x FCF multiple, my fair price is €173, which, as I will show in the next section, is a conservative multiple for such a quality business operating in one of the fastest-growing markets.

Taking the average price from both valuations, my fair price is €163, presenting a huge discount compared to its current price of €98.5 and providing investors with a wide safety margin.

For 2028, I expect the company to have a market value of €50.5B and a share price of €246, providing investors with an 18% CAGR return plus a 2.5% dividend yield.

Valuation

Evolution is currently trading at its low valuation range with an NTM multiple of 19x. I believe the DCF model presented is highly conservative since I am assuming a 20x multiple on the last twelve months' FCF.

Usually, when I find a company trading at low valuations compared to its average, there is a reason for so, a negative market sentiment, lower expectations for future growth, key management leaving the company, or bad capital allocation. In Evolution's case, I can't find any of these reasons from the available information.

Even though the RNG segment might be growing slower than expected, it is not the core of Evolution's business, and shouldn't justify its low valuation. I believe the tax increase is already incorporated in price since we knew it was going to happen a long time ago, and even with increasing effective tax rates, the company is going to be able to provide increasing net profits and free cash flows.

Risks

Over the long term, the major risk I see for Evolution is the company being unable to keep up with innovation and the release of unique games that engage with customers. Even if this is the biggest risk to monitor over the long term since it would have strong effects on expansion, I believe the current situation is favorable for Evolution. The company is increasing the gap with competitors, gaining market share, and has a great executive to continue increasing its leadership position.

From the gaming market perspective, this is a controversial sector, and reputation is really important for all companies operating in the sector since a single mistake could have important effects on the trust of players.

Evolution has a team of about 55 members working at the Game Integrity and Risk department, which monitors 24/7 through manual and automatic systems all tables, games, gambling behavior, and transactions to ensure operational excellence. The company has also established due diligence processes for when new agreements are signed and to evaluate existing customers to detect attempts of fraud and money laundering.

The other big risk for Evolution is regulation, since the company generates almost 60% of its revenue from unregulated markets, if laws are passed that determine that online gaming is illegal, it could affect the company's revenues.

Evolution dedicates important resources to monitoring how regulation evolves in every market (national and regional) to avoid legal and reputational damage, and to become the first to obtain a gaming license when a new market is regulated.

Even though regulation is going to be a recurring topic in the company's evolution over the next years, I believe its diversification mitigates the risk, since it operates worldwide.

Evolution is facing customer concentration risks, which I believe is significant, but has been reducing since the company went public. In 2015, its five major customers generated 53% of revenue, while currently, the ratio stands at 30%.

Further acquisitions in the gaming operators segment would increase customer dependency if a bigger company holds many small operators, reducing Evolution's ability to diversify and increase prices.

Finally, I would like to state the macroeconomic risk, since gaming is not a first necessity product, a turbulent macroeconomic environment could damage revenues generated from customers in a deflationary environment. I don't see that much risk in inflationary environments since revenues are mostly generated as percentage fees.

Conclusions

Current Evolution's valuation presents a risk-reward asymmetry since the company is the leader in one of the fastest-growing markets and there are no signs of slowing down. The current valuation of 20x NTM FCF is not representative of such a quality business, with low debt and 25% ROIC.

Evolution has been a pioneer in the Live game industry and is enjoying a significant moat, which is increasing as the company gets bigger.

The company is generating strong FCF in an asset-light business and their margins are increasing thanks to the economics of the industry and a highly scalable business model.

I don't see any short-term threat from competitors and the company is managed by an excellent executive team that has been demonstrating for many years their ability to expand the business through innovation, technological development, market expansion, and acquisitions.

Even though the company presents some risks, none of them are new and I believe the current price does not take into account the big opportunity that Evolution presents by exposing investors to the growing online gaming market.

For those reasons, I am strongly bullish on Evolution's shares, which provide a huge discount of almost 40% compared to its fair price of €163 in a base case scenario.

For further details see:

Evolution AB's Unjustified Huge Discount