Evolution (EVO.SS)
Written on April 8, 2021
Price at time of writing: SEK 1,344
Disclaimer: This report is not financial advice - please do your own due diligence.
Business Description
Evolution Gaming is a Swedish-based company that develops, markets, and licenses live-action casino games to gaming operators. Live casino games are a variation of online gambling in which instead of seeing computer-generated cards being dealt, a professional dealer in an Evolution-curated studio deals the cards for all players to see.
The live casino business model is simple: players pay gaming revenues to gaming operators (such as DraftKings), and gaming operators pay a fixed plus variable commission to Evolution. The variable commission depends on the degree of environment uniqueness that the gaming operator wants to provide for its end user: customizations include native speaking dealers, private tables, and other VIP offerings. All-in-all, this commission is calculated as a % of the operators’ winnings via its Evolution offering, which is typically around a 10% take-rate. Evolution does not, however, share the losses of the operators: if the operator makes money, so does Evolution, but if the operator loses money, Evolution does not.
Evolution currently provides the live casino experience through 10 Evolution-owned studios worldwide. The first opened studios were in Europe, while the most recently opened studio was in Pennsylvania and the next forecasted studio opening is in Michigan in 2021. This centralized studio model provides an obvious cost advantage for Evolution. In a game like craps, where the presence of more players does not slow down the rate of play, one Evolution table can service significantly more players than a traditional casino. Evolution offers most traditional casino games without the costs of a traditional casino, namely free drinks for players, wait staff, and real estate costs.
The company not only provides traditional casino games, but also games proprietary RNG (random number generator games) that are proprietary to Evolution. RNG games are the equivalent of slot games, where a computer randomly picks the outcome of each turn of the game. These are slowly gaining traction and goodwill with Evolution players, as evidenced by its most famous game Crazy time, and the revenue split displayed below.
Evolution has grown revenues at an incredibly fast clip, while maintaining healthy operating margins and fantastic free cash flow conversion metrics. In the latest reported quarter of Q1 2021, Evolution reported revenues of EUR 236 million, which equates to a YoY increase of 105%.
Operating margins are high, coming in at 60% in the latest quarter. The growing and strong margins speak to Evolution’s scalability since its biggest expense are its personnel costs to service its tables. Evolution now has 10,226 employees, representing a 24% YoY increase in headcount.
The rapid revenue growth comes not only from organic growth, but also from highly accretive acquisitions. The two most recent acquisitions that Evolution has announced are NetEnt, which it recently closed in Q1 2021, and Big Time Gaming, which it expects to close in Q2 2021. Both acquisitions represent Evolution’s commitment to being the #1 global live casino as both NetEnt and Big Time Gaming are two of the largest players in the online slots segment. These acquisitions therefore place Evolution as the clear global market leader in both live casino and live slots. And while the acquisitions do improve Evolution’s competitive positioning, they were also financially sound. NetEnt, for example, will provide Evolution with EUR 40 million in annual cost savings. Big Time Gaming was purchased for a total of EUR 450 million (which includes a EUR 230 million earnout subject to performance goals), which is a bargain given its historical 40% revenue growth and high EBITDA margins: 2021 revenues and EBITDA were EUR 30 million and EUR 29 million, respectively. It is hard to see how this deal would not be accretive to Evolution.
Moreover, Evolution is in solid financial standing. It has no debt, and roughly EUR 200 million of net cash on the balance sheet. The company is entirely self-funded, evidenced by the fact that it pays out 51% of its net profits as a dividend.
Competition
Evolution has partnered with the most globally recognized gaming operators and land-based casinos in the world, such as DraftKings, WilliamHill, PaddyPower, Unibet, Penn National, PokerStars, and many others.
Evolution benefits significantly from its first-mover advantage, having started out as a gaming provider in 2006. Its great timing into the industry has given it a significant scale advantage over its competitors, making barriers to entry very high in this industry. Its scale allows players worldwide to access the service 24/7 across several regions and languages. A new entrant will have to provide a subpar experience that is either not monitored 24/7 or has inferior technology, such as high latency and poor resolution. Additionally, Evolution has a dedicated 24/7 security team that monitors for fraud and player security.
Evolution’s games (and, not to mention, its dealers) have generated significant goodwill with its players. A casino that chooses another provider risks losing customers because they have hired an inferior competitor.
Management
Insiders own a significant portion of Evolution’s outstanding shares. Jens von Bahr (50, chairman of the board and co-founder) owns 13% of the company. The rest of Evolution’s management are incentivized appropriately as their share ownership far outweighs their annual salary, especially given the most recent run-up in share price. The CEO alone owns roughly EUR 50 million in Evolution stock relative to his EUR 1.4 million base salary. Other senior management board members are similarly incentivized.
Valuation
According to H2GC, the global gambling market in 2020 was EUR 293 billion, but 80% of this figure is from land-based casinos. The remaining 20% is left to online gambling, of which 27% is attributed to casino-style games. This equates to a EUR 16 billion total addressable market, which includes online and live casino, that Evolution is tackling. In 2020, Evolution captured 3.5% of this market with EUR 561 million in revenues. As gambling regulations become increasingly lax, however, I expect not only for this TAM to expand, but also that Evolution will continue capturing a wider percentage of it. For example, Evolution is currently only licensed to operate in the US in three states: Michigan, Pennsylvania, and New Jersey. The momentum and the path are set for online gambling to become legalized, which will unlock one of the largest markets in the world.
Evolution’s current share price of EUR 137 implies a EUR 35 billion market cap, which equates to a ~88x p/e on a TTM basis. While expensive at first glance, this multiple is warranted given the company’s rapid growth. I believe that the valuation still leaves room for investors to achieve a healthy return even after the multiple inevitably contracts.
The current valuation is extremely attractive if you believe that Evolution can reach EUR 4-5 billion in revenues in 2025, which is attainable given its current EUR 1B revenue run rate for 2021. If you assume a 60% free cash flow conversion rate (which is conservative given Evolution’s track record), you are paying just 10x 2025 FCF for an extremely high-growth business. Given that there are 219.4 million shares outstanding after accounting for dilution, this is equivalent to EUR 13.7 FCF per share on a 2025 basis.
Conclusion
Evolution is the leading provider of live casino games with no competitor that can match its offering, given its first-mover advantage and scale benefits that prohibit new entrants to provide a similar experience without significantly diluting its game offering or returns on capital.
Evolution’s management is experienced, having started Evolution in 2006, and is properly incentivized with significant skin-in-the-game, evidenced by significant insider ownership of Evolution’s equity.
Even though the share price has run up significantly, today’s price is an attractive valuation to enter a fast-growing business. Evolution is at the forefront of legalized online gambling, a nascent industry that is just beginning to gain traction in Europe and in the US. Evolution is the gaming provider that most worldwide operators choose and will continue to do so at the risk of losing customers by offering a cheaper, but worse alternative.