PYTCF - Evolution Gaming: Part 2 Of Deep-Dive Into A Live Casino Powerhouse

Summary

• Aside from becoming the world’s leading B2B slots provider, the M&A activities serve as talent and technology acquisitions.
• Executing the localization strategy is essential to EVO’s long-term success.
• Its successes can be drawn from the highly innovative product team, and the company’s culture of being customer-obsessed and not complacent.
• While one-stop-shop makes sense from a strategic and integration point of view, it is not a new innovation.
• Valuation is priced in according to my estimates.

Investment Thesis

Evolution AB (EVVTY) ("EVO") is a leading live casino game provider in Europe, and recently, they are gaining presence in the newly regulated markets, such as the U.S., LatAm, and Spain. There is currently an ongoing tailwind in the casino industry driven by the increasing number of legislations, and the shift from land-based to online casinos.

EVO offers its self-developed live casino games to casino operators, as well as end-to-end live casino solutions that assist land-based operators to transition online. Its obsession with customers, operational excellence, and product innovation drive better experiences for players, and this forms the core of its success.

Through the acquisitions of Big Time Gaming ("BTG"), Ezugi, DigiWheel, NetEnt, and NoLimit City ("NLC"), EVO assembled a team of highly talented and innovative product team, including EVO's CPO Todd Haushalter, BTG's CEO Nik Robinson, NLC's Co-Founder Jonas Tegmen, and DigiWheel's CEO Joe Purcell. These purchases place EVO as the leading Live Casino provider, as well as the world's largest B2B slot supplier.

As a continuation of part 1 of my deep-dive , in this article, I will touch on EVO's acquisitions, localization strategy, one-stop-shop, financials, management, culture, and risks. If you had not already done so, I highly encourage you to read part 1 before moving on.

Evolution's Acquisitions

Introduction

"It's not like it happens now because we did something else…we need to widen our portfolio towards slots, and to be able to, the perpetual goal or whatever you call it…the goal is to be the number 1 in online casino…now we need slots, and to do that, we need NetEnt, Red Tiger, fantastic acquisitions, and now BTG." - CEO Martin Carlesund Speaking to Gaming Intelligence

From 2021 to 2022, EVO went on an M&A spree to acquire NetEnt, Red Tiger ("RT"), Big Time Gaming ("BTG"), NoLimit City ("NLC"), DigiWheel, and Ezugi to become the number 1 slot providers. Aside from acquiring the slots, these purchases serve as both talent and tech acquisitions.

NetEnt

NetEnt has one of the widest selections with a game portfolio of over 200 slot games, and a network of over 200 active customers. On Sept 2019 , NetEnt acquired Red Tiger through a mix of debt and cash, which was paid off by EVO. This turned EVO into a slot powerhouse, especially in the U.S. where it is dominated by slots. NetEnt's operators' networks also allow EVO to get existing products to new players.?

However, its popularity slowly died down and after its arrival, most of its gaming pipelines were discarded due to not meeting EVO's standards. Management's focus on quality over quantity had led to the management intentionally slowing down the releases of new games. According to Bigwinboard , one of the leading online slot reviewing sites, NetEnt failed to catch up with the newer generations who prefer more volatile, and rewarding games. Players' reviews also suggest that NetEnt is lacking innovation. NLC's Co-Founder, Jonas Tegman talked about how the industry has developed over the years. In the past, successful slot providers, including NetEnt only had to build slots, release them, and then, make lots of money. There was no way to tell if games are successful. It was purely a guessing game and studios were just churning out games. However, the industry has changed since. Things around slots, including brands, identity, relationships with players, and data analysis are used to create slots players want. He claimed that NetEnt is stuck in the old way of producing slots, and a big common problem among incumbents is that old titles are still making money.

In the 1Q21 earnings call , CEO Martin Carlesund stated his ambition to be the world's top slot provider, and he often questions if these games could be in the list of top 5 games in 2021. I am impressed with the way he thinks and this speaks to the standards he upholds when it comes to producing extraordinary games.

This is a quick look at NetEnt's latest 3Q20 financials before the takeover by EVO.

In FY19, NetEnt revenue declined due to re-regulations in Sweden. In FY20, it resumed low double-digit growth due to (1) Red Tiger contribution (likely to be insignificant), (2) weak comps in FY19, and (3) strong growth in the U.S. In the 4Q20 earnings call, NetEnt reported growth was 5% Y/Y. Overall, the growth was weak.

Note that NetEnt has also struggled in the Live Casino arena, and the acquisitions with EVO could be a move to also fend off future competition.

