In that trading release the company categorically stated that the performance in the financial year to date has been in line with analysts’ profit expectations. In fact, gaming revenues have actually increased by 19 per cent in the first 24 days of March to take the cumulative year-to-date increase to 8 per cent. That’s a marked acceleration on the first two months of the year and hardly the sign of a business going backwards. However, investors paid no notice and not even news of a three-year sponsorship deal with Glasgow Rangers Football Club to coincide with the start of the 2014/15 football season could kick start a share price recovery. In fact, it has proved more of an own goal as 32Red’s share price has fallen a further 20 per cent in the five trading days since that announcement was made.
Perhaps that’s because investors perceive the need to raise the company’s profile in this way reflects weakening growth in the underlying business. However, I see it as an extension of the current marketing strategy which has focused on expanding the reach of the company’s gaming platforms to a wider audience and which has been highly successful to date.
Let’s not forget that 32Red’s marketing spend continues to reap decent rates of return including a three-year deal with ITV whereby the hit programme 'I'm a Celebrity... Get Me Out Of Here' features as a slot machine game exclusively at 32Red.com for casino, poker and bingo players. 32Red also sponsors Channel 4's 'Late Night Film' on Film4 around both the 11pm and 1am film slots every night of the week. Investment in all 32Red’s partnership agreements highlights a proactive approach by the management team under chief executive Ed Ware to widen the potential net of new customers. Indeed, over 20,500 new depositing players were recruited by the 32Red casino brand in the second half of last year. And it’s not as if the Glasgow Rangers sponsorship is unlikely to increase brand awareness further as the club has the largest fan base in Scotland and a considerable following overseas too.
It also seems lost on investors that the impact of changes to UK taxation on bookmakers’ profits from fixed odds betting terminals don’t impact 32Red at all. That’s in stark contrast to betting giants William Hill and Ladbrokes which have both issued updates on the financial impact of the tax changes.
Betting tax looms
True, there is no escaping the forthcoming introduction of a point of consumption (POC) tax for online gaming companies which is due to come into effect in December and could generate around £300m in extra tax revenue for the UK Treasury, according to some industry experts. All offshore gambling companies will be taxed on their gambling profits from UK customers, and that includes Gilbraltar-based 32Red which currently enjoys a tax rate of just 1 per cent and this is capped at £425,000.
From December gaming companies will be liable to pay remote gaming duty, general betting duty or pool betting duty, all of which will be taxed at 15 per cent. But this is hardly ‘new’ news as we have known about this UK gaming tax change for quite some time now. It’s also worth putting the tax take into some perspective: I estimate that the new POC tax would wipe out around a quarter of the company's adjusted pre-tax profits of £4.8m last year after factoring in cost savings and offsets such as reduced payments to 32Red's suppliers. It’s worth pointing out too that it’s still beneficial for the company to base its operations in Gibraltar given the minuscule corporation tax rates there.
The standard rate of corporation tax in Gibraltar is only 10 per cent which explains why The Rock has proved so attractive for the offshore gaming industry. That is likely to remain so irrespective of the introduction of the remote gambling tax. As I have pointed out previously, a large amount of the £2bn of annual revenue from the remote UK gaming market is generated by Gibraltar-based gaming companies.
It's also worth flagging up that after the share price sell-off the company is being valued on only seven times last year’s cash profits of £5m. And even that overstates the rating because at the start of this year net cash on 32Red’s balance sheet was £3.4m, or 10 per cent of its current market capitalisation of £36m. Adjust for that cash balance and the company is being attributed an enterprise value of only £32.4m, or a bargain basement 6.5 times cash profits.
Attractive valuation
Investors heading for the exit seem to be ignoring the point that 32Red is still in a growth phase with analysts predicting revenues will rise almost 20 per cent this year to £30m. If achieved and based on a cash profit margin of 20 per cent, expect cash profits to rise a fifth to £6m. In other words, the profit enhancement this year almost offsets the future hit to profits in 2015 due to the introduction of the new government 15 per cent gross profit tax.
On this basis, expect adjusted pre-tax profits to rise to £5.7m to produce underlying EPS of 7.3p which means that the forecast dividend of 2.2p a share, up from 1.8p in 2013, is covered more than three times over. Or put it another way, after the savage derating the shares are trading on a miserly seven times earnings estimates and offer a forward yield of 4.4 per cent, making 32Red by far the lowest rated UK-quoted gaming company.
