Evolution Gaming risks ($EVO)
Evaluation of company specific risks
Most of my writing thus far I have wanted to capture my investing philosophy and journey. I have been laying out groundwork for my identity as an investor while defining my checkpoints and goals along the way. At times, I do want to develop the skill of diving into specific companies I hold or am closely following. With the caveat that this is largely not my background or expertise, I want to refine this skillset with the more investing experience I obtain.
With seemingly almost every stock going up in the market in 2024 (the S&P 500 is up 23% year to date as I am writing this), I wanted to examine one of my core holdings that has not performed well and been under steady pressure. I do not just want to “buy and hold,” but seek to “buy and verify,” to “understand the value not just know the price.”
“A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price.”
― Benjamin Graham, The Intelligent Investor
What is the reason this stock has not performed? What are the business risks currently and also moving forward? Is the intrinsic value increasing despite the decline in stock price? Are there significant business risks long term or are the market signals more short term noise? Should I take any action (buy, hold, trim)? I should be doing this for all of my holdings, but am especially vigilant of underperformers as there may be a time to add to these or possibly even bid them a fond adieu. In order to be a good investor, you need the mindset to be an independent thinker and the ability to emotionally detach yourself from the stock.
Now the market can certainly be inefficient in the short term, but in the long term it is largely an efficient system. Firstly, I want to operate from a place of humility and not assume that I am smarter than the market, but rather seek to understand what it is that the market is saying. From that understanding, I can then formulate my own analysis and make my own determination on whether I agree or disagree with the market sentiment. Remember, for every trade there are always two sides. A bear for every bull, a risk for every opportunity. If a stock is consistently going down, it may be time to pause and ask yourself what is the root cause of the decline.
There can be numerous reasons for stock price declines, but we cannot behave in an overly optimistic manner that we are right as there are always legitimate risks and business concerns which every company will inevitably encounter. My goal is to always think like an optimist, but to behave as a rational optimist. As I wrote in “A Falling Knife,” in general I am seeking to add to my winners and cut my losers, but what if I determine business fundamentals are indeed increasing while the price is decreasing? Price volatility is after all to be expected in the market. Is the company a falling knife or a buying opportunity? My aim is to proceed cautiously, but Evolution Gaming seems to me to fit the bill of a decent buying opportunity as I will describe in further detail below.
Sentiment always follows price in the market. As an individual investor, my job is to dig beneath the noise on the surface, and actually dive into the business fundamentals. Currently, I view Evolution Gaming as a business where negative sentiment has followed the downward price movement. Not that the business is without challenges and risks, what business is, but from my review, the business has performed strongly and I view the business as a great buying opportunity amidst the pessimism.
Focusing in on Evolution (EVO 0.00%↑) and attempting to shortly explain my thought process while carefully weighing the risks and rewards. I am not doing a deep dive on the company, but rather a brief risk analysis for my own mindset.
A short primer, Evolution develops, produces, markets, and licenses live casino and slots solutions to gaming operators primarily in Europe and the United States. The company runs the game from a casino gaming table, which is streamed in real time and end users make betting decisions on their devices, such as computers, smartphones, tablets, etc. Its portfolio of online live table games primarily includes Live Roulette, Blackjack, Baccarat, Super Sic Bo, Dragon Tiger, Craps, Live Casino Hold'em, Three Card Poker, and Ultimate Texas Hold'em; and operates approximately 1,000 tables. The company was founded in 2006 and is headquartered in Stockholm, Sweden.
Since going public in 2015, Evolution Gaming had been growing its revenues by ~50% per year. This has been greatly trending down in recent years, but can the long term average still hover around ~15%?
Credit: The Wolf of Harcourt Street / @wolfofharcourt The company trades at a 16.5x trailing PE, 14.5x NTM PE. Forward FCF Yield of 7%. Forward EV/EBIT of 12. All significantly below current market valuation metrics. (Disc: This was as of 10/10/24, prior to Q3 2024 earnings)
$EVO trading at it lowest valuation in a decade (Credit: Koyfin) Returns 50% of profits via dividends and now even more via share buybacks to shareholders and only requires ~4% of revenues for CapEx. Dividends per share have grown at a staggering 61.66% CAGR in the last 5 years. A very shareholder friendly capital allocation policy.