NoLimit City

This acquisition serves as a talent and game title acquisition. Unlike other slot providers, NLC's strategy of launching fewer, distinctive (i.e. gory and hardcore), and premium games have played out well. NetEnt is adopting the same strategy now.

Here is what Co-Founder Jonas Tegman has to say about its strategy:

"We are a little bit edgy. It came slowly by analyzing what worked for us and also the change of product that we wanted to target, a niche... we want to dominate this segment, and it felt quite natural to be quite extreme in different ways both through themes, but also through volatility…. can't have normal ideas…. we have to be a little bit crazy… this is the path we are on now, and that might not be the case if we do 60 games per year… when we started to change the way we work a product, we build a couple of really good games. They don't churn and it has a huge effect on how much money you earn… we also want to build them cheap… have a healthy relationship between cost, quality, and quantity." - Podcast by Pierre Lindh #70 - Jonas Tegman, Co-Founder, Nolimit City

Bigwinboard shows that NoLimit City is voted the best slot game provider by the community members, and its game, Tombstone RIP is the 2nd best game in 2022.

Here are reviews that are testaments to its high-quality releases, and they were well-received by the community members.

So, while NLC does not provide EVO with access to many operators, its talents and superior and unique slot titles make it a valuable purchase. Co-Founder Jonas Tegmen states that the company is growing at a staggering 100% annually . Like BTG, EVO had tracked NLC for a few years and the management was seemingly impressed with its style of slot games.

Big Time Gaming

EVO acquired BTG for its technology, Megaways Mechanic, and talents, including CEO Nik Robinson.

By definition :

"The Megaways Mechanic is a unique technology owned by… BTG. This feature, which debuted in 2016, creates a dynamic grid interface and multiplies the total number of possible payouts… Megaways Mechanic increases the player's chances of winning, but even if it doesn't, the game gets more unpredictable and thrilling…"

Megaways Mechanic is incorporated into over 200 games by B2B providers such as Kalamba Gaming, Microgaming, and Relax Gaming, and this business model will continue post-acquisition. Additionally, BTG can leverage EVO's significantly larger distribution channel. In 3Q21 , its revenue growth is reported to be 35%.

BTG is known to provide a fixed RTP of 96% for their games, unlike others with variable RTP (e.g. 86%, 92%, 94%, 96%, etc).

CEO Nik Robinson engaged frequently with Bigwinboard's community members for new game launches, and it won the most trustworthy provider in 2021 . Note surveys might be biased. For example, players might choose favorites rather than the most trusted providers. As shown above, players have been criticizing the quality of game releases since BTG was bought by EVO. CEO Nik's responses also further supports that. This is something to note.

Ezugi

Ezugi is a smaller live casino game provider acquired by EVO in Nov 2018 . While the $20m purchase of Ezugi does not break EVO's bank, this is one of the most important purchases. Ezugi is a combination of tech and talent acquisitions to enhance EVO's dual-play solution (i.e. Dual-play helps land-based casino operators to live stream games from their own premises).

Customer experience is an ever-growing feedback loop. Integrating Ezugi's best talents, practices, technologies, and operational capabilities, they get to draw from one another's experiences to deliver better casino experiences for the end-users in specific markets or regions.

DigiWheel

DigiWheel is the developer of the world's first HD spinning gaming wheel. According to the CEO, EVO will be integrating its technology into online live casinos and game shows in 2022. This serves as both talent and tech acquisitions.

Overview of EVO's Transactions

This is an overview of EVO's acquisitions, in which I included their revenue, EBITDA margins, growth rates, and purchase multiples, as well as those of EVO's competitors and their acquisitions made.

I do think that NetEnt's acquisition was expensive given the significantly lower growth and EBITDA margins. Its turnaround has also proven to be more challenging (although in hindsight) than initially anticipated, and its apparent lack of innovation. However, we could argue this NetEnt instantly positions EVO as a slot powerhouse, especially in the U.S., and also gains it access to its valuable intellectual properties, brands, operators' network, and management teams. Whereas, for BTG and NLC, the multiples are reasonable given their higher margins and growth rates.

Localization Strategy

Here is a definition of the Localization Strategy by Pitney Bowes.

Every country differs in languages, cultures, and games, and operators and suppliers are to cater to players' nuances and preferences. Asia Gaming is a live casino game provider that specializes in Asian-style games, and games are broadcast in English and Chinese. They have Asian-theme customized tables, a unique game interface, and localized games like Keno and Sic Bo that are more popular among Asians. This can differ from region to region.

