Why This Investor Believes A Long Position In Online Bingo Is No Risky Gamble

Jackpotjoy plc. (formerly called Intertain) is a Canadian online gaming company that focuses primarily on online bingo. Despite some negative outlook on the company recently, Intertain recently relisted on the LSE and is the dominant player in the UK online bingo industry. Lennard Zwart, portfolio manager at Amsterdam-based family office Res Privata, believes Jackpotjoy has taken off in a new direction after the relisting and a debt refinancing. Meanwhile, the complex structure of the company has hidden the true healthy state of the business, which he believes is set to re-rate to at least double its current value.

SumZero: What about Jackpotjoy (JPJ) initially caught your eye as a value investor?

Lennard Zwart: We like to look at special situations in the current environment, and JPJ was a relisting that was also subject to a lot of attention by short sellers, so we took a closer look. After my fellow portfolio manager Iljaas Abdoella and I concluded that the short arguments were not valid anymore and that the stock had a very attractive and stable cash flow, we took a small long position. After the stock dropped hard in October of 2016 because it encountered relisting delays and the appearance of another short report, we made this our second largest position at a 20% normalized cash flow yield.

SumZero: What is the market missing?

Lennard Zwart: This company was basically an ugly rollup with a management team that was more remuneration focused than shareholder focused. Early in 2016, the board of the company was already administering some effective self help however through getting rid of most of the old management team and deciding on a UK-centric strategy.

Another factor as to why people do not like the stock is an outsourcing agreement with Gamesys, which has caused people  to worry about Gamesys entering the bingo market themselves when cleared in 2020. We believe the risk that Gamesys will reenter is small as Gamesys has a lot of skin in the Jackpotjoy game.  Gamesys receives  part of their revenue, has future milestone payments and also has a large JPJ share holding. JPJ can also do significant damage to Gamesys by pulling away its bankroll for the people working at Gamesys on JPJ’s behalf. Gamesys has also stated that they want to be a platform company and not a business-to-consumer company. Another important point to remember is that there are actually not a lot of gaming companies that own the IP of their tech. Last year Gamesys extended its noncompete by two years.

We consider the change in investor base and some scary looking regulatory and tax moves in the UK to be the final ingredients contributing to JPJ’s undervaluation.

SumZero: What key metrics should investors be paying attention to as your thesis matures?

Lennard Zwart: I’d initially pay attention to deleveraging related metrics. When JPJ reaches a credit facility leverage of 2.75, the company intends to start paying a dividend. This leverage stands at 3.37 at the moment but before the company can start reducing their credit facility leverage, they need to pay about GBP 135m of earnout liabilities. We expect the 2.75 level to be reached around Q1 2019 but a large portion of the stock’s re-rating will take place before that. Ongoing reductions in leverage will increase JPJ’s comparability with the other gaming related stocks on the LSE and during this process its attractive EBITDA and FCF multiples will become more important.

SumZero: How has the relisting of Jackpotjoy on the London Stock exchange created value for the company?

Lennard Zwart: Most importantly, it has created value for us as the delay in the listing provided us with some appealing entry levels. In all seriousness though, one of the reasons the relisting will add value for JPJ is because the GBP accounts will neutralize the currency related volatility as most of the revenue is in British Pounds. Even more importantly, the company has a lot of comps in London and these imply the JPJ market cap should at least double based on EBITDA and FCF multiples. We can now start to see UK research initiation with favorable coverage of the name. This, together with the deleveraging and dividend prospects will drive institutional ownership and share price gains over the next few years.

SumZero: Why isn’t the online bingo industry as competitive as the rest of the online gaming world?

Lennard Zwart: Bingo is a smaller subsection of online gaming, much smaller than online casinos and poker. Also, the customers skew more female and they tend to have a greater focus on the social element which JPJ captures through its prominent hosted chat function. This means that they tend to be more loyal. For JPJ specifically, online Bingo is less competitive because with 22% market share they are the largest player with the largest bankroll and hence the best win ratio. The second largest player only has 14% of the market.