Generates 60%+ EBIT margins. These are incredibly high metrics due to the capital light business model. Can these margins hold as competition increases?
With these strong metrics and tailwinds, just where exactly has Evolution gone wrong? Let us dive into the risks and evaluate the type and severity of each. Digging underneath the surface and each risk alone could easily have their own separate post, but these are just my quick high level thoughts of what I am tracking.
Regulation - This is the overarching major risk that will seemingly always hang over the company as it operates in the gambling industry. Gambling has always been around and organized gambling dates back to the 18th century. How does each country, or in the USA each individual state, set forth their own rules and regulations to allow or disallow online gambling. The market hates uncertainty as it is impossible to model, and regulation creates heavy uncertainty over what lawmakers will enact or not enact in the future. This also creates heavy legal complexity as Evolution operates in many different legal environments which are all constantly evolving and take considerable resources to stay current and compliant. Approximately 60% of revenue comes from unregulated markets (not illegal). Evolution operates in many “gray markets,” mainly Asia, which means that there are no explicit rules and regulations on online gaming, but the risk is that a country could outlaw and/or restrict the industry in the future. Evolution’s technology can also be taken and used by third party operators in strictly illegal markets. Evolution has to staff a sizeable legal team just to stay on top of all the ever changing rules and closely work with regulators to maintain compliance. Due to this regulation uncertainty, the company currently and may always trade at a discount to the market as investors certainly frown upon uncertainty.
Worker strike - In mid-July 2024, a portion of Evolution’s employees in Georgia (the country, not the state) went on a hunger strike protesting working conditions and pay. Management felt they provided competitive pay and a fair working environment already, and the protests unfortunately turned into vandalization. Evolution then made the decision to permanently downsize the Georgia studio and to operate it at a greatly reduced capacity. Is this just a one-off event and just noise or is this a larger cultural issue at the stem or just a product of the challenges of staffing across different geographic markets?
Dilution - Evolution has made multiple acquisitions to buy companies such as $2.1b for NetEnt (been a huge disappointment thus far and majorly diluted shareholders), $535m for Big Time Gaming, $350m for Nolimit City, $85m for Galaxy Gaming (I really like this acquisition). How accretive are all these acquisitions still remains to be seen as their push into the RNG (Random Number Generator space aka slots) has been met with meager results. There has also been dilution from stock-based incentive schemes for key personnel, although this has not been that significant especially compared to US tech companies.
European stock - Being a Swedish company and European listed stock, EVO 0.00%↑ trades at a major discount compared to a S&P 500 tech company for instance. Maybe this is more of an opportunity, but part of the reason for the discount is that Europe is generally viewed as less favorable regulatory environment, which especially hampers Evolution who operates in varying operating markets and legal conditions. European companies also have been known to be run more fiscally conservative, which has just now seen Evolution turn on the stock buyback machine. Will European stocks make gains compared to US listed stocks, or will that remain a headwind in the future? I have to think that this will at least slowly revert back to historical averages as the US stock market has been on an absolute tear.
Credit: A Wealth of Common Sense - Ben Carlson Crypto and Asia risks - Similar to #1 above, in certain unregulated markets, Evolution earns via crypto-enable channels, which could theoretically be cracked down against. The above link was a risk report released by reputable research firm Inpractise. There are various concerns when combined with this and the Asian “gray’ market in general. South Korea and Japan, in particular, could see regulation that could materially impact Evolutions long-term business operations. The trend has been that if any regulation does come it typically moves from an unregulated to a regulated market, however, the risk is that a gray market could move to being prohibited. Australia, for instance, does not allow online casino gambling due to the Interactive Gambling Act of 2001.