Having an early presence in newly regulated markets marks the first step to working with regulatory bodies and operators to offer games to end-users. However, longer-term success lies in deeply understanding users' wants and needs in each market. This involves setting up local offices and local teams. A great example is Erick Mendez , a current LatAm regional manager in EVO who spent 10 years in Ezugi and has 15 years of experience in the LatAm region.

Not unique to EVO, a close competitor in Europe, PlayTech (LON: PTEC) has the same playbook . Newly regulated markets are growth catalysts, but it also attracts competition, and distinguishing itself requires grasping and successfully executing the localization strategy.

One-Stop-Shop

What is OSS?

One-stop-shop ("OSS") integrates all of EVO's products and its brands, including NetEnt, Red Tiger, BTG, NLC, and Digiwheel into one platform. This initiative benefits both operators and EVO.

Rather than having operators do multiple integrations, they only have to do one integration. This provides ease of integration for operators to access its full game portfolio. For EVO is the reduction in time-to-market (i.e. the length of time it takes from a product being conceived until its being available for sale). EVO does not have to visit and market games individually to operators, and it can communicate directly with operators. This ensures smooth integrations of future acquisitions and enhances cross-sell opportunities.

The Concept of OSS is Not New

The concept of OSS is not new, however. Peers including Light & Wonder (previously Scientific Gaming) ( LNW ), IGT ( IGT ), and PlayTech own their platforms that integrate game titles from their own in-house studios and third-party ("3P") studios.

On top of the OSS's benefits mentioned earlier, these platforms layer on functionalities including dashboards that supply data insights from players' activity, players' retention rate, to GGR, as well as marketing tools for game launches, which EVO may add in the future.

The winner, I believe, is what CEO Martin Carselund has reiterated is that providers that can offer premium, unique, fun and innovative games users love to play. Product innovation is the barrier to entry. When players love the game, they reward by spending more money, and in return, operators make lots of money. This reinforces the acquisitions EVO has made.

Financials

Revenue - Strong Live Casino Revenue Growth, Weak RNG Growth

Live Casino revenue grew at a 43% CAGR in 5 years, and this is a 6 times increase from FY17.

This growth can be boiled down to 3 main factors:

1. Its highly innovative team led to a large and growing portfolio of games and this is driving global demand

2. Expansion into newly regulated markets such as the U.S. and Latin America.

3. A growing number of operators help EVO to distribute its game to end-users

Its RNG segment includes NetEnt, Red Tiger, Big Time Gaming, Ezugi, NoLimit City, and DigiWheel.

This RNG segment was poor. As of 3Q22 , its Pro-Forma revenue (NLC financials was included for the first time in 3Q22) grew 2% Y/Y. Management wants to drive double-digit growth, but the slow rollout of game releases is hampering its growth:

"We must admit that the development in this quarter is weaker than I expected…we've not delivered as planned…not released enough new games…we're confident that we'll get there but it has taken a bit longer and we see the effects of that weaker RNG performance in this quarter…to put it simple, execution has to increase in speed…during the past period, we have focused a lot to get the structure right to where to put the games, both for Big Time Gaming and for Red Tiger as well as for NetEnt."

EBITDA Growth & Margin Expansion

EBITDA growth was even more impressive as it compounded at 63% for 5 years, growing faster than its revenue growth. Its EBITDA margin grew from 45% in FY17 to 69% as of LTM FY22.

The drivers of this strong operating leverage are

1. Economies of scale that stems from its scalable business model. Live Casino allows 100s of players to join a game as opposed to land-based where there is a limited number of players.

2. During Covid, increased traffic volume for operators and fewer available tables have led to margin expansion. Coming out of the pandemic, margins are likely to be impacted as they built new studios and expand existing studios which will lead to more tables.

FCF Margin Expansion, Growing FCF Per Share, No Debt, and Strong Cash Balance

FCF margin expanded from 23% in FY17 to 33% as of LTM FY22. The decline in FCF margin from FY20 is because of the acquisitions made. FCF should normalize moving forward. On a per-share basis, FCF per share has compounded at a CAGR of 54% for 5 years. More importantly, it has no debt and a strong cash balance of EUR $319 million.

