GVC Holdings — Update 4 February 2016

GVC is a leading provider of B2C and B2B services to the online gaming and sports betting industry. GVC’s B2C offerings mainly target European and Latin American markets with further operations in North America and the rest of the world. The company started life as Gaming VC offering the CasinoClub brand in Germany. M&A has long formed a key part of its growth strategy with the Betboo (2009), Sportingbet (2013) and now the Party Poker, Party Casino, bwin and Foxy Bingo (2016) brands all joining the group via acquisitions. GVC benefits from its own proprietary sportsbook and mobile platforms. The company’s recent acquisition of bwin.party (February 2016) was valued at £1.14bn and adds c 2,500 employees to GVC’s existing staff of c 520. The company is headquartered in the Isle of Man with offices in the UK, Gibraltar, Europe and world-wide.

GVC shares delivered a total shareholder return of 135% in the two years following the Sportingbet acquisition. That deal offered the company increased scale while revenues remained predominantly derived from unlicensed markets. The bwin deal offers even greater scale benefits and cross-selling opportunities, while also significantly increasing the company’s licensed revenues and diversifying its geographic spread. Assuming it achieves the expected synergies, GVC trades at a 17% discount to the sector on an EV/EBITDA basis for 2017e. We believe this represents a value opportunity that should close as the synergies are delivered, the company’s strong cash-flow generation becomes apparent once more, and the dividend is re-initiated in 2017e.

GVC is a highly cash-generative business partly due to the low capital requirements of the online gambling industry, but also due to the highly efficient and return focused manner in which its management team operate. We expect top-line growth as the enlarged group realises increased cross-selling opportunities, with strong profit growth as GVC brings its disciplined cost conscious management approach to the bwin asset base. We expect the EBITDA margin to rise from the 21.9% (GVC) and 16.5% (bwin) achieved by the independent businesses in FY14 to 27.1% in 2017 as the combined business begins to enjoy the full benefits of the €125m of anticipated synergies (calculated against the 2014 cost base; circa €110m off the 2015 cost base) .

GVC’s acquisition of the bigger bwin.party digital entertainment introduces the typical post deal integration risks. These include higher than expected restructuring costs, failure to realise the stated synergies as anticipated and technology risks resulting from the platform migration. These all have the potential to negatively impact GVC’s profitability and cash-flow generation, which could impede its ability to pay down debt as quickly as we forecast. As with other gaming companies, a key risk for GVC is that the regulatory environment may change in any of its key markets, which could imply new taxes, product restrictions or even civil or criminal action. The proportion of unregulated revenues is reduced by the bwin acquisition and GVC provides its services from licensed jurisdictions (and via a B2B arrangement into Turkey). It will apply for licences where they become available and are economically viable. Other sensitivities to our estimates are normal business and economic risks including sensitivity to consumer spending; competitive markets; dependence on key personnel and third-party software and payment providers; and FX exposures.

The February 2016 acquisition of bwin.party projects GVC into the top five of gambling companies globally by online revenues (see our 20 November 2015 Update report). The deal marks the continuation of GVC’s long held strategy of organic growth supplemented by M&A designed to facilitate entry into new markets, diversify its geographic footprint and expand its product offering. The online gambling market continues to grow strongly as technological advancements enable a richer user experience, particularly on mobile. The number of countries with more clearly stated regulation is also growing, leading to more licensed jurisdictions.

GVC provides its sports and gaming products on both a B2C and B2B basis, principally into European and Latin American (Latam) markets. Sports betting continues to be GVC’s core offering (contributing 41% of pro forma FY15e net gaming revenue, or NGR) and historically it has been the focus of the majority of its marketing spend; we expect this to continue. It then cross-sells other gaming products to its sports betting players. Historically this has meant casino games with a very small amount of poker and bingo. The bwin acquisition adds scale and standalone poker, casino and bingo brands including PartyGaming and Foxy Bingo brands (Foxy Bingo is one of the most popular bingo brands in the growing UK online bingo market). bwin also brings in a number of ‘Other’ businesses including Kalixa (payment processing), InterTrade (financial markets trading) and some small social gaming assets.