Cyber attacks - This risk has recently emerged and affected growth as cyber criminals have started using advanced technology to intercept video feed, and redistribute it without authorization. Evolution operates in an opaque industry where there are ill-intentioned players who seek to profit illegally, which forces countermeasures to be put in place and information security to be invested in. While this is a cost of doing business, I do think that actions like these reinforce Evolution’s moat, as smaller companies simply cannot make the same kind of investments to effectively enter the market.
Other potential risks
Competition - Evolution has extremely high gross/operating margins, which could invite more competition in the future. Playtech (public) and Pragmatic (private) are two competitors to keep an eye on. Evolution has dominated the live casino market thus far, but struggled to gain a foothold in the RNG market. Can they maintain dominance and/or gain momentum in other ancillary markets?
Slower growth - Organic growth has been slowing over the past few years. Despite major acquisitions, the company has not been able to generate growth in the RNG market, which is viewed as a more commoditized product. What is the long term terminal growth rate for Evolution and the online gambling industry as a whole?
Operational complexity - Operating in multiple geographic markets amid ever evolving black and gray legal markets creates many organizational and strategic challenges for the company. Maintaining gaming security and integrity is paramount, while also providing foreign workers a positive and safe work environment despite operations being spread out geographically. There are external legal forces at play out of the company’s control, but they should be successful if they remain adaptable and forward looking while still focusing on their core products and driving player engagement.
Customer concentration - Casino operators pay Evolution a lot of money for their games, as evidenced by Evolution’s high margins. In 2023, 2 customers accounted for 13% of sales each. 5 customers in total account for 41% of sales. This is testament to Evolution’s product quality, but something to keep an eye on if Evolution can diversify any further away from this concentration as this is much higher than your typical company.
Key man risk - The C-suite has good experience and significant ownership in CEO Martin Carlesund (CEO) and CPO Todd Haushalter. The biggest risk to me is maintaining Todd Haushalter, who is basically the Steve Jobs of gambling. Todd, who is only 45 years old, is amazingly creative and builds the best games. His product development team is constantly innovating and releasing new and popular games. This is Evolution’s key competitive advantage and what I am paying close attention to. The release of new games and how popular they are is paramount while also maintaining dependable quality to ensure the integrity of the games. If the games are good and well operated, they will attract players, who will pay to play, and operators will be forced to pay Evolution whatever the asking price keeping margins high.
Pros
Extremely profitable with high margins. I would expect these to at least slightly compress as more competition enters the market, but these are some of the highest operating margins out of all the companies I own and should remain high.
High inside ownership. CPO, Todd Haushalter, widely regarded as the best in the business. 110 new games were introduced in 2023 as the pace of innovation has continued.
100% of excess net cash flow (after investments and M&A) will be distributed to shareholders. 50% of annual net profits will continue to be paid as dividends. Remaining funds will be used for share repurchases. Buyback programs have been continually rolled out by management recently. This framework positions Evolution to be a share cannibal due to high cash flow generation and low CapEx intensity. This is a crucial point to continually monitor as Evolution’s stock is currently at attractive buyback levels (current buyback yield is ~2%). Can they seize the opportunity and meaningfully lower total share count say (~3%) per year? If the valuation stays depressed at current levels, this will be a key part of the thesis to monitor as this could really help drive compounded returns.
$EVO issued equity in 2021 for acquisition of NetEnt, but has started to ramp up the buyback program in 2024. Will this continue? North America revenue is at roughly 12.5%. How many companies actually have North America, the world’s biggest economy, as their plan for international expansion? I view this opportunity as a call option on the company and curious to see how the strategic regulation unfolds over the coming years. I expect slow, incremental gains, but governments need to enlarge their tax base to keep up with federal spending deficits. The difficulty with the US is that regulation is done on a state-by-state basis each with their own set of rules, regulations, and timelines. Additional tax revenue will be hard to oppose for too long as deficits mount, and I see state regulation as a potential tailwind as momentum begins to slowly adopt. Even post-COVID, when landbased casinos reopened, the online casino market has continued to grow and I would expect that trend to continue, but what will be the rate of state regulation adoption?