A valuation that low implies the company has gone ‘ex-growth’. However, that is not the case as underpinned by robust cash generation, 32Red’s capital investment programme is reaping bumper returns: active players in the core 32Red casino business rose by almost a quarter to 71,266 last year and yields were pretty robust at £485 per player, down only slightly from £500 in 2012. And the increased use of tablets and mobiles for gaming is clearly on the rise, having more than doubled last year to account for a fifth of casino revenues overall. It’s obvious to me that this segment will account for the majority of the business in the future, so it only makes sense to target marketing spend to drive revenues from this growth segment higher.
It’s also blatantly obvious that if 32Red generates £6m of annual cash profits, or the equivalent of 8.3p a share, then the current £3.4m cash pile is going to swell even after factoring in a full-year payout of 2.2p a share. In fact, I would not be surprised at all to see the cash pile double to £7m by the year-end, or the equivalent of 20 per cent of 32Red’s current market capitalisation. I am not alone in this prediction either as analyst Ivor Jones at Numis Securities estimates year-end net funds of £6.7m. In other words, net of forecast cash at the end of December 2014, the shares are now trading on a miserly 4.7 times cash profit estimates! That is not only a bargain basement valuation, but means that the new government POC tax next year is more than fully factored into the current valuation.
It’s also worth noting that the shares are massively oversold with the 14-day relative strength indicator (RSI) showing a reading of around 20 and the share price a hefty 27 per cent below the long-term 200-day moving average of 67p and almost 20 per cent below even the short-term 20-day moving average. Yesterday’s price move also resulted in a 'long-tail' on the point and figure chart with the price opening at Thursday’s close of 52.5p, hitting an intra-day low of 45p before rallying sharply to 49.25p at the close yesterday. In other words, the price decline could very shortly be coming to an end. It would make sense too because the 45p area represents a major support level, coinciding with the price highs which capped progress for virtually all of 2012. From a technical perspective, it would be logical for this area to offer substantial support.
In my considered view, the shares are a value buy on a bid-offer spread of 47p to 47.5p and I would exploit the weakness as a buying opportunity. I still believe that the price targets of Numis Securities (100p) and Daniel Stewart (95p) are not unrealistic.
NetplayTV derating unwarranted
My other play in the gaming sector, Aim-traded NetplayTV (NPT: 17.25p) has been hit hard too in the past six weeks even though the company has reported record results in that time. True, analysts at brokerage N+1 Singer eased their current year pre-tax profit estimate from £6.1m to £5.7m to reflect uncertainty over competitor’s trading activity ahead of the introduction of the POC tax in December, but this still means that profits are set to grow more than 16 per cent from the £4.9m reported in 2013 to boost EPS by 20 per cent to 1.9p. In turn, this underpins forecasts of a 0.6p a share dividend this year, covered more than three times by net earnings, representing a 20 per cent hike on 2013.
So with the shares priced on a bid-offer spread of 16.75p to 17p, the forward dividend yield is 3.5 per cent and the PE ratio less than nine. But that ignores the fact that NetplayTV ended last year with £13.9m of net cash, or the equivalent of 4.7p a share, and with the benefit of robust cash generation net funds are expected to rise to £17.7m by the end of December. That equates to 6p a share.
In other words, strip out net cash from the current share price and the shares are trading on a little over five times this year’s earnings! True, if the new POC tax had been in place last year then this would have wiped £1.7m off profits. However, investors seem to be ignoring the point that NetplayTV has already taken steps to mitigate the impact of the introduction of the new POC tax.
For instance, the company has a number of contractual offset agreements with suppliers, where the revenue generated is directly linked to the amount payable to a supplier, and the potential additional cost due to the POC tax will consequently reduce the amount payable to these suppliers. NetplayTV could also consolidate its UK and overseas operations into one location to take costs out of the business.
Moreover, undoubtedly some competitors within the UK gaming market will be forced to exit the market altogether once the POC tax is introduced as it will no longer be viable for them to operate. In my opinion, NetPlayTV looks well positioned to make market share gains in the inevitable consolidation within the industry. The company is also targeting international expansion longer-term which will mitigate the reliance on the UK gaming market. All these measures will reduce the profit impact of the POC tax.
But even if we ignore the steps NetplayTV is taking, and assume the tax had been in effect for the whole of last year, then the shares are still only trading on a cash adjusted 10 times historic earnings per share, a rating that implies the company has gone ex-growth. Clearly, this is not the case as revenues are still expected to grow in double digits this year to around £32m.
Interestingly, from a technical perspective, the share price decline could now be basing out. For starters, there is positive divergence on the 14-day RSI whereby the price has tested the March low and dipped slightly below, but the RSI has not created a new low. For good measure, the 14-day RSI is massively oversold too and the price is at a support level. So just like 32Red, I see the savage derating in the shares as an opportunity to buy into a very lowly rated company at an attractive valuation and one offering significant upside for the medium-term.
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