Intertain: 20.4% Cash Flow Yield, 35% YoY EBITDA Growth And An Imminent Re-Rating
By Lennard Zwart :
Intertain's ( ITTNF ) stock has seen a significant drop over the last few weeks due to technical pressure related to a relisting and the resurfacing of bear arguments that are no longer relevant. We assert a re-rate to at least 2x current levels is imminent due to hard near-term catalysts.
Intertain is a Canadian online gaming company with a focus on online bingo, a very profitable online gaming niche featuring very loyal customers. The company's main markets are the UK (66% of revenue), Sweden and Spain, and it is the market leader in its respective markets. Intertain's largest segment by far is Jackpotjoy, a UK-centric online bingo platform that was acquired from Gamesys in April of 2015. Intertain is emerging out of a controversial period; this is basically an ugly looking roll-up with a healthy underlying business which is being turned around and is now committed to an organic growth strategy.
We considered the stock to be an interesting investment with the stock around CAD 11. Since the 6th of October, the price has dropped from CAD 11.21 to a
We believe that its imminent relisting in London (the company will also change its name to Jackpotjoy) and other near-term catalysts will lead to a rerating of this stock towards its UK-based comps.
At a minimum, we expect this stock to rise to CAD 15 (GBP 9 after relisting) through 2017 with further upside possible as the strong cash flow and its impact on the debt profile and dividend potential become apparent.
We first became aware of Intertain by way of a 27th of July VIC article . We would recommend it for some good background on this situation and the company's franchise.
Why does this opportunity exist?
Difficult history and complex structure
The company launched in 2013 with an aggressive, acquisition-based growth plan. The former management of the company had a shady past, received a worse-in-class reward scheme, and was highly promotional.
Besides this, the flagship Jackpotjoy acquisition from Gamesys that closed in April of 2015 was quite complex, with the technology remaining at Gamesys under an outsourcing agreement. This arrangement combined with a relatively large earn-out component resulted in a story which was sensitive to a negative interpretation. Spruce Point did a short report mid-December 2015 and this knocked the stock price from the CAD 13-14 area to the CAD 8 level by early Feb 2016.
In August 2016, the company announced its 'UK Strategic Initiatives' plan, which was accepted by the shareholders on the 23rd of September. An important part of this plan is a relisting on the London Stock Exchange ((LSE)), the UK is responsible for the majority of Intertain's revenue and the LSE is also more intimately familiar with online gaming. This relisting is now imminent and is leading a lot of Canadian investors to bid the stock farewell. Listing formalities are also delaying the process, adding even more uncertainty to this situation.
UK Gaming Probe
On 21/10/16, the UK Competition and Markets Authority announced on its website that it is going to launch an inquiry into the gambling industry to establish if gambling clients are treated fairly in the UK. The focus will be on misleading promotions and unfair terms offered to gamblers. This inquiry caused some consternation in the market, even amongst the large, established players.
Brexit and a terminated acquisition process
Brexit might also cause nervousness amongst Intertain's still mainly Canadian investor base. It almost certainly played a role in the termination of discussions with potential acquirers over the summer. The recent drop in the pound which is the main revenue currency also had a small negative effect on Intertain's CAD-based income numbers, although this was largely offset by gains on GBP-denominated liabilities (including a currency swap).
In this unfavourable environment including forced sellers and a rotation of investor base, a Canadian short seller launched an extremely well-timed short campaign repeating many of the pre-2016 points mentioned in the Spruce Point report.
Analysing the bear case
In this section, we analyse all current bear arguments.
Early this year, Deloitte did an extensive investigation into the allegations in the Spruce Point report and concluded that the accusations related to the quality and performance of Intertain's underlying businesses were wrong in every material aspect. Still, a special committee of independent directors replaced both the chairman and the CEO.
The special committee also developed the aforementioned UK Strategic Initiatives. Besides a relisting in the UK, this plan involves engaging a strong management team with an operational focus. This new team consists of skilled UK gambling executives (Neil Goulden as chairman and Andrew McIver as CEO) with decades of relevant experience and who made a solid impression during the investor presentation in London on the 7th of September.
A new conservative management incentive plan has been put into effect and financial disclosure has improved materially.
Of the offending previous management team, the CFO is still in place. He seemed in tune with the new strategy during the investor presentation, and we understand that an important reason for his presence is to show minimal CFO turnover in order to support a swift future application for a premium listing on the LSE.