Key Management and Its Culture

CEO Martin Carlesund's vision is clear - to assemble the best talents and build the world's most innovative product team:

"We have Todd Haushalter, and now we have Nik Robinson. We're building the product team and my goal is to make this creative, innovative hub of game creation… If you want to build games and release them into the greatest network in the world, you go to Evolution so that you feel that this is the place to be if you want to be innovative, and not just copy games… we're going to do something for the future, the TikTok generation…create something that is unique…" - CEO Martin Carlesund speaks to Gaming Intelligence

CEO Martin also talks about how everybody works like crazy and the absence of work-life balance. They are working towards a common goal of building the greatest company. To do that, they have to be customer-obsessed, the most innovative team, uncomplacent, and constantly dissatisfied where they are:

"While it's important for us to keep the players that we already have, we are almost obsessed with the players that we don't have… continue to innovate, always refine the playing experience and be the leader that develop new groundbreaking products… Innovation and the best games will always drive Evolution… we have to stay on our toes and never be laid-back and content in order to keep increasing the distance to our competitors. Ever so called paranoid, trying to run faster every single day, do something better today than yesterday, constant focus on end user satisfaction." - 3Q21 Earnings Call

Risks

1) Corporate and iGaming Taxes

Corporate taxes

• On Dec 2022 , the European Council reached an agreement to impose a minimum tax rate of 15% on multinational corporations with revenue of EUR $750 million, in every jurisdiction they operate in. This is to discourage companies from avoiding paying taxes by shifting operations to tax havens. EVO with more than EUR $1 billion in annual revenue and a current effective tax rate of 6.9% is impacted. CFO Jacob Kaplan, during the 3Q21 earnings call, also stated that tax rates would rise.

iGaming Taxes

• Each country varies as either players' winnings or casino operators' gross gaming revenue ("GGR") are taxed. If operators are taxed, players do not have to pay any. Increased taxes can cause operators to run out of business, and players' winnings are less. This indirectly impacts EVO's revenue and profits. Therefore, regulators are to be careful in levying too high taxes.

2) Failed M&A

While the M&A activities make sense from a tech, talent, and strategic perspective, it is no denying that RNG's turnaround has been incredibly challenging.

My concerns revolve around that:

1. Building slot games require a different set of know-how from Live Casinos

2. Bringing together product teams from various companies might result in the possibility of a culture clash. NetEnt's failure to keep up with the changes has caused the downfall of the once-leading slot studio, while studios like NLC were fast to adapt. Their perspectives/views/opinions surrounding building slot games might not resonate with one another.

Management is confident that the RNG segment could turnaround. However, the timeline of the turnaround is impossible to predict, and this is the main uncertainty for me.

3) Re-Regulations

Re-regulations can come in various forms such as

1. Increase in taxes on operators, which reduces B2B provider's revenue

2. Require operators to possess licenses. For instance, in 2017, the Gambling License Investigation stated that Swedish operators must operate with a license. Without obtaining the license, operators cannot operate, and B2B providers will see short-term revenue loss. In addition, the licensing process is known to be long and tedious.

4) Risk of Illegal/Black Markets

According to the short report done in 2021 , EVO seemed to be operating and offering games to end-users in the illegal/black markets, allegedly not conducting the know-your-customer ("KYC") process like they claimed to, which would be violating the law and regulations. If discovered, licenses may be potentially revoked. This is something to note.

Valuation

1) Income Statement

As of 3Q22, Live Casino's year-to-date ("YTD") revenue is $1.05 billion. Since 4Q22's revenue is likely to be equal to or slightly higher than 3Q22's revenue, its expected revenue is $320 million. Making the same assumption for RNG, its estimated 4Q22 revenue is ~$69 million. This brings the total FY22 revenue to $1.44 billion, which is ~$300 million of revenue added from FY21.

From FY23 to FY27, I believe it's highly achievable for Live Casino to continue growing by $300 million every year, and this is due to multiple growth drivers:

1) Market share expansion, both in new and existing markets:

In my previous article, I stated that Europe is a relatively mature continent. However, more than half of the listed markets have less than 50% of online gambling revenue, whereas markets like Sweden and Latvia have market shares as high as 80%. This means that there is still room for market share expansion. Not to forget, EVO is also expanding into newly regulated markets including U.S., LatAm, & Spain, where market share is still very little.

2) New product releases:

New games can be released into new, and existing markets, such as Europe, where players are more receptive to EVO's brand and games, and new innovations also help to reach new audiences. This plays an important role in EVO's long-term growth.

For RNG, I'm forecasting a 2% CAGR due to the uncertainty of the turnaround. Of course, the turnaround can occur earlier and revenue picks up, but the timeline is hard to predict. This brings me to a revenue of $293 million and combined revenue of $3.07 billion by FY27.

For its operating expenses, EVO is currently expanding quickly into newly regulated markets, including Spain and U.S., and with the increasing global demand for its products, they are ramping up on new studio production and expansion of existing ones. OpEx and Capital Expenditures ("CapEx") will increase along with revenue growth. Personal expenses, in particular, will likely grow much faster due to the ramp-up of headcounts to cater to new and bigger studios. This is also factoring that they have come out of Covid restrictions, which hindered their growth from FY20 to FY21.

