Cube Midcap Report (10 Sep 2019) – Unlucky 888 #JD
Good morning! The midcap report returns today, and I am looking at:
Separately, Ashtead (AHT) delivered Q1 results in line with expectations and the business services group Sanne (SNN) also said that it had confidence in its full year outlook when publishing its own half-year report.
- Share price: 156.85p (-7%)
- Market cap: £577 million
At the time of writing, I have a long position in 888.
I’m going to write a summary of the results first, before watching the analyst presentation at 10am.
This is a share I have held for less than a year, after noticing that it seemed unduly “cheap” (though I’m not sure if I would make the same trade today, as my quality filters are becoming more and more restrictive).
My entry price is 161.6p, and I have received 6.2p in dividends so far. So you could say that my dividend-adjusted entry price is 155.4p.
The main point from today’s report is that trading is in line with expectations. While the RNS unfortunately doesn’t state what these expectations are, I understand that the company is forecast to generate revenue of $561 million this year, with $84.7 million of EBITDA and $64.2 million of EBIT.
The company’s cash balance at the end of H1 was $111 million.
To get a sense for current valuation, therefore, let’s convert the latest market cap to USD: at latest exchange rates (GBPUSD = 1.23), the market cap is $712 million, making for an enterprise value of ~$600 million.
The EV/EBIT multiple is therefore around 9.3x. Still pretty cheap, I reckon, but let’s think about what we’re getting for this price.
Like-for-like revenues increased 7%, “driven by the UK turnaround and progress in regulated markets”. UK revenue growth is 23% at constant FX.
With respect to categories, the gains have been “led by Casino and Sport”, while the performance at Bingo has been weak and Poker has been very poor.
The B2B and B2C revenue splits reported by 888 are tricky to understand, since some of the revenue streams have migrated from the B2B segment to the B2C segment, due to acquisitions.
The best thing to do is focus on the specific categories of B2C income:
- Casino revenue up 6% (9% at constant FX)
- Sport revenue up 19% (28% at constant FX)
- Poker revenue down 24% versus H1 2018, but the company highlights that it has improved 26% compared to H2 2018.
- Bingo down 3% on a like-for-like basis, after adjusting for acquisitions. Up 10% on a statutory basis.
The declining value of the pound and the strength of the dollar has been a blow to the statutory results, as the UK is the largest source of revenues and the company reports its results in USD.
Notes from the analyst call
Following the CFO’s description of the numbers, the major part of this is the operational review by the CEO.
He is particularly proud of the turnaround in the UK, which he reminds listeners is the biggest online gaming market in the world. His ambition is for 888 to be “the leading online casino brand globally”.
Inside the Casino, the company has developed many of its own proprietary games (“Mermaid’s Millions”, “Egg-Xtravaganza”, “Lucky Orbs”, “Noche Muertos”, “Greedy Dragon”). 888 naturally enjoys higher margins from its own games studio, as it doesn’t have to pay 3rd-party providers for their work.
It also wants to be a “top-tier” Sports provider. Sport had a really good H1, despite not having an international soccer tournament this year. Euro 2020 will provide more opportunities next summer. 888sport has its global hub in Dublin.
Poker: the CEO confirms that 888 wants to remain as a top 3 Poker provider. Through product enhancements and shared liquidity, the company is looking for this category to return to growth. 888 continues to sponsor the World Series of Poker event – an event that I personally love watching – and this should help to maintain 888’s high profile in the poker community.
Poker is also undergoing “the biggest product enhancement project” within 888, with new ideas including portrait mode on mobile. They want to make it as fun as possible for recreational players – but I hope they are thinking about professional players, too, because the pros provide a huge amount of the liquidity on poker sites. As 888 itself acknowledges, “liquidity is king”.
In the USA, 888 has a “Smart and Selective” strategy. It’s not looking to move into every State, but instead looking for the attractive ones only. This is the same as the company’s approach in Europe.
There’s not much here to change my view of 888. It still looks like a well-managed and diversified online gambling brand.
The negative share price reaction can be explained in a variety of ways. I note that the share price rallied from a low of around 140p last month: tome traders may have been speculating that it would upgrade expectations, and they have been disappointed.
Also worth noting that the interim dividend has been reduced from 4.2 cents to 3 cents, and this might triggered some investors to sell. The dividend cut doesn’t bother me in the slightest, as I hope that the company can think of more useful things to do with its cash balance than returning it to shareholders, and I’m happy for it to remain cash-rich. But it could also be a factor.
In terms of the financial performance, the increase in 888’s international gaming duties are my main concern.
The CFO presented this useful chart (click here for full size).
Gaming duties in H1 increased from $38 million to $45 million, driven by a $6 million increase in the UK.
Gaming duty rates have increased, and so has 888’s revenue in those markets with increasing duties. So the gaming duty bill has increased materially, from 13.8% to 16.2% of revenue. This helps to explain why 888’s adjusted EBITDA margin fell from 19.2% to 15.1%.
