Small Cap Value Report (Tue 5 Nov 2019) - Gambling/888, BOTB, FDP, UPGS, FLTA, CTP

Good morning folks,

Quite a few RNS's that may be of interest, but I'm going to start with a quick look at the gambling sector. This follows the publication of an interim report by the All-Party Parliamentary Group on Gambling Related Harm, which whacked a number of share prices yesterday.

Then the RNS's that I might look at are (provisional list):

• Best Of The Best (LON:BOTB)
• First Derivatives (LON:FDP)
• UP Global Sourcing Holdings (LON:UPGS)
• Filta Group (LON:FLTA)
• Castleton Technology (LON:CTP)

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Gambling Stocks

• 888 (in which I have a long position): down 15% in two days
• Flutter Entertainment (LON:FLTR) (owner of Paddy Power): down 4% in two days
• GVC Holdings (LON:GVC) (owner of Ladbrokes): down 10% in two days
• William Hill (LON:WMH): down 17% in two days
• Rank (LON:RNK): down 10% in two days

Gambling Related Hard APPG: Latest News

All-Party Parliamentary Groups are "informal groups of Members of both Houses with a common interest in particular issues".

They can't pass legislation, but they can make proposals, and their proposals tend to have a good chance of success (since they have cross-party support).

The work carried out on behalf of this particular group has been funded by (and I appreciate the transparency, with these names given on page 1 of the report):

• Derek Webb, who has made a fortune inventing games for land-based casinos
• Bacta, the trade body for operators of land-based games machines
• Hippodrome Casino
• Gauselmann Group, which owns the High Street gaming chain Cashino

I can't think of any reasons why these groups would want curbs on online gambling, can you? Similarly, it was a coincidence that Sheldon Adelson was Donald Trump's largest donor!

Conspiracy theories aside, let's review some of the key findings:

• around 20% of online gamblers are net winners. This is not much worse than spread bet/CFD companies. For example, 25% of retail investors at IG Group (LON:IGG) [disclosure: long] are net winners.
• £5.6 billion was lost by online gamblers in 2018.
• Proposal: The APPG thinks that it's urgent to introduce stake and deposit limits. There are stake limits at spread bet/CFD companies, so a similar logic applies here, too. The proposed deposit limits aren't quantified.
• Proposal: The APPG thinks slot machine games should have the same stake limits online as they do in land-based venues, i.e. £2. They don't think that gaming operators are able to adequately assess which gamblers are at-risk and betting more than they can afford.
• The APPG expressed concern about the aggressive marketing and addictive design of online games. They say that gambling content is available online which would be illegal in an offline setting.
• Proposal: The APPG thinks that the use of credit cards and overdrafts to fund gambling accounts should be ended immediately.
• Proposal: operators should improve affordability checks based on the proportion of a gambler's income they are spending. Banks and challenger banks should help operators to do this.
• Proposals: review the use of bonuses, incentives and affiliates by gambling operators. Operators should also restrict the use of VIP accounts and offer blocking software to customers who wish to self-exclude.
• Proposal: statutory levy of 1% to fund harm prevention projects.

Other industries are also in the crosshairs:

• Spread bet/CFDs: "spread betting should fall under the auspices of the Gambling Commission instead of the FCA, and subject to the same social responsibility protections as gambling operators".
• Gaming: in online games, it's sometimes possible to buy "loot boxes" which have random items inside (health, weapons, etc.). The APPG wants these to be regulated!

Investment Implications

As a shareholder in 888, there is one proposal which particularly stands out to me:

Gambling Commission licensees should cease active trading in jurisdictions that have not formally legalised remote gambling

According to 888's H1 results, revenue from regulated and taxed markets accounted for 74% of total revenues.

While that proportion has been increasing and is likely to continue increasing, I fear that 20%+ of the company's revenues could be threatened by this rule, if it were to come into effect.

The proposed statutory levy of 1% of gross gambling yield would also take a big bite out of 888's margins, as I am not aware of any contribution that it currently makes to harm prevention projects. A 1% drop in revenues might reduce net profit in the UK by c. 10%.

Stake and deposit limits would also clearly damage profitability. Like spread betting companies, casinos (both of the online and offline variety) depend on their high rollers. Those who make big deposits and bet on high stakes are disproportionately responsible for the company's profitability.

