The company’s net gaming revenue rose by a third to £24.6m in the six momths to end June 2016, excluding the £5.8m contribution from last summer’s acquisition of remote online gaming operator Roxy Palace, a performance that underlines the fact that 32Red is one of the industry winners in the post-Point of Consumption Tax gaming market. Including the Roxy Palace contribution 32Red’s net gaming revenue (NGR) surged 63 per cent to a record £30.4m, and with gross margins edging up 1.5 percentage points on the same period last year, and administration costs stable, this resulted in underlying cash profits more than doubling to £4.5m.
Solid growth drivers
The key growth drivers behind this stellar performance have been the mobile casino segment of the business which grew by 45 per cent in the period and now accounts for half of 32Red’s total casino gaming revenues. In turn, casino revenues surged by almost a quarter in the first half, buoyed by the launch of a new responsive multi-platform website in April which has improved retention rates and new player conversion rates. The absence of losses in the fledgling Italian start-up operation also helped boost profits and is now expected to break-even in the full-year.
The £8.4m acquisition of Roxy looks not only a shrewd buy, but a well-timed one too. It fits in well with 32Red’s regulated markets growth strategy – three quarters of the company’s revenues are generated from regulated and taxed markets – and has enabled the business to leverage the expertise that the Roxy team has built up over many years in overseas markets. Roxy had 230,000 registered users at the time of the acquisition. It was a highly profitable operation when 32Red completed its acquisition as Roxy generated cash profits of £1.6m on NGR of £10m on a cash profit margin of 16 per cent in its previous financial year.
It’s growing too as Roxy has just reported NGR of £5.8m in the first half of this year and analyst Jane Anscombe at Edison Investment Research predicts Roxy’s NGR will rise to £6.2m in the second half. Moreover, there have been significant savings too as Roxy operates on the same gaming platform as 32Red (Microgaming) and 32Red rationalised the operation by the end of last year, keeping the brand separate but saving over £1m in costs this year. In addition, revenue synergies from cross-selling, the exchange of marketing know-how and wider table and game bet limits, have contributed to an improved profit performance. In fact, Edison estimates that the EPS accretion from the acquisition of Roxy is over 30 per cent in 2016, a factor that helps explain why analysts predict 32Red will be able to deliver cash profits of £6.6m on NGR of £34.4m in the second half of this year, well up on cash profits of £4m on NGR of £30.1m in the same period of 2015.
On this basis, 32Red’s cash profits are set to more than double to £11m in 2016 and with the benefit of a £1.1m cut in operating costs, this feeds through to a 181 per cent rise in underlying pre-tax profits to £9.3m and a more than doubling of adjusted EPS from 3.8p to 9.8p. Guidance from 32Red’s management team which is led by chief executive Ed Ware, the company’s founder and former managing director of Ladbrokes International division, is in line with these estimates.
Raft of marketing deals
I don’t expect 32Red’s heady growth rates to flag either. A raft of marketing deals put in place should maintain the company’s brand presence on a number of media and sporting platforms including an exclusive license with ITV, announced alongside yesterday’s results, to operate an ''Ant & Dec Saturday Night Takeaway'' slot machine game in addition to the current, successful ''I'm a Celebrity...Get Me Out Of Here!'' game. Both games use popular iconography, theme tunes and features to bring the excitement of the shows to casino games that are available exclusively to 32Red customers over the three year licence agreement.
32Red will also have a high profile presence on our television screens on Boxing Day when the company sponsors the historic King George VI Chase at Kempton Park, a blue ribbon event for the best three mile national hunt steeplechasers, to add to more than 250 races it sponsors between October and April each year. There are opportunities to develop a presence in the lucrative sports betting market too. Currently representing only a small part of the company’s operations, sport betting offers a strategic opportunity for 32Red in terms of customer acquisition, cross-selling and improving retention rates. To tap into this opportunity, 32Red has a 12-month deal to advertise around live sport on Sky including half-time adverts during Premier League football matches. The company also has a sponsorship deal with Leeds United and Glasgow Rangers.