After increased amortisation (due to M&A activity) and all other costs, H1 PBT more than halved to just $22 million
Looking forward, there is a risk that European governments will continue to see 888 and other gambling operators as an easy source of cash. Increased gaming duties might drag on margins again and again.
On balance, I’m likely to hold on to my stake in 888 for a while longer. The performance hasn’t been as good as I hoped but neither has it been a disaster. Gaming duty rates and exchange rates are ultimately beyond the company’s control. If you strip out their effect, it seems to me that 888 has done fine.
The company continues to make good progress in developing its customer base. For example, the chart below shows the long-term trend in deposits, from 2010 to the present day.
Deposits continue to grow, and are more weighted to the “regulated” markets (coloured in blue) than ever before:
While the regulated markets require higher taxes, they arguably suffer less political risk in terms of the radical change that they might undergo. Nearly three quarters of 888’s revenue is now from these regulated markets.
So I intend to keep holding 888 for now, and see if a return to profit growth might cause a rebound in its market valuation.
Besides the duty rates, results have also been held back by strength in USD. A reversal of the recent trends in exchange rates could see a strong boost to the bottom line, and renewed optimism for the stock. I’m going to try to be patient with this one.
JD Sports (JD.)
- Share price: 670.7p (+6%)
- Market cap: £6,525 million
These are some nice results. PBT is up by 6.5%, or by 12.8% if you strip out the effect of the new accounting rules which apply to leases.
These rules, for those of you who don’t know, require companies to bring their leases onto the balance sheet. They even apply to the likes of 888, but the effects are much more dramatic for retailers such as JD.
JD’s results are further improved if you are willing to strip out the £21 million partial impairment of goodwill, and other exceptional costs, relating to the tents and camping business Go Outdoors.
Problems at Go Outdoors contributed to a £20 million loss at JD’s Outdoors division, though the group still thinks that it has good long-term potential.
But the core remains strong…
I don’t feel qualified to judge whether the camping business does or does not have long-term potential. But let’s leave it aside for a moment.
If we focus only on the core Sport Fashion segment, operating profit has increased by a stunning 47% to £188 million (using the old accounting treatment).
The operating profit result is not quite as shiny under the new accounting treatment, but is still very positive.
While the accounting rule changes have a huge impact on the income statement, they shouldn’t have any effect on cash flows. Strong underlying performance is reflected in a huge swing from net debt of £85 million a year ago, to £118 million of net cash at the end of H1 this year.
The proposed capex spend this year (£175 million – £200 million) is comparable to last year (£186 million), with the spend switching from the company’s Rochdale warehouse to its retail fascias.
What has gone right?
Executive Chairman Peter Cowgill comments:
Against a backdrop of widely reported retail challenges in the UK, it is extremely encouraging that JD has delivered like for like sales growth of more than 10% with an improved conversion reflecting consumers’ increasingly positive reaction to our elevated multichannel proposition where a unique and constantly evolving sports and fashion premium brand offer is presented in a vibrant retail theatre with innovative digital technology. JD also continues to gain momentum in Europe with a further double digit increase in total like for like sales and a net increase of 23 stores in the period.
Well done to JD for beating the retail gloom and delivering strong LfL sales growth.
JD seems to be in the sweet spot of the “athleisure” trend, where young people buy sports gear for socialising. Its rival Sports Direct (SPD), meanwhile, is more focused on the traditional sportswear segment (i.e. clothes which are actually used for sport!)
Another point of contrast between Sports Direct and JD concerns their M&A strategy.
Sports Direct, under Mike Ashley, has gone on a strange buying spree of all sorts of beaten-up retail stocks, and most recently has been engaged in a battle with Debenhams.
JD, on the other hand, seems to be more careful in how it approaches corporate activity.
It has made “a number of small selective complementary acquisitions” in fashion brands, including a tiny (£1.5 million) deal for Pretty Green, out of administration.
Much more significantly, it picked up Footasylum for £86 million (and £8 million of net debt) in April.
Footasylum (FOOT) had been publicly listed since 2017, at around 200p per share, before shocking investors with a couple of nasty profit warnings. JD picked it up for 82.5p per share, and the Competition and Markets Authority is now reviewing the deal. It’s not hard to imagine some synergies which could be achieved by this deal.
While the acquisition history at JD is hardly perfect (see Go Outdoors above), in my opinion it is far more reasonable than the picture at Sports Direct.
I admire JD’s performance, but I bring my customary caution to it, as I do to all retailers.
It would take an awful lot to convince me to add another traditional retailer to my portfolio, in addition to Next (NXT) which I have held since early 2017. But there is no denying the fact that JD has performed exceptionally well.
If forced to add another retailer, maybe I would choose JD?
Out of time for today, but I hope this was interesting! See you again soon.
All the best,