Jackpotjoy deal and Gamesys relationship
We do not believe the Intertain-Gamesys outsourcing deal is very unusual. In the first place, most online gaming companies procure their tech from external parties. The agreement between Gamesys and Intertain also provides the latter with protections regarding the revenue-generating parts of its business. Intertain has recently made some useful changes to this agreement, securing better access to its IP and extending the non-compete by two years.
Under the outsourcing agreement, the cost structure is fixed until April of 2020. The only risk is an increase in cost reimbursement, but Intertain always has the option to move the relevant personnel (about 265 people) in-house. The contracted increase in cost in April of 2020 will also have a relatively small effect on FCF (see the section "Valuation - Adjusted EBITDA to Normalised Free Cash Flow" for more details).
Gamesys and its owners are also large shareholders in Intertain and they made clear that they intended to stay that way for the foreseeable future.
Jackpotjoy margins are too high and they rose by too much after acquisition
This was a major red flag for the short sellers who have raised the possibility that the cost reimbursement included in the outsourcing agreement is artificially low to inflate both the value of the earn out agreement and the Intertain stock. According to the short sellers, the proof for this theory is their claim that the margin of the Jackpotjoy business rose by an enormous amount after its acquisition by Intertain.
The crux of their analysis is that the "normalised" margin of theJackpotjoy carved-out business was 23% from 2008 to 2014 - this assertion is wrong for the following reasons:
1) The 23% that is arrived at is an after-tax margin, which is not a good comparison given that Intertain's current and foreseeable (i.e. post re-listing in London) tax rate will be close to zero given its large D&A.
2) Gamesys's corporate overhead and other businesses are included in the margin whilstJackpotjoy's current reported margin is free of corporate overhead.
3)Jackpotjoy has been a successfully growing business since 2008 and exhibits a high operating leverage (see our section "Valuation - Segments & Growth"), hence taking an average going back to 2008 is not a good comparable for the business today where e.g. mobile growth is expanding margins rapidly.
To get to the correct margin bridge, we start with the carve-out numbers as provided by the Gamesys accountants in the Intertain equity prospectus that was issued on the 23rd of February 2015, and we take the pre-tax numbers to get to the normalised profit margin.
As can be seen from the above the pre-tax adjusted normalised margins all tie-out consistently to roughly 50% from 2013 to 2015. After the Point of Consumption (POC) taxes are applied in 2015, the margin drops to 39%, which has been consistent with reported numbers up to Q2 2016.
Intertain overpaid for Jackpotjoy
We do not believe this is the case.Jackpotjoy was purchased for 9x the 2015 EBIT of GBP 63.1m + 4.5x the EBIT growth. This growth is defined as the amount by which the average of the March '16 TTM EBIT and the March '17 TTM EBIT exceeds GBP 63.1m. This all means Intertain pays 9 x 63.1 + 4.5 x 16 to 20m of additional EBIT or a weighted average multiple of 8.3 to 8.6 on the current LTM EBIT ofJackpotjoy. This is not expensive; see the valuation section below for comps.
Earnout liability uncertain and could go up by lot
The current earnout liability is GBP 231m for an expected LTM 2017 EBIT of 85-95m, a pretty decent deal as we can see above. Let's assume we incur another 50m of earn out, that would mean another 22.2m of March 2017 EBIT, implying that 2016 guidance was massively conservative, not exactly a bad problem to have.
Bingo market is declining in the UK
Does not seem that way; see theJackpotjoy revenue growth in the Segments & Growth section below.
UK gaming probe
This gaming probe is a general inquiry focused on the industry as whole, and we see no reason why this should be concerning to Intertain. In fact, we think this is a positive as more regulation favours large established companies in this business (as in any other).
We also believe Intertain/Gamesys understand the importance of customer service and satisfaction (see the September 2016 investor day webcast for a lively demonstration). Note that in 2015, 89% ofJackpotjoy revenues came from players that joined in 2014 or earlier suggesting a large degree of customer loyalty.
Debt to EBITDA is certainly high at 3.5, with management stating that 2 is its target. Even assuming the company has to raise equity at the current unfavourable level to bridge the gap, the FCF yield would still be 15.9% post dilution (see the "EBITDA to Cash Flow" section below for the calculation). Just to be clear, the company has stated it is NOT contemplating an equity raise.
Earn out financing risk
Another short argument relates to the GBP 150m earnout payment that Intertain agreed to make to Gamesys before 28/02/17 and the apparent liquidity risk that this implies. In reality, a standstill arrangement is in place that allows Intertain to postpone payment if funds are not available. If Intertain postpones this payment, the only thing that would happen is that a two-year exclusivity extension that was recently agreed with Gamesys would be terminated. Investor relations confirmed that it is talking to banks at the moment and that it expects financing to come through shortly.