GVC’s board and executive team has a considerable depth of experience in online gaming, which has been further strengthened following a number of recent appointments designed to enhance management expertise and strengthen corporate governance. The 2013 acquisition of Sportingbet, where synergies were delivered ahead of time while still growing the business, provides a positive precedent for the coming bwin integration project, albeit with the bwin deal being on a larger scale.

Kenneth Alexander has been chief executive since March 2007 and was previously managing director of Sportingbet’s European operations, which he joined in 2000. Finance director Richard Cooper joined GVC in 2008, having previously been a founder of Trident Gaming in 2005 (which bought, developed and then sold the Gamebookers online gambling business).

Kenneth Alexander has already begun to restructure his management team to make the most of the best talent from both GVC and bwin under a management structure that emphasises clear reporting lines and management accountability. The newly combined sportsbook division will be led by GVC’s chief marketing officer Adam Lewis and bwin’s Labels director Sam Sadi. They will take the roles of group head of sportsbook marketing and group head of sports book operations respectively. Shay Segev will join as group COO while current GVC COO will become group head of trading and operations. Shay is the former COO of leading gaming software provider Playtech and his early focus will include leading the integration of the GVC and bwin technology platforms.

Jon Salmon (head of CasinoClub) will see the PartyCasino brand join his sphere of responsibility, while Tom Waters of bwin will head up the PartyPoker and Cashcade (including Foxy Bingo) operations.

bwin’s sports betting focus was a key feature of its appeal to GVC, and this has also been cited by bwin’s management as a reason why it saw GVC as offering an excellent cultural fit compared to a rival 888 bid. Outgoing CEO Norbert Teufelberger will join the GVC board as a non-executive director, bringing valuable experience at the board level, which will facilitate the integration process.

Two additional non-executive directors, Stephen Morana, CFO of Zoopla, and Peter Isola, senior partner at Isolas in Gibraltar, have been appointed to the board of directors following GVC’s promotion to the Main Market. Stephen spent 10 years as part of the management at Betfair, including serving as CFO and interim CEO during his time there. Gibraltar-based Peter brings extensive gaming law and regulation experience built up over a long legal career, having been initially called to the Bar of England and Wales and the Gibraltar Bar in 1982.

The management of the enlarged group is well incentivised with a new LTIP plan of c 29.5m shares. Within this GVC has announced that the Chairman, CEO and CFO have options over a total of 17.6m shares (at 467p and 422p) which vest over a 30 month period (subject to total shareholder return performance conditions).

GVC started life in 2004 as Gaming VC, which consisted of the largely German market-facing CasinoClub business. Over time management has successfully used a mixture of organic growth and M&A to grow the business, adding new geographies and product lines in the process. Key milestones include:

The bwin.party deal marks GVC’s second transformative acquisition in three years following the March 2013 acquisition of Sportingbet. We estimate that the enlarged group had 2015e pro forma revenues of €831m, making it a top five online gambling company globally, diversifying GVC’s revenues by both product category and geography. This is attractive as scale is becoming increasingly important as the industry goes through a period of significant consolidation.

The offer was approved by over 99% of both GVC’s and bwin’s shareholders in December 2015 and consisted of 0.231 GVC shares and 25p in cash for each bwin share. The deal was fully funded through a mix of GVC’s existing cash balance, an issue of new GVC shares and a €400m loan provided by Cerberus. Up to 194.8m GVC shares have been issued to bwin shareholders, giving them c 66% of the enlarged group.

The bwin deal shares similarities with the previous Sportingbet deal as it offers the opportunity for GVC’s management team to leverage its gambling sector expertise over a larger asset base. Like Sportingbet at the time of its acquisition, bwin has underperformed in recent years, (mainly due to failures post the bwin/PartyGaming merger in 2011 and declines in the poker market). As a result it offers the potential for considerable value creation should a successful turnaround be executed. The deal has the following appealing characteristics:

GVC has stated that it will migrate its players to the bwin.party platform in a way that minimises any potential disruption. As a result management has stated that it will take place after the UEFA Euro 2016 Championships and will begin with the smaller brands such as Betboo. This will offer the opportunity to iron out any unforeseen issues before migrating the larger number of Sportingbet customers. Moving GVC customers across to the bwin platform has a number of advantages:

