William Hill: Long-term growth at a value price

William Hill is one of my favourite companies right now: the long-term fundamentals of the industry are good, management are adept at utilising new technology, and the potential from acquisitions is large. Let's look at these points one-by-one.

1) Long-term fundamentals

By instinct I am a value investor so I spend most of my time thinking about companies facing pretty poor long-term trends.William Hill offers the best of both words: long-term secular growth at a value price.

The key to William Hill's potential is online gambling. Not only is this product taking share from offline gambling but, more importantly, online is rapidly increasing the overall demand for gambling.

Let's put some numbers to this. In 2009, total off course gambling turnover, as estimated by the Gambling Commission, was £9.9bn. Horse racing made up about 57% of the total amounts wagered. In 2014, the total amount wagered off course was £8.9bn. Horses made up about 54%.

In 2009, online gambling turnover was £10.2bn. Data for the breakdown by sport isn't available for this year. In 2014, online gambling turnover was £25.4bn with football making up 40% of the total. Tennis is also a huge market worth some 20% of the total.

So lots of numbers, what are the takeaways? First, is that online gambling is growing rapidly but, somewhat surprisingly, this hasn't resulted in massive falls offline. The reason why, and I think something slightly contrary to what bookmakers are saying, is that the average online gambler is different from the average offline gambler. Yes, a lot of people use both but the real growth is online-only gamblers betting on sports like football and tennis.

How big are football and tennis? In 2009, £4.3bn was wagered on football online, now £10bn is wagered every year. Offline, only £1.1bn was wagered offline, less than the dogs. In 2011, £2bn was wagered online on tennis, now £5.0bnis wagered annually. Tennis isn't even a big enough category offline to feature in Gambling Commission statistics.

Compare this to horse racing, £4.8bn wagered offline but £1.9bn wagered online in 2014. Horse racing is clearly still a very significant category offline, particularly as it has huge gross gambling yields, but it just isn't that relevant online.

The truth is that the new consumer attracted to online gambling isn't going to go into a betting shop, they are seedy and pretty awful. I think bookmakers, including William Hill, are completely overstating the synergies between offline and online. Yes, a significant minority of online customers may have then gone offline but the growth and real potential has all been online. Online gambling has fundamentally reinvented the industry.

Now, of course, this isn't all good, William Hill owns a ton of offline gambling locations. Retail is pretty much the worst business to be in when your top-line declines. Operating leverage destroys the bottom-line quickly. So people look at William Hill and think, "Yeah this online stuff is great, what in the name of God are you going to do with all those shops?".

Well, this is legitimate question and one that management really haven't answered. The emphasis on multi-channel growth suggests that nothing drastic is going to happen for a few years at least. This is fine as the business continues to generate cash. It is worth pointing out though that a non-trade buyer with the right liability structure could clean up by rolling up a few offline bookmakers. As mentioned already, the offline product is just different. Different customers betting on different sports with different gross win margins. I don't think the offline business matters though for two reasons.

One, at the moment we have a situation where online continues to grow but is offset by decline offline.Run this forward ten years though and the situation will clearly be quite different. Online will continue to grow and if the industry does consolidate, given regulatory changes this seems likely, then pricing should improve too. Two, the potential outside of the UK is huge. Bet365 has already demonstrated this, it is number one because it has cracked the big gambling markets like Australia, Spain, and Italy. However, online gambling penetration is still relatively low in these countries. William Hill can apply the marketing expertise gained in the UK to these situations, the dramatic fall in CPA in Australia is an example of this. Which leads to my next point.

2) Online Marketing Expertise

Compare the companies that have done well online and those that haven't. Famously, Ladbrokes and BWin have done very badly online, why?

The basic reason why is that William Hill understood that marketing online isn't the same as marketing offline and they dedicated resources, and equity to Playtech, to making it work. Whilst Ladbrokes was trying to add physical locations in Europe and BWin was cutting huge sponsorship deals with European football teams, William Hill was hiring in the digital marketing experts at Playtech. Running affiliate networks, optimizing promotions, and closely analysing marketing ROI is what made William Hill the leader online. 

The deal with Playtech looked rather foolish at the time, William Hill gave up equity in a solidly profitable business to an unknown entity, but was clearly hugely valuable in the long-run. This value isn't recognised in the price. 

Online marketing ability is starting to be recognised but remains basically poorly understood, an example of what really good marketing can achieve is Plus500. Yes, there are some questions here but we basically have a company that went from zero to generating huge amounts of cash due to very capable online marketing. Investors are just beginning to wake up to the huge scale economies here and realise that skill here does create a legitimate competitive advantage, particularly when your competitors seem to enjoy setting fire to their money by sponsoring Real Madrid.

As online gambling continues to grow, I think the value of this expertise will become more apparent to investors.

3) Potential acquisitions

William Hill's failed 888 bid indicates we are on the cusp of another period of consolidation in the industry. Increased costs in regulated markets mean that larger companies now have the advantage, acquisitions can be used to build scale and realise the substantial economies inherent in the online model. What are the possibilities here?