Impressive cash generation
Given the nature of the business, and the surge in profits, the company is hugely cash generative, so much so that even having paid out 5p a share in cash dividends in the first half of this year, split between a special dividend of 3.3p and a final payout of 1.7p, net funds have risen by almost a fifth to £7.9m, a sum worth 9.3p a share, since June 2015. The board have just raised the interim payout per share by 18 per cent to 1.3p, and Edison predict the final payout will be raised from 1.7p to 2p a share. On this basis, the shares offer a decent 2.3 per cent prospective dividend yield, rising to 2.5 per cent on forecasts of a normal payout of 3.6p in 2017. It could be more because with cash conversion strong, net funds are predicted to hit £10m by the end of 2016, rising to £18m, or 21p a share, at the end of 2017 based on another year of rampant growth.
To put this into some perspective, Edison predict cash profits will rise from £11m to £15.5m and deliver a 43 per cent surge in pre-tax profits to £13.3m in 2017 based on 32Red growing NGR by 19 per cent to £78.2m in 2017. Between 2012 and 2015, the company posted an average annual growth rate of over 25 per cent, so this forecast doesn’t seem unreasonable to me.
On this basis, EPS rises from 9.8p forecast in 2016 to 13.9p in 2017, meaning that the shares are trading on a prospective PE ratio of 10. But even that underestimates the value on offer as on a cash adjusted basis, taking into account the burgeoning cash pile, the forward PE ratio drops to only 9. There are not too many investments in the market that are rated on such a low PEG ratio and which offer potential to grow pre-tax profits by almost half next year while at the same time delivering progressive cash returns to shareholders.
Risk assessment
Of course, no investment is not without tisk and there are a few to consider in the gaming sector, the most obvious is regulatory risk.
For instance, licence conditions and tax rates could change in 32Red’s markets. For example, HMRC is currently consulting on the precise way that Point of Consumption Tax (POCT) will be extended to free play from August 2017, which is likely to change game play and impact margins. Edison have factored in a 2-3 point increase in the effective POCT rate in their forecasts. In addition, earlier this year HMRC issued an informal working paper on VAT becoming chargeable on advertising services bought in the UK by Gibraltar based companies like 32Red, but at this stage it is impossible to know how it would work or quantify the financial impact of it either.
32Red also derives about a quarter of its revenues from countries that are unregulated. Some of these countries, including Holland, are in the process of introducing regulation which could introduce new costs or taxes, while others are yet to regulate.
Competition is a worth considering too. That's because 32Red operates in highly competitive markets and is up against larger rivals with significantly larger marketing budgets. That said, the company's management is experienced and has a strong brand presence.
The risk of an economic slowdown is also worth flagging up. The gaming sector has proved resistant to economic slowdowns in the past, including the last major slowdown of 2007-08, but this is not to say that it will fare so well in the future.
Finally, Brexit could be an issue. That's because 32Red is based in Gibraltar and would be affected if Gibraltar followed the UK out of the EU or if it became part of Spain, as unlikely as that would seem. That said, 32Red holds local rather than EU licences and the Gibraltar government has been keen to stress its flexibility and desire to support its gambling industry as the terms of the UK’s future EU relationship unfold.
Having taken all these risks into consideration, I am of the opinion that for my time horison at least, none of these are unlikely to detract from the positive operating back drop the company is currently enjoying, nor prove detrimental to investor sentiment.
Target price
So, having first recommended buying 32Red’s shares at 51.75p ('Game on', 7 Jul 2013), since when the board have paid out a total of 12.5p a share in dividends, and last advised running your profits at 134p ahead of yesterday’s results (‘Spinning higher’, 2 Aug 2016), I now feel there is a high probability of the share price returning back to the March 2016 all-time high of 186p, and possibly beyond. If achieved it would price the shares on a more reasonable 13 times next year’s earnings estimates, a fair rating in my view given the EPS growth profile. More importantly, these targets look achievable.
Interestingly, the chart set up is bullish as a close above the 152p summer highs would set up the share price for an attack at the 186p highs dating back to March. The 14-day relative strength indicator is not overly stretched, and the MACD momentum oscillator is above its signal line and in positive territory, so the technical set-up is supportive too.
On a bid-offer spread of 140p to 141p, valuing 32Red’s equity on a modest seven times cash profit estimates for 2017 to its enterprise value, I rate the shares a strong buy.