According to gambling market intelligence firm H2 Gambling Capital (2014), the global online gambling market has grown significantly in size over the last 10 years at a CAGR of 13% to 2014. This is well ahead of the broader growth of the gambling market, which is estimated to have been 3.3% over the same period. As a result by 2014 online gambling had risen from a relatively nascent revenue stream to make up 8.4% of total global gambling revenues worth $34.8bn in 2014, and is expected to continue to grow at 8.7% a year from 2013 to 2018. Within this mobile is the primary growth driver in every product vertical, largely driven by the increased adoption of smartphones and tablets and growing high speed internet penetration across the world. With an estimated CAGR of 27%, mobile gambling is expected to grow to $19bn and represent 40-45% of online gambling revenues by 2018.

The strong headline growth figures somewhat mask the fact that individual gambling markets are extremely heterogeneous, largely as a result of differing regulatory regimes. While land-based gambling regulation is well stated in most countries, legislators have been slow to implement laws relating to the specific practicalities and nuances of the online channel. In Europe a number of countries are now fully regulated (eg the UK, Italy, Spain, Denmark), while others are in different stages of introducing regulation (eg Netherlands). Markets that are still unregulated range from those where the licensing regime is fluid, such as Germany and Greece, to those where online gambling is only legal if supplied by local monopolies, such as Turkey.

Both regulated and unregulated markets can from time to time produce fluctuations in earnings, if there are changes in the level of advertising allowed, products that can be offered and the licensing and tax structure. Typically there is a ‘J-curve’ in profits when new markets regulate, with a dip in profits due to the introduction of new taxes and licensing costs but with the market subsequently growing more rapidly due to new advertising opportunities and greater consumer trust.

Scale is becoming increasingly important. Regulatory costs, marketing costs and IT costs have all grown significantly in recent years, requiring operators to have very deep pockets just to maintain their position. As a result, M&A activity in the industry has picked up over the last 18 months (as shown in Exhibit 4) and we would expect this to continue in the medium term. GVC’s management have clearly stated that M&A remains a core part of their corporate strategy and we expect that they may be part of a further round of future industry consolidation once the assimilation of bwin has been successfully completed.

Regulatory risks: the acquisition of bwin has increased the proportion of GVC revenues derived from regulated markets to over 50%. However, in common with most other online gambling operators it also operates in unregulated markets, which could introduce licensing regimes at some stage, with new associated taxes. Typically this produces a ‘J-curve’ in profitability and eventually expands the market due to freer advertising and greater customer trust. Even regulated markets may change the range of permitted products or tax rates from time to time (eg the December 2014 15% UK Point of Consumption POC tax). There is a risk that an individual market reduces in size due to clampdowns or product restrictions, or even that GVC faces civil or criminal action in an unregulated market. GVC minimises regulatory risk by diversifying across a range of geographies, being extremely experienced in its markets, supplying its services from licensed jurisdictions and closely following regulatory developments.

VAT: From 1 January 2015 the EU’s VAT rules have changed so that VAT on electronic services is applied based on the location of the consumer rather than the provider. Both GVC and bwin have been paying this (in Germany and Ireland) but there is some potential historic liability and some uncertainty regarding the basis of calculation (Ireland has clarified that it is based on NGR).

General business risks: GVC and the enlarged group are exposed to general economic risks including the strength of consumer spending in different markets. GVC has some exposure to Greece, where capital controls were imposed in 2015 that can severely restrict remittances and where further economic volatility could continue to affect consumer confidence. Other general business risks include dependence on key executives and personnel; fluctuating sports margins; issues relating to IT and technology (including some reliance on third-party providers); and competition (the group’s markets are highly competitive and rapidly evolving/consolidating). Both GVC and bwin management has long experience in their markets and in managing such risks.

Dividend policy: GVC’s stated dividend policy is to distribute at least 75% of net cash generated. However, a combination of the debt covenants attached to the Cerberus Loan Agreement and the anticipated restructuring costs resulting from the integration of bwin into GVC mean that it will take a dividend holiday in 2016. The company intends to resume dividend payments in 2017 once a material proportion of the expected synergies have been realised. Should that realisation be delayed or ultimately fall short this would negatively impact the company’s ability to re-instate its dividend as planned. Failure to refinance the Cerberus loan on attractive terms could also impact the timing and size of the reinstatement of the dividend. GVC’s dividend record has been very consistent, and management have strongly stated a commitment to returning to the dividend payers register. It should also be noted that following the Sportingbet acquisition, GVC realised the anticipated synergies quicker than originally anticipated.