However, there is a difference in how these rules would be implemented.

Spread betting companies enjoy exemptions from the rules under the "elective professional client" regime. But there are no exemptions planned for the stake limits on casino style games. It doesn't matter how wealthy you are or how responsible you are as a gambler, it will not be possible to bet more than £2 on a slot machine game, if this APPG gets its way. This would seriously impact the "High Roller"-style revenue generated by these games.

My view

(Please note that I consciously ignore the social/political merits of the proposals, and am only considering the financial consequences! I'm aware of the harm caused by addiction, and I hope that it can be reduced over time.)

There has always been a major regulatory risk to 888 and the gambling sector in general, but it has turned out to be a bit worse than expected. The fact that the two major parties seem to be in agreement on the matter makes change inevitable.

The UK is responsible for 35% of 888's revenue. A 1% levy on this would mean a material hit to profits. 

On top of that, revenues are likely to be significantly lower if credit cards and overdrafts are banned, along with the introduction of deposit limits and stake limits. 888 already warned investors that the Gambling Commission was examining the use of credit cards.

The fact that there would not be any exemptions for high rollers makes it much worse than the situation for spread betting, in my view.

And then there is the threat to revoke licenses, unless operators stop trading in unregulated markets. That's another 20%-25% of revenue that is vulnerable.

I haven't sold my stake in 888 yet, but it is now a candidate for sale. I'm worried that a huge chunk of revenues and margins could be taken out of the business by these rules.

Another reason to sell 888 is to reduce my dividend income, which is something I am gradually working on at the moment.

On the other hand, it could take quite a while for these rules to be enforced, and they may end up being watered down between now and then.

And the regulatory risk was arguably "priced in" already by a low valuation. The EV/EBIT multiple for the current financial year is now perhaps 10x, falling to a single-digit multiple for 2020 based on the pre-existing forecasts.

I might end up selling out of this, but will have to analyse it some more. I'd love to find the patience to hold it, and then ultimately discover that the rule changes weren't so radical after all! Let's see.

This analysis turned out to be a bit longer than anticipated, but hopefully was of some interest!

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Best Of The Best (LON:BOTB)

• Share price: 282p (-1%)
• No. of shares: 9.4 million
• Market cap: £26 million

Trading Update

This is micro-cap gambling business which has been covered many times previously in this report, notably by Paul. Here is its website, if you need to remind yourself what it does. And here's a link to Paul's coverage of it in September.

H1 PBT is tracking ahead of expectations:

This is largely attributable to the continued strong performance of the Company's online strategy and move away from physical locations. The Board remains confident about the prospects of the Company in the year ahead and its pure online strategy.

While I haven't studied this company in the same detail as Paul, I share his positive impression of management and I admire its track record of profitable growth.

From a regulatory perspective (and bearing in mind that I'm not a lawyer), BOTB runs a prize competition.

The gambling commission has this to say about prize competitions:

To be a genuine prize competition, rather than a lottery, there must be an element of skill, knowledge or judgment that is reasonably likely to prevent a significant proportion of people who wish to participate from doing so or prevent a significant proportion of people who participate from receiving a prize.  

For example, if a panel of judges determine the position of the ball and participants have to apply judgment, skill or knowledge to match their own decision of where the ball is with that of the panel, it is more likely to be a prize competition than a lottery.  

If the competitions were instead considered to be games of chance or lotteries, then it would be illegal for BOTB to run them without a gaming license (or at all).

In summary, BOTB's "Spot the Ball" competition relies on its classification as a "game of skill" that "prevents a significant proportion of people who participate from receiving a prize" for its lack of regulation.

The nuances involved here might not be obvious to those who haven't looked into it.

I don't think there is any evidence that parliamentarians are about to start regulating "Spot the Ball" competitions, even after reading the APPG report this morning, but I wouldn't rule it out happening some day!

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First Derivatives (LON:FDP)

• Share price: 2289p (+4%)
• No. of shares: 26.5 million
• Market cap: £607 million

Interim Results

This was the target of a short attack in October 2018, and the share price hasn't quite been the same since.

It's hard to summarise exactly what First Derivatives does: its own summary is that it provides "products and consulting services", and has a "world-leading database technology".

FD says that its competitive advantage "derives from its unique combination of knowledge of financial markets and expertise in financial services technologies".