My estimated total OpEx is $1.19 billion, and an operating profit ("EBIT") of $1.87 billion by FY27.

2) Taxes, Changes in Working Capital, and CapEx

EVO's changes in WC in the past 3 years have been quite lumpy since 4Q20 (i.e. when NetEnt's financials were first consolidated). For instance, FY21 was $95.3 million versus FY20 of ~$35 million, so forecasting them is challenging. And as of 3Q22, its YTD changes in WC is ~$67 million, lower than 3Q21 of ~$76 million. Therefore, I'm assuming that FY22's changes in WC will come in lower than FY21. For 4Q22, I'm referencing 4Q21 and 4Q20 numbers, which gives me FY22 changes in WC of $86.8 million.

To smooth out the lumpiness, I took an average of FY20 to FY22 which gives me an estimated ~7% of revenue from FY23 to FY27.

I mentioned in the risk segment that tax rates will rise due to the 15% minimum tax rates imposed on multinational corporations with over EUR $1 billion in revenue, so I'm forecasting that it will raise steadily from ~7% in FY22 to ~9% in FY27.

In 3Q22, its CapEx came in at $23.5 million, which brings its YTD CapEx to $69 million, and investments in 4Q22 will continue at the same pace according to the management. This is driven primarily by investments in studios in the U.S. This brings FY22 total CapEx to ~$93.5m ($23.5m + $69m). Moving forward, I do anticipate CapEx investments to continue at a similar, or if not higher pace in FY23. This brings the overall CapEx to $193 million by FY27. These CapEx investments will drive higher revenue growth for EVO as operators add more tables.

For EVO's Free Cash Flow ("FCF"), after netting out taxes, changes in working capital, and CapEx, and adding back D&A, my expected FCF is ~$1.52m by FY27, with a 49.6% FCF margin.

WACC

I applied a WACC of 18%, which is higher than usual due to EVO's risk exposure to multiple markets. Referencing valuation multiples from peers, acquisitions (made by both EVO & competitors), and competitors, and comparing the margin profiles, I'm using a FCF multiple of 16x.

Adding in the sum of PV of FCF, and netting out the net cash gives me an enterprise value of SEK $154,616 million, which is a 38% downside from the current market cap of SEK $251,625 million.

Do note that my assumptions may not be accurate and you should also conduct your own due diligence.

Concluding Thoughts

Here's what I have covered so far:

1. EVO's M&A activities

2. One-stop-shop

3. Importance of localization strategy

4. Financials

5. Key management and EVO's culture

6. Risks

7. Valuation

After studying EVO for a while, I believe its competitive advantages are boiled down to - (1) operational excellence, (2) product innovation, (3) a customer-centric mindset, (4) their constant dissatisfaction with where they currently are, and the (5) moat of live casino studio (Live casino requires studio in each state/market).

Recently, I also have been listening to more podcasts, and there are 2 meaningful lessons that could be applied to EVO.

Firstly, people often look for competitive advantages in companies. But what they don't perhaps realize is that managements are the one determining what and how long these competitive advantages last. Secondly, Buffett also said that "nobody who takes care of its customers ever lost". EVO really embodied these 2 principles in my opinion, which I believe ensures the longevity and success of the company. This reminds me of Sam Walton of Walmart (WMT) and Jeff Bezos of Amazon (AMZN).

One last thing about M&A is that it can be a tricky topic. Since I'm no expert, there are other considerations that I have not thought of or am not aware of apart from evaluating it from a financial perspective (i.e. EBITDA multiple, growth rates, etc). After all, management possesses industry expertise. We trust that they are operating within their competence and that these acquisitions will ultimately pay out in shareholders' and management's interests. While they are confident in RNG's turnaround, I believe investors ought to allocate a longer timeframe to monitor and judge the performance of those acquisitions. Alternatively, investors can make use of alternative sources such as Bigwinboard to track reviews and ratings of their game releases.

Lastly, my estimates indicate that Live Casino continues to grow, while RNG remains stagnant. Being conservative for the RNG segment is appropriate here due to the uncertainty of a turnaround. I'm aware that your estimates might differ, and if you like to engage in a constructive manner, do comment down below or message me.

Thank you for reading. What are your thoughts on the company? Let me know in the comment section below!

For further details see:

Evolution Gaming: Part 2 Of Deep-Dive Into A Live Casino Powerhouse