Currency: Both GVC and bwin operate in international markets. About a third of GVC’s revenue is euro denominated and the two other most important currencies are the Turkish lire and, to a lesser extent, the Brazilian real, which it does not hedge. Both currencies have devalued materially over the past year. GVC has indicated that 40-50% of the enlarged group’s earnings will arise in euros (the reporting currency).

GVC is an established company in a competitive sector. Therefore we believe that peer group comparison is the most appropriate method by which we should assess its valuation. We consider Stockholm-listed Betsson to be the closest peer to the enlarged group, although it derives a much higher proportion of its revenues from unregulated markets (80-90% on our estimates), including a B2B business in Turkey (25%e of gross profit). Unibet is also pure online sports-led businesses with sizeable operations in unregulated markets and are closer comparators than the much bigger Ladbrokes and William Hill with their land-based estates and 888, which is casino led.

GVC has historically traded on a valuation discount of approximately 20% to its peer group (on an EV/EBITDA basis) in recognition of its relatively higher exposure to unregulated markets and small size (pre-deal market cap c £280m). However, the bwin deal reduces the proportion of revenues that the company derives from such markets and materially increases its scale. As a result we believe this warrants a positive re-rating in GVC’s share price, as does the move up to the Main Market - something which has started to happen in early trading following the completion of the deal.

Based on our forecasts, GVC trades at a slight EV/EBITDA discount to the peer group on FY16e numbers, although we believe these forecasts understate the steady state profitability of the enlarged business, and at a 17% discount on 2017e. The gap widens in 2018 (not shown here) when we expect the full effects of the expected synergies to be achieved. Any positive newsflow regarding the success of the integration process is likely to act as a near-term catalyst which we believe will narrow the forward discount.

We commented on both GVC and bwin’s 2015 recent trading updates in our Update note dated 11 January. We expect the combined GVC and bwin businesses to report pro forma revenues of €831m for FY15. Within this GVC has reported in its trading update on 11 January 2016 that it achieved NGR of €247.7m. This compares with our last published 2015 revenue forecast (July 2015) of €240.0m and constitutes y-o-y growth of 10% over the €224.8m achieved in 2014. Revenue was split broadly equally between Sports (€116.0m) and Gaming (€131.8m) with each demonstrating solid growth of 5.3% and 15.0% respectively. This was despite significant currency headwinds in some of its most important markets (the Turkish lira fell by c 15% y-o-y versus the euro while the Brazilian real fell by c 30%). Also 2015 lacked a major summer football tournament and the resultant boost to demand for sports betting. The enlarged group will benefit from the UEFA Euro 2016 this coming summer.

We believe that GVC will have delivered a clean EBITDA margin of 20.6% in 2015e. This is slightly down on the 21.9% achieved in 2014, largely reflecting the increased tax burden resulting from additional VAT payments in some European markets including Germany and the UK POC tax that was introduced in December 2014.

bwin reported 5% growth in Q415 revenue (with strong performance in sports and casino), which points to full-year revenue of c €583m, including an estimated €223.2m from sports betting, €196.0m from casino, €60.5m from poker and €53.3m from bingo. This constitutes a fall of 6.3% (€36.1m) when compared to 2014. The majority of the fall in NGR comes from the company’s continued struggles in poker, which mirror wider structural industry challenges in the poker vertical, while the fall in ‘other’ revenues reflects the sale of a number of non-core businesses such as Winners, World Poker Tour and Win.

Exhibit 6 shows both pro forma and reported numbers for 2016e to illustrate both the underlying 12-month trend and our forecast reported numbers which incorporate 11 months contribution from bwin consistent with the 1 February deal close.