Well the first point to note is that William Hill probably can't be bought out itself. Anyone who is large enough has market share in the same market and probably wouldn't want the physical retail assets. I would say that William Hill really needs to have a plan in place for the retail assets, they are generating cash right now but at some point they are a roadblock for further strategic moves.

If we look at Paddy Power or Ladbrokes, we can make the same point. Paddy Power has a great online business and an emerging powerhouse in Australia but has a ton of stores. A trade buyer could come in and try spinning the stores to a non-trade buyer, that would work nicely but it is obviously a complicated deal. 

Ladbrokes, in my view, has almost zero strategic value to anyone but private equity. The online business is largely worthless as it stands, Playtech could turn it around but the fact that it has taken more than half a decade to get to this point suggests that management are the problem. Some of the acquisitions they made, what is now Ladbrokes Exchange formerly Betdaq, look decent but they are clearly quite a few steps behind now. Betting on Ladbrokes is just a bet on the value of the offline business, a tricky bet to make give regulatory uncertainty.

BWin has been mooted as another takeover candidate. We know that Amaya, Ladbrokes/Playtech, William Hill, and private equity came in to have a look...and didn't appear to like what they found. There is an activist here but it is pretty clear they are up the creek without a paddle. In particular, they failed to understand point 2, online gambling is very different from offline. BWin did huge sponsorship deals that did nothing for the bottom line. The company has a good position in Spain and a creditable casino business. Eventually, someone who understands how to cut costs will come in and divide up the corpse. Management's hostility to this seems to have been the sticking point so far.

888 is an attractive target, the introduction of the point of consumption tax is really going to hurt them. They are very good at what they go but are beginning to look slightly sub-scale, companies like William Hill can spend much more on marketing but at a lower proportion of revenue. A buyer could also realise greater value from cross-selling with a better sports betting product. William Hill probably thought they could come in after PoC was implement and pick up a bargain, insiders seem to have resented this. I don't think that 888 can stay independent for long. GVC is another possibility, I don't actually understand this business well but there is a long standing relationship with William Hill as they cooperated for the acquisition of various parts of Sportingbet. The sports betting product at GVC is clearly very good, I am not sure about the markets they operate in.

Betfair is the black sheep of the industry, half bookmaker and half betting exchange. The first few years of listing were deeply unsuccessful. A high cost base combined with poor UI meant that the jazzy multiple paid at listing quickly looked ridiculous. New management were brought in and have turned the company around. The problem for any acquisition is that the exchange product is kind of a substitute for bookmakers. I think long-term it would be a smart move, I also think costs are probably still a tad high, but it is a hard choice to make in the short-run, especially as you couldn't really integrate it with the rest of your business.

The other question to ask is who is William Hill competing with for acquisitions. Bet365 is the number-one online operator. Last year's results showed £335m of operating profit putting it comfortably ahead of Paddy Power and William Hill. Bet365 was far quicker to spot the international opportunity and has remained focused on sports betting. Beyond this, the company is something of an unknown entity. It remains family-owned so may not be willing to dilute the distinctive culture. The only logical deal would be 888 but Bet365 haven't shown any real enthusiasm for casino product anyway. An acquisition of BWin isn't possible due to Bet365's large share in the Spanish market.

Paddy Power is William Hill's main competition. A merger between the two is not totally off the cards (how do you reconcile the two companies' cultures though) but is unlikely given both have significant physical retail operations. Again, the question comes up: what can be done with all those stores? If this question was resolved, either by William Hill or Paddy Power, then consolidation of the industry would dramatically accelerate. Beyond that, I think Paddy Power is skewed towards international/casino acquisitions like William Hill.

Finally, there is Playtech. The huge cash balance and involvement in BWin suggests that they are looking at deals. Partnering with Ladbrokes looks like a fairly terrible choice, I am sure they know better than me though. Playtech shares actually look fairly cheap (but not very much so) as they could really do well out of an acquisition. Again, 888 is a possibility but they would definitely prefer an online-only business. Amaya was also mentioned in relation to BWin, I am not sure how serious this was. The Pokerstars deal showed they are willing to mix things up but it seemed quite far out of their circle of competence. 888 is a non-starter as it would mean that Amaya owned almost 100% of the online poker market.

Summary

Lots of information, what are the key takeaways? First, William Hill are a major operator in an industry that is experiencing tremendous growth. This isn't apparent from the financials but will come become increasingly clear over the next decade. Online doesn't just take from offline but actually creates new demand. Second, William Hill have a competitive advantage. The online business is clearly very competitive and barriers to entry are generally low. As the industry develops, the barriers to entry are rising and marketing expertise becomes very valuable. If we saw pricing improve, the upside would be huge. Third, the potential for acquisitions is very large. Who will win out of this is unclear at the moment but significant consolidation seems inevitable. 

As I have said a few times before, by the end of this decade I believe there will be a UK (&I) -based international online gambling company worth over £10bn, it is just inevitable. Bet365 is probably worth close to £4bn, William Hill Online was valued at £1.5bn in 2013, Betfair is worth the same today, and Paddy Power's online business is worth, at least, as much. As international growth accelerates and the industry consolidates, we will see these values grow and certain companies pull ahead. Exactly who is difficult to say, at 11x PBT we are getting a fair price to find out if it is William Hill.