Can the RNG segment where Evolution has invested heavily in acquisitions actually inflect? Evolution has been attempting to make strides operationally, but seen very little growth (1%-2%) thus far. While not expected to be as near accretive as live casino, can growth rates here push closer to 8%-12% range? It seems that many investors have written this segment off, but can management outdeliver by streamlining operations?
Evolution is continuously expanding into new geographic markets seemingly every quarter. They are launching their first studios in the Czech Republic and Colombia, and on the brink of new studios in Brazil and the Philippines. These studios not only serve their respective countries, but also reach out to the broader region. France could potentially regulate, albeit with an incredibly high tax rate. My sense is there are far more growth tailwinds than regulation headwinds.
Evolution’s games and user engagement continues to remain at strong levels and they are still dominating the live casino online market. The product team continually crafts their offerings to user preferences and latest trends, for example, betting with influencers and streamers (as shown below). This has proven to drive demand and engagement, and the company is utilizing AI to even further cater games based upon the history of gamers’ behavioral preferences.
As long as Todd Haushalter and team continue to bring innovative products to the market, the business performance should speak for itself (with results like below).
The money quote:
We see the comments on the game from end users, and we measure their engagement and entertainment, and to continue to build new games that challenges the boundaries of online gaming is what success looks like in a longer time persepctive. Don’t follow and copy what others do. That is simply not enough. lead the way and innovate. Understand the demand of the younger generation growing up and create the games that will entertain them in the future. - CEO Martin Carlesund, Q3 2024
Conclusion
In conclusion, the lack of stock price performance does concern me to a degree with how severely the market views the risk of unfavorable regulation and this cannot be discounted. That general risk may not fully change anytime soon, if ever, but there should be incremental gains as regulation becomes more fully defined in coming years, albeit at a very slow pace. For example, look at how scrutinized Uber was early on as cities were trying to outright ban them and it was met with heavy skepticism that a complete stranger would pick you up and transport you to a different location. Obviously now, rideshare is such a commonplace service and widely socially accepted, but it was far from that case when it first started. My underlying question, does the short term pessimism open up a door of opportunity for a long term investor like myself?
The best investment ideas should be straightforward and simple to articulate with only a few key factors to monitor. There should be an easy to articulate valuation case that ties into the direct evidence of business fundamentals actually playing out.
Here is my simple case for Evolution. As the market leader in the online live casino supplier segment, Evolution has a quality brand and is strongly positioned for continued growth as the global casino market transitions more to online. The company has built a leading position by offering high-quality and innovative products which has helped it to stay well ahead of the competition and drive customer loyalty. Strong business fundamentals, a favorable shareholder policy (hopefully share buybacks continue strong especially with the discounted share price), and a conservative current valuation offers a high reward with lowered risk as long as revenue can maintain steady growth (~>10%).
I am excited for more of these company “x-rays” on companies and to come back to pieces of writing like these in the next 3-5 years to determine how the business has performed and whether my thesis played out. Where was I right and where was I mistaken? Most importantly, how do I continue to learn and grow from this process moving forward?
Happy Compounding,
Poor Charlie
EVO 0.00%↑ - Additional resources
Follow Ali Gunduz on Twitter for real time company coverage.
Great deep dive here by Fundasy Investor. Recommend his content.
Great deep dive here by Wolf of Harcourt Court. Recommend his content.
Speedwell Research - Company deep dive podcast
Interview with CPO Todd Haushalter
Thank you for the great comment C&F!
#1) I view the strike as more short term in nature. Evolution has over 20 studios to offset lost capacity. If more strikes do pop up, then maybe there is a deeper cultural issue, but for now it seems to be a one-off and handled timely by management.
#2) I did not know about Viking, but do not focus on short selling as they are playing a much different game than myself. There certainly seem to be better names to short given the valuation here, but just my take!
The potential changes in regulation could also be seen as a plus. Indeed, a company like Evolution is much better suited to deal with this than a new or worse competitor.