In fact, having retested the May lows around 47p in recent days, 32Red’s share price appears to have formed a base formation and one solid enough to support a rally to the May highs of 67p at the very least, a price level that coincides with the 200-day moving average. If that level is taken out then a return to January’s highs of 88.5p is a natural and realistic objective. The 14-day relative strength indicator is in the mid fifties so is not yet in overbought territory, thus offering scope for the rally to continue. Interestingly, the share price has regained its 20-day moving average and for good measure the moving average convergence and divergence indicator (MACD) has had a positive cross over. The technical set up looks like the real deal to me.
The fundamental case for investing is also very supportive. A positive first half trading update ahead of results on Wednesday, 23 September revealed that 32Red increased net gaming revenues by 20 per cent to £15.2m in the six month period, driven by a 22 per cent uplift in the company’s casino operation. Active casino customers shot up by 20 per cent year-on-year to 50,890 players, but importantly not at the expense of profitability as player yields edged up to £400. True, the 23,500 new customers in the six month period, up by more than a third on the same period of 2013, were recruited at a cost of £180 each, up from £159 per player in the first half of 2013. However, these new accounts are clearly profitable given that overall player yields are more than double acquisition costs.
As I have reported previously, 32Red continues to attract an increasing number of gaming accounts using tablets and mobiles. Having more than doubled last year to account for a fifth of casino revenues overall, the mobile segment accounted for nearly a third of gross gaming revenues in the first half of this year, up from 17 per cent in the same period of 2013. It’s clear 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 area.
Targeted marketing paying off
And that’s exactly what the company is doing by committing further resources to strategic marketing in the second half of this year. Following the appointment of new commercial director Matt Booth, the marketing team has adopted a more analytical approach to marketing, evidence of which is the growth now being seen.
Deals concluded this year include a three-year sponsorship deal with Glasgow Rangers Football Club to coincide with the start of the 2014/15 football season. 32Red also sponsors Channel 4's 'Late Night Film' on Film4 around both the 11pm and 1am film slots every night of the week and has 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.
Investment in all 32Red’s partnership agreements highlights the hands on approach by 32Red’s management team to widen the potential net of new customers. It is clearly working as over 20,500 new depositing players were recruited by the 32Red casino brand in the second half of last year, and this ramped up to 23,566 new players in the first half of 2014.
It was also reassuring to see that the start up Italian casino operation trebled its player base to over 5,700 accounts, having recruited more than 3,000 new players in the six month period. Net gaming revenue from this business unit doubled to around £500,000. This new operation posted a £1.2m loss last year on net gaming revenue of £600,000, and analysts at Numis Securities expect losses there to half this year. But even after factoring these in, analysts at broking house Daniel Stewart still expect 32Red to be able to generate current year pre-tax profits of £4.5m and EPS of almost 6p a share. In turn, that should underpin another rise in the dividend to 2.2p a share, up from 1.8p last year when the board increased the normal payout by almost 30 per cent. On this basis, 32Red’s shares trade on a very reasonable 9 times forward earnings and offer a prospective dividend yield of 4.2 per cent.
Importantly, the positive momentum has continued into the second half as gross gaming revenue across all 32Red’s operations has increased by 45 per cent in the first three weeks of July, albeit the business was up against a comparatively soft trading period last year. New products include the recently launched 32RedSport premium online and sports betting business, take-up of which has so far been “encouraging”.
Understand profit impact of new betting tax
As I stated at the start of the article, the gaming sector has been under a cloud this year due to uncertainty created by the introduction of a point of consumption (POC) tax for online gaming companies in December. This new tax is set to generate around £300m in extra revenue for the UK Treasury, according to analysts. 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 onwards, 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 on their gross gambling profits. Still, it’s worth putting the tax take into some perspective as I estimate that the new POC tax would only wipe out around a quarter of the company's pre-tax profits after factoring in cost savings and offsets such as reduced payments to 32Red's suppliers. These calculations are based on 32Red generating net gaming revenues of £30m this year, up from £25.4m. I have assumed a gross profit margin of 30 per cent at cost of sales of 70 per cent of revenues.
Cautious investors also seem to be missing the point that 32Red is still in a growth phase, as the pre-close trading update highlights. In fact, analysts at Numis Securities expect net gaming revenues to rise to £33.9m in 2015 and the company to generate annual cash profits of £7.2m. In other words, I estimate the profit enhancement this year and next year almost covers the future hit to profits due to the introduction of the new government tax.
It’s worth pointing out too that it’s still beneficial for 32Red to base its operations in Gibraltar given the minuscule corporation tax rates being offered there. The standard rate of corporation tax in Gibraltar is only 10 per cent which is why The Rock has proved so attractive for the offshore gaming industry. In fact, a significant amount of the £2bn of annual revenue from the remote UK gaming market is generated by Gibraltar-based gaming companies.
In my view, investors have massively overreacted to the imminent introduction of a point of consumption (POC) tax which has created a value buying opportunity. That’s because at the current price the company is being valued on less than eight times Daniel’s Stewart’s cash profit estimate of £5.2m for fiscal 2014. Numis forecast underlying cash profits of £6m for 2014, but this excludes likely losses from the Italian operation so it’s best to use the Daniel Stewart’s forecasts.
But even that overstates the rating because at the start of this year net funds on 32Red’s balance sheet was £3.4m, or 9 per cent of its current market capitalisation of £39m. Adjust for that cash balance and the company is being attributed an enterprise value of only £35.6m, or a bargain basement seven times cash profits. No matter which way I look at it the shares are undervalued.
Target price
After this year’s derating, 32Red’s shares are trading on a miserly 9 times IFRS earnings estimates and offer a forward yield of 4.2 per cent, making 32Red one of the lowest rated UK-quoted gaming companies. A valuation that low implies the company has gone ‘ex-growth’, which is clearly not the case as yesterday's pre-close trading update highlights.
It’s also clear to me that if 32Red generates £5m of annual cash profits, or the equivalent of almost 7p a share, then the £3.4m cash pile at the start of this year 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, a chunky sum in relation to 32Red’s current market capitalisation of £39m. I am not alone in this prediction either as analyst Ivor Jones at Numis Securities estimates year-end net funds of around £6.5m.
Or put it another way, net of forecast cash at the end of December 2014, 32Red’s shares are trading on a miserly six times cash profits. That is not only a bargain basement valuation, but means that the new government POC tax is more than factored into the current valuation.
Needless to say, I rate 32Red shares a decent income and value buy on a bid-offer spread of 51p to 53p. The price targets of Numis Securities (100p) and Daniel Stewart (95p) are not unrealistic in my view either. My immediate price target is 67p from a technical perspective. If that is hurdled I would then look for a return to January’s 89p high. Offering potentially 68 per cent share price upside, I am a buyer ahead of the company’s results in a couple of months’ time.
Please note that I first initiated coverage on the shares a year ago when the price was 51.75p (‘Game on’, 7 July 2013) and last updated the investment case three months ago when the price was 47.5p (‘Game on’, 23 April 2014).
■ Simon Thompson's new book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stock-picking'