We expect pro forma 2016 NGR to rise modestly by €15.7m to €796.4m. This constitutes underlying growth of 2% y-o-y of the group’s core gaming revenues, with the legacy GVC business contributing 5% while we hold bwin broadly flat. This recognises the fact that the UEFA European Championships 2016 will take place this year, but also allows for a further fall in bwin poker revenues, albeit at a reduced rate, together with a small amount of player attrition, which we believe is an unavoidable part of any platform migration. At the group level, we expect pro forma revenues to fall slightly by €6.3m to €824.4m, reflecting our forecast decline in ‘other revenue’ resulting from the full-year effect of the 2015 disposal of non-core businesses.

We subsequently expect a pick-up in growth and forecast 6.1% of revenue growth at the group level in 2017, as the positive effects of GVC’s management plans start to be felt, including the planned optimisation of bwin’s marketing expenditure and an increased level of cross-selling across the group.

In the prospectus GVC identified €125m of cost synergies. However, this took 2014 as the base year. bwin’s management has already reported that it achieved c €15m of synergies in 2015 as part of its existing cost-cutting programme. We expect GVC’s management to significantly accelerate this efficiency drive, assisted by the synergies made possible by the coming together of these complementary businesses.

We have forecast recurring synergies of €110m (off the 2015e base), which will ramp up between 2016 and 2017. We assume €38.0m in 2016, calculated on the basis of a 58% run rate by the end of 2016 (but with most falling in the later months of the year). The full run rate should be achieved by the end of 2017 (we assume €71.5m to allow for the monthly ramp-up towards the total of €110m by the end of 2017, which is fully recognised in 2018). The restructuring costs required to achieve these synergies are estimated to be €60m which we estimate will be spread €55m in 2016e followed by €5m in 2017e. Assuming that these synergies are achieved in line with management’s current timetable, we would expect the clean EBITDA margin to rise to 23.8% in 2016p before settling at around 30% in 2018.

We expect normalised EPS to fall in 2016 due to the dilutive effect of the deal in the short term. We then expect EPS to rise sharply over the subsequent two years due to the recurring nature of the synergies and a falling interest expense. We have assumed that depreciation will continue at around historic 2015 levels but recognise that this may be change subject to possible post acquisition asset write-downs. We have also assumed a new €200m debt facility to replace the Cerberus loan in 2017e. Exhibit 6 also shows an 11-month representation of the group’s financials to illustrate our forecasts for expected reported earnings. It includes €38.0m of estimated synergies which we expect to start to be realised some months after the 1 February deal completion.

Online gambling is a highly cash-generative business and GVC’s management is recognised as being amongst the most efficient operators in the industry with a high level of costs discipline. We forecast a cash outflow of €107.3m in 2016, allowing for deal fees (€77m), restructuring/other charges (€55m) and interest charges of €50.0m (the Cerberus loan of €400m at 12.5%; our P&L forecast also includes €6.5m of capitalised interest). Management has stated that it intends to take a dividend holiday in 2016e as one of the conditions of the Cerberus loan agreement. The Cerberus loan was arranged quickly to ensure that the bwin deal could proceed in a timely fashion and as a result we believe that the 12.5% coupon is higher than a company with GVC’s expected high level of cash-flow generation would ordinarily pay. We are confident that GVC should be able to refinance it at a much more attractive rate. Consequently we have reduced the rate of interest payable to 7.5% from March 2017e (on an assumed €200m of refinanced loans) and expect net finance charges to fall to €20.8m (€24.9m including capitalised interest) as a result. This is a fraction of the €221.5m of operating cash flow that we forecast for 2017, providing plenty of headroom for management to return to the dividend payers register in 2017. We expect c 44c per share to be declared in 2017e (with 32c paid). We subsequently expect the dividend to return to its pre-deal level of 56c per share in 2018e (with 52c paid in that year).

Both companies have historically operated with conservative capital structures, with GVC carrying a nominal level of net debt on its balance sheet (mainly the William Hill loan re: the Sportingbet deal) and bwin bringing in estimated net cash of c €26m. The overall impact of the bwin acquisition means that we expect end-2016 net debt of €120m, which falls significantly in 2017 to €56.1m and then to only €7.6m in 2018 (despite allowing for €161m of dividend payments in that year). We believe that this level of cash generation gives GVC plenty of financial flexibility to participate further in future industry M&A.