EVGGF - Evolution Gaming: Remarkable Business Dominating The Transition To Online Casinos

2023-04-17 06:22:11 ET

Summary

• Evolution Gaming is the leader of a fast-growing market.
• The company should keep increasing its revenue rapidly.
• There are still some risks, given the controversy on gambling.
• I rate the stock as a buy, as the potential returns are worth taking the risk.

Evolution Gaming ( OTCPK:EVVTY ) is a provider of online casinos, in charge of the digitization of the gambling industry. The company operates in market with strong tailwinds, partially in charge of the stellar growth the company has had. Furthermore, being the undisputed market leader, this growth will probably continue for a long time.

Business model

Evolution develops and sells fully integrated digitization solutions for casinos.

First, they develop a multitude of online games. Evolution has 13 offices to create and develop the games, 8 in Europe, 4 in the US, and 1 in Canada. Furthermore, the staff in charge of each round (such as dealers) works there.

The games are then offered to gambling houses. Subsequently, the latter include those games on their pages and deliver them to the customers. Finally, customers play the games developed by Evolution, thus generating revenue from customers.

The revenue model is simple and effective at the same time. Evolution charges fixed and variable rates to clients. The fixed rates depend on the agreement reached with each client.

Afterward, the variable rates depend mainly on the income the bookmakers generate thanks to the Evolution games. There are also other variable income generators. These include, for example, specialized tables for each client.

Diversified games portfolio

Let's see how Evolution carries out his activity to understand it fully.

Evolution divides its activity into “Live Casino and RNG” segments. The “RNG” segment refers to slot games, which can be designed with different themes. Here we can see some examples of RNG games developed by the company.

On the other hand, as simple as it sounds, a Live Casino is like a real casino but accessible from any device. When you play Evolution games, like a classic as BlackJack, a real dealer is shown on the screen, at a real table, and dealing real cards. So it is practically the same as going to a casino.

However, the advantage of the "Live Casino" is that they offer games beyond the classics, creating games with multiple themes that would be impossible to recreate in real casinos, making the game more exciting.

Moreover, the "Live Casino" segment is divided into two subcategories. Evolution offers both "Live Games" and "Game Shows." The first are traditional games such as roulette or Black Jack. These can even include games specific to each culture. Then, "Game Shows" are more innovative and striking games (some examples in the image above). They are original Evolution games that generate great excitement among players since they cover many themes, such as MONOPOLY or football.

Great growth opportunities

Evolution has been growing at spectacular rates since its inception in 2006. Since 2013, Evolution's revenue has grown at a stunning 53% CAGR.

Furthermore, EBIT margins have increased from 22% in 2013 to 62% in 2022. Thanks to this margin expansion, profits have multiplied 150 times since 2013, generating 75% CAGR earnings growth, some mind-blowing numbers.

Nonetheless, logically, this growth should decrease over the years. Let's see what the growth opportunities for the future are.

Strong tailwinds backing up Evolution's growth

The live casino market has some huge tailwinds. Following the digitization of all sectors of the economy, gambling is undergoing massive digitization. Land-based casinos are very interested in making the transition to the online segment. Several reasons explain this:

1. "Live casino" allows casinos to differentiate from other competitors. This is thanks to the customization opportunities we've seen before.
2. At a time when video entertainment is of utmost importance, the "Live Casino" is much more attractive and entertaining. This technology even allows players to interact with people from all over the world while playing.
3. Following the digitization trend, the transition to online casinos would facilitate operations, thus allowing them to save costs.

The market grew at an annualized rate of 38% between 2015 and 2019. Afterward, between 2018 and 2022, the growth slowed down to 20.5% annually, according to H2GC. However, Evolution has grown at a rate well above the market during all these years, constantly gaining market share.

In 2022, physical casinos occupied 79.5% of the total market share of casinos, RNGs 15.5%, and "Live Casinos" 5%. Indeed, land-based casinos still occupy a large part of the market. As a result, online casinos still have a long growth path ahead of them.

Risks aren't neglectable

In such a controversial market, risks are always high. Therefore, Evolution's biggest problem is the implicit risk of the sector, which is much higher than in other markets.

Regulation Risks

In certain countries and regions permits are necessary to operate. Evolution is focused on operating in markets where they are regulated . In addition, all the clients they have are perfectly regulated.

The importance of being regulated is very high since, at any time, new restrictions or regulations that would damage the business may appear. As for this, the risk is considerable for Evolution. Today, 59% of revenues come from non-regulated markets (page 93), mostly from Asian markets.

However, this risk can also be a growth opportunity for the company. There are still certain regions that Evolution cannot operate in, so should those licenses be obtained, the potential would be significantly increased.

Great examples of regulated markets are the United States and Canada. In 2018, Evolution obtained the first licenses in some regions of these countries. It has rights in 5 US states and 5 Canadian territories, some recently obtained, resulting in rapid growth.

Risk of disruption

In such a profitable market, where technological innovations are so important, there is always the risk of some copycat appearing. In this market, the barriers to entry could be more powerful. On the contrary, the chances of success are much lower, and this is where Evolution stands out.

First, success in the sector depends significantly on the game's attractiveness. The more attractive, the more people will play them. It also generates a brand effect. Indeed, when the company develops many successful games, gamers prefer to play the games of that brand, which is what happens with Evolution. As the gap between Evolution and its competitors increases, it is easier for them to gain market share faster.

In addition, innovation is a must, and companies must achieve operational excellence. In such a controversial market, in which you are playing with people's money, you must avoid committing a single mistake, since however small they may be, the reputation can be destroyed.

Both its operational excellence and its capacity for innovation allow Evolution to gain market share and increase margins quickly. This occurs given that Evolution's costs are mostly fixed, corresponding to staff salaries and headquarters' creation. Therefore, the more customers are attracted to a game, the more revenue a single employee generates, increasing margins rapidly.

We can conclude that the risk of disruption is currently relatively small. This is confirmed by a study by Counterpoint Global Research together with Morgan Stanley, which includes Evolution in its list of companies with the greatest competitive advantages in the world (page 37) .

Valuation

To value Evolution, I use a simplistic Inverse DCF Model. I use a 12% WAAC, as the business is not the safest, implying a higher required return. As Exit Multiple, I have used a 22x LTM EV/FCF (5% FCF Yield), meaning an NTM FCF Yield over 5%. Those multiples could be higher, given the quality of the business, but I think Evolution should always trade at a discount, given the implied risk.

Today's price implies a 16% five-year FCF growth rate, which is fair. Considering analysts' estimates, revenue should compound at over 20% for the next three years. In addition, considering that tax will increase, earnings will increase slightly slower than revenue, but it won't affect earnings substantially. Effectively, because of recent regulations , the effective tax rate should increase to 15% before 2024, up from 7% last year. Backed up by a small margin expansion, we could easily see 16% growth.

Conclusion

Evolution is a fantastic business backed up by strong tailwinds. Even though risks are higher than in other companies, the implied return is very appealing.

To conclude, I rate the stock as a buy . I would like the margin of safety to be more comprehensive, but there's still a tiny margin of safety, considering that the implied growth rate is still conservative. Moreover, this business's great moat and quality expand this margin of safety.

I am already an Evolution shareholder, having bought some shares at 840 SEK. Luckily, the markets are sometimes inefficient, and if the price drops again, I will line my pockets with more shares of this amazing business.

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