SumZero: Is there a growing cultural headwind against gambling that could affect future earnings?

Lennard Zwart: We don’t think there is a cultural headwind against gambling, at least not in Europe. There is political pressure to close tax loopholes and regulatory pressure to curb excesses and ensure fair treatment of customers. We believe developments like the UK Gambling Probe entail a maturing of the industry and that regulation will be good for incumbent market leaders like JPJ.

SumZero: Intertain has had a difficult history. Can you explain what happened in 2016 with allegations against the former CEO and CFO? How does this affect your view?

Lennard Zwart: The old management team was accused of extravagant behavior and had a generally checkered past. The short thesis against JPJ went on to accuse this management of basically cooking the numbers. This last assertion we believed to be incorrect and together with the fact that most of the old management team was replaced, this made us very comfortable viewing the reputation of the old management as a source of undervaluation.

The CFO of the old management team is still in place. We met him and he seems competent and on board with the new direction of the company, even though we do not like the size of his legacy remuneration package.

SumZero: Has the UK Gambling Probe had any effect on Jackpotjoy?

Lennard Zwart: The latest probes are focused on unfair treatment of customers and betting terminals in offline betting shops. These are both generic in nature. In terms of fair treatment of customers, one just has to look at the brand loyalty within JPJ’s customer base to see that this is not an issue for JPJ. They have a nice graph on customer loyalty in their investor presentation. Weeding out the chaff will entrench JPJ’s position.

SumZero: What are your thoughts on the assertions that the margins for JackPotJoy are over-inflated after the acquisition?

Lennard Zwart: That was basically the heart of the short argument. We pointed out that taking a consistent tax basis and operating leverage into account, the cost basis for the JPJ activities and the margin development pre- and post-acquisition were consistent, including the introduction of the POC taxes in 2015. We later confirmed our calculation when the Gamesys accounts became available last January. Instead of confirming the short thesis, this analysis showed how robust the JPJ segment was in terms of growth and operational leverage as JPJ quickly mitigated the negative POC tax effect through organic growth and operational leverage.

SumZero: What are the biggest risks associated with the trade in your view?

Lennard Zwart: There could be some dramatic political or Brexit related event happening to the UK gaming market. We could also be wrong about Gamesys not making  a new entry into the UK online Bingo market. Both of these risks seem pretty small to us relative to JPJ’s valuation. Furthermore, any adverse Gamesys move would be at least a few years away given the recently extended non-compete clause.

SumZero: What will catalyze the market to see the value in Jackpotjoy?

Lennard Zwart: We believe steady deleveraging driving down the debt and driving up the EBITDA multiple will catalyze the market. Then, during 2018 the deleveraging will drive the company to be mainly valued on its prospective dividend and FCF yield towards the UK peer group.

SumZero: Where else do you see value in the market today?

Lennard Zwart: The US market is obviously very richly valued and we are not very comfortable with the political and structural issues in Europe. At the same time we do not want to venture outside of our circle of competence (in terms of the country risks and accounting standards that we know). The upshot is that we hold a decent amount of cash and we concentrate our investments on very high margin of safety stocks in terms of asset values and stability of cash flows. These stocks tend to be small to midcaps at the moment. We also focus on complex special situations (spinoffs, regulatory changes, liquidations etc.). This strategy provides a decent level of relatively uncorrelated returns while we eagerly await the next bout of turbulence.

SumZero: Tell me about your fund strategy and focus?

Lennard Zwart: We just started our fund and are currently building our track record with our own capital. Res Privata invests in pretty much every instrument available on the company level and geographically we look at all the English speaking countries and Western Europe.

Our strategy is to find alpha on the intersection between value investing and quantitative analysis. This means we combine thorough value based analysis with quantitative behavioral finance methods to help us identify valuations that are incorrect because of human biases. Crucially, the system will also warn us when we threaten to follow our own biases during the investment process. Not exactly by coincidence, identifying biases and ignoring our own is exactly what the dicey backstory of Intertain / JackPotJoy called for.