Financing and listing delay are signs of serious problems
Financing for the February £150m earnout prepayment and the relisting were originally expected to be finalised late September to mid October. We spoke to investor relations about this and it told us that the listing was subject to procedural issues and it expected permission to be granted imminently. We can think of no reason why the relisting could be in jeopardy.
According to the company, the financing is delayed because it did not go through with a European junk bond because of market developments and it is currently discussing a bank facility with existing lenders.
Company does not produce any cash flow
Another bear argument is the poor FCFs that the company allegedly generated over the last few quarters. We see FCF of 84.9m for H1 2016 and a conversion ratio of 86%. The 84.9m even includes the drag caused by timing difference arising from Maltese tax deposits/releases and one-off items.
Conclusion of the bear case analysis: the company has a difficult past and still makes mistakes in messaging, but none of the short arguments seem currently valid.
Segments & Growth
* Acquisition adjusted
The two most important segments are growing revenues very quickly at the moment.Jackpotjoy is also showing positive operating leverage (revenue growth of 19.6% vs. adjusted EBITDA growth of 48.4%).
For Intertain, we are comfortable to use (company) adjusted EBITDA as a basis for our valuation analysis. The adjustments concern one-time items and acceptable adjustment like amortisations. The stock-based compensation element is very small.
The company is guiding adjusted EBITDA of CAD 175 to 195m, extrapolating results from the first half year we are expecting a range of 180-195m. In the longer run, the company expects to continue outgrowing the 9% market growth with EBITDA growing faster than revenue.
* Per 30/06/16, pro-forma for GBP 150m refinancing, currency adjusted per 3/11/16.
Adjusted EBITDA to Normalised Free Cash flow
* The above numbers are pro forma for the move to the UK and also pro forma for a GBP 150m debt raise (assuming a high 9% interest rate).
** The recent increase in UK Point of Consumption (POC) tax will only take effect in August of 2017.
*** Currency effect on EBITDA from the investor meeting 7/9/16 to 3/11/16 (EBITDA assumed to be 78.6% GBP and 21.4% EUR).
The base case 2016 FCF yield is 20.4% on an EV / EBITDA of 6.45 (using a stock price of CAD 7.50). An unrealistically low valuation related to Intertain's growth, it margins and also to its comps as we will see below.
In April of 2020, the cost of the Gamesys outsourcing agreement will rise from about 20% revenue to around 25%, adding about CAD 15m of cost on the basis of the current revenue. Even if the company stopped growing and became static at this point, it would knock only 2.8% of the free cash flow yield, leaving a respectable 17.7% for the equity holders.
Please leave us a comment or send us a message if you have questions on any of our modeling assumptions.
Adjusting for the debt load
The free cash flow yield and EV/EBITDA both look very attractive, but as discussed, the debt load is quite high. Below, we provide the EBITDA to free cash flow overview if we assumed the company would do an equity raise (at the current depressed level) and would use the cash to reduce debt in order to meet its target debt/EBITDA ratio.
Just to be clear, management and IR have explicitly stated that they are NOT going to do an equity raise at this point in time. As an aside; we discussed why they would not do a buyback given the current levels, but they said they did not want to create any moving parts in relation to the listing process.
For Intertain/Jackpotjoy, we see a rerating to around 2x the current price level when the company gets through its listing and refinancing process and becomes established on the London Stock Exchange. We expect this to happen in 2017, most likely during the first half.
When the market gets comfortable with the debt reduction and Intertain's commitment to start paying a dividend, we could see a rerating towards 3x the current price level. This could happen later in 2017 or 2018. We also believe Intertain would be an attractive acquisition target for its UK peers at the 2x to 3x level.
* Relisting (imminent).
* Debt refinancing (imminent).
* Q3 results (15th of November), we expect strong further execution from the new management team and continued growth forJackpotjoy. Investor relations confirmed that management will be allowed to buy stock after the Q3 call as well.
* Continued execution through 2017.
* Potential acquisition target given valuation and consolidation trend in UK gambling sector.
* Shorts are right, business is fake, Deloitte was wrong, Gamesys has provided false numbers and current management is also crook.
* Something hugely disruptive happening to the UK online gambling market.
See also Chesapeake Energy: Stop Reading Press Releases And Start Looking At The Data on seekingalpha.com