2023-08-02 09:11:16 ET
Summary
- Enthusiast Gaming's business model is not sustainable, and the company experienced significant challenges in their revenue growth and profitability.
- The company's debt position requires compliance with certain covenants, and more cash injections in the form of equity will likely finance this burden at the expense of shareholders.
- The overall downside risk is up to 40% as the newly issued shares will cause very expensive dilution.
We already covered Enthusiast Gaming ( EGLX ) back in 2021, assigning a hold rating, and it is down 83% since our last article. At the time, some concerns around their websites, their projects, and their unit economics were outlined. In retrospect, we were right in showing cautiousness around the company, and indeed it underperformed, but we believe that this story is not over yet.
The overall weakness experienced by the advertising market, in general, is inserted into an extremely weak company with a precarious balance sheet. The poor liquidity position aligned with a significant cash burn rate, and substantial leverage is often a great mix for a disaster, and this time is probably coming at the expense of shareholders.
Overview and Thesis
EGLX is an advertising company focused on gaming and e-sports entertainment in the US and Canada. The business model is very simple: create and engage creators (like gamers and streamers), and use digital assets (websites and channels) to promote advertising content. They enter into partnerships and agreements with companies that want to target the audience of EGLX's content, and they pay to be on their products. It is quite a simple business, and like many other advertising companies, it is currently suffering from cuts in marketing spending.
We believe that EGLX's business model is not sustainable and the company will need constant cash infusions in both the short and medium term, which must be in the form of equity dilution. We think that the unit economics, the overall macro, and sector-specific environment, and the constant lack of strong execution skills will doom the company's future prospects.
Revenue and net income (Seeking Alpha)
This is how the financials and growth look like for the past 4 years at EGLX. Scaling came at a huge cost and the momentum stopped in 2022 leading to lower revenue growth but deepening losses.
CFO (Seeking Alpha)
The cash burn has also worsened and is now at all-time highs. EGLX is burning close to $20 million per year while sitting on just $2.7 million in the bank(!). And this is the main point in support of our thesis that the company will seek constant access to the equity capital markets.
Again, as in many other cases, we believe that SBC masks many increases in cash losses and expenses. Indeed, if we include SBC as an actual cash expense (which is true for equity holders), the actual losses surpass $20 million per year. With more than $5 million in SBC, this would amount today to a dilution of around 8% of the company's share in today's prices.
Closely monitoring the capital position: Covenants could trigger a game-over
As profitability issues and demand slowdown create structural issues, the most worrying detail is the debt. In fact, the company used both cash and debt to fund its very expensive acquisitions over the last few years. These transactions accumulated intangibles and goodwill, which account for more than 80% of the company's assets.
Talking about the debt, it is in the form of a Term loan and a revolving facility. The second one is used to fund operating (working capital) needs. It is priced at CDOR rate plus 7.5% per annum, so it represents quite an expensive form of borrowing which confirms the high-risk profile of EGLX, and it has many covenants.
These covenants are in place to safeguard the lenders and trigger certain events (such as default) if they are breached. They are as follows:
The Amended Commitment Letter contains certain covenants that the Company must comply with, including (i) maintaining a minimum funded debt to gross profit ratio, which varies by quarter, (ii) at all times, a cash runway ratio of a minimum of 4 months, tested quarterly, until the quarter ending March 31, 2023, and then a cash runway ratio of a minimum of 6 months, tested quarterly, until the quarter ending December 31, 2023, and (iii) beginning December 31, 2023, a minimum funded debt to EBITDA ratio of no more than 4.0x, calculated based on the trailing 12 months and tested quarterly.
Now as one can imagine, having a cash runaway of 6 months as a covenant, losing $20 million per year, and sitting on just $3 million of cash might be a problem. This is one of the most serious points we consider to be the key to our very bearish opinion on EGLX common stock. While it is true that the lenders might agree on a waiver of the covenants or work out any other creative solution to keep the company alive, the equity holders will pay for this. It is just a matter of hierarchy.
To give some perspective on how much it would cost for shareholders, we propose our own estimates on share dilution of a capital raise that would be used to gain compliance with the covenants:
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The cash runaway needed for the 4 months is roughly $7 million. Which needs to be maintained as a minimum cash balance through December 2023.
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At the current price of $0.44 per share, this means around 16 million new shares issued or more than 10% of the current outstanding shares.
And this would be needed just to keep the company in compliance with the debtors' demands.
Risks to our thesis: What could go right with EGLX
It is also good to discuss what could go right for the company (and thus badly for our thesis). We think there are a lot of challenges for the current management to overcome, but we believe that a successful turnaround is still possible.
Indeed, if EGLX is able to regain some revenue growth from an improving advertising market, along with a strong reduction of their SG&A expenses, there is a lot of room for FCF expansion. This would make the company immediately look cheap in the eyes of the market, and trigger a valuation re-rate. We also think that a sudden stop of the aggressive M&A activity would be positive for the company as it would slow down the cash burn and buy more time.
Last but not least, given the huge challenges and disappointing performance suffered by EGLX in the last years, we would not rule out an activist involvement. This would definitely cause the share price to rise again.
Valuation and scenarios: It is very hard not to think about bankruptcy
Given all that we mentioned above, it is very hard to compute an optimistic valuation of the company, at least for common stockholders. We think that as the new equity raises will kick-in in 2023, the fair value per share will change dramatically as the float will increase. Even using multiples is a bit odd. The company is not even providing EBITDA computation in its financials (despite this being one of the covenants), and earnings are constantly in deeply negative territory. Thus, EV/EBITDA or P/E ratios would be quite useless.
We believe, however, that we may be able to estimate the cash needs under different scenarios and then provide our own expectations of the incoming dilution and relative share prices. Here's a summary of these different cases:
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Best case: Under this scenario, EGLX is expected to be able to cut the majority of its costs while keeping revenues mostly unchanged (very optimistic assumption). Margins will then improve, and the company may turn cash positive by H1 of 2024. This means that the monthly cash burn will come lower and lower and eventually turn positive. We estimate cash needs of $10 million + $7 million right now to be in compliance with covenants. This amounts to roughly 39 million new shares and a 26% dilution. The target price under this scenario would then be $0.33.
Estimated Monthly cash burn (Author's estimates)
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Medium case: the company will go on with the same strategy (no significant Opex cuts), but will be more conservative with spending. We always assume revenues flat throughout 2023 as the current environment remains tough for advertising. This would result in a total cash need of around $20.5 million, or a fair price per share of $0.30.
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Worst case: EGLX continues in this trajectory of cash burn rate per month, and doesn't implement aggressive nor moderate cost savings strategies. The cash needed to fund the business + the applicable covenants throughout December 2023 will translate into a cash need above $24 million and a price per share of around $0.27.
Whether one of these scenarios will materialize (or not) will depend on the management's approach going into the second half of 2023. However, it doesn't seem a pressing issue for even the newly appointed CEO, who mentioned the word "cash" only 6 times in the latest earnings call. These mentions were not even concerning the possibility of doing a big raise during the year, and clearly understated the chance of running out of liquidity.
If one of the mentioned scenarios takes place, the downside would be between 25% and 38%.
Conclusion
Enthusiast Gaming is not in a good position, with structural issues related to its business model, to urgent liquidity needs. One (or more) equity raise will probably be necessary to both keep the business alive and remain in compliance with debt covenants. We believe that the shares are overvalued, given that shareholders will pay for all the capital needs. Downside between 25% and almost 40%.
For further details see:
Enthusiast Gaming: Not So Enthusiastic About Their Future