My impression is that the short-sellers were right when they said it was primarily a low-margin consultancy business. The operating margin is less than 10%.

But short-sellers generally need more than a poor-quality business and an overvaluation. They need a catalyst for share price destruction, too. The publication of a "short dossier" might be enough, but it might not be.

The basic facts are that FD has reported positive net income year in and year out. It has paid a rising dividend stream, and hasn't diluted shareholders much over the last five years.

Net debt is now at a more challenging £60 million, following the acquisition of the "world-leading database technology" division.  Here is its website.

And this is what the company has to say about its increased debt load:

While the Group is comfortable operating at this level of indebtedness, it is expected that the current level of net debt represents the peak and should reduce in future periods, driven by operating cash flow, subject to other strategic activities that may be undertaken in future periods.

My view

I don't feel qualified to judge whether this company has any competitive advantage in its field, but I do lean towards the bearish position that it is heavy in consulting activities which are unlikely to make for a wonderful investment.

On the other hand, the bear thesis that shareholders were going to get diluted hasn't happened yet, and it might not happen if the acquired business performs as expected. So I wouldn't want to be short this one, either.

Stocko doesn't like it, calling it a "Falling Star" (high quality but low on momentum and value).

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UP Global Sourcing Holdings (LON:UPGS)

• Share price: 84.2p (+9%)
• No. of shares: 82 million
• Market cap: £69 million

Final Results

Ultimate Products, the owner, manager, designer and developer of an extensive range of value-focused consumer goods brands, announces its full year results for the year ended 31 July 2019. 

This is another one we've discussed before, and generally singing off the same hymn sheet: UPGS manages consumer brands which may have some pricing power, but are unlikely to justify or to command very high earnings multiples, relative to premium brands.

Performance in FY July 2019 is impressive:

• Revenues are up >40% (within which international revenues have doubled).
• PBT  up 51% to £8.2 million
• Dividend up 50% to 4.085p

And the current year is going ok:

The market conditions for general merchandise remain challenging in the UK and Ultimate Products, like many others, is faced with an uncertain environment for consumers, retailers and suppliers. However, current trading is in line with expectations and the FY 20 order book is moderately ahead of this time last year. Therefore, despite the wider market uncertainty, we remain confident in the future prospects of Ultimate Products."

My view

I don't see any need to look into this in further detail today. If you want to get a better idea of where the sales are coming from, you can see the product websites for the main revenue contributors:

• Beldray
• Salter
• Intempo
• Russell Hobbs

I reckon it is fairly valued around current levels - the cheap earnings multiple prices in the risks and gives investors the chance to be richly rewarded, if the brands can sustain their value and the international logistics continue to run smoothly.

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Filta Group (LON:FLTA)

• Share price: 150p (-22%)
• No. of shares: 29 million
• Market cap: £44 million

Trading Update

This RNS starts out fine, but takes a turn for the worse in the fourth paragraph. Brace yourselves:

We remain confident of fully realising the planned efficiencies in FOG (fats, oils and grease) in 2020 and delivering against our expectations for that financial year, but progress in the second half of 2019 has been slower than was, at first, anticipated. It has been necessary to divert resource to catch up on an order backlog in our FOG businesses and a small amount of installation work, which had been expected in the fourth quarter, has been delayed into 2020.

Additionally, over the last 3 months we have invested in additional personnel to maximise the opportunities in the UK. 

Hmm. Isn't an order backlog usually a good thing? Could this be a "good" profit warning, if it signals strong demand? The trading update later states that the backlog has been eliminated and that the company's planned cost savings are on track.

The "small amount" of delayed installation work, and the additional personnel, don't sound like the end of the world, either.

Forecasts

• FY 2019 adjusted EBITDA is now expected to come in at just £3.3 million (previous forecast £4.5 million).
• FY 2019 Adjusted EPS is now only forecast to be 3.3p, versus 9.2p last year and the previous forecast of 8p. The research note by Cenkos says that a "temporarilty high tax rate" is responsible for this.
• FY 2020 forecasts are unchanged.

My view

I think investors are right to be unnerved by the extent to which FY 2019 forecasts have been slashed, so a c. 20% fall in the share price today might be a fair reaction. If 2020 expectations can be delivered, as promised, then it's a nice buying opportunity, but how much faith can we have in that?

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Castleton Technology (LON:CTP)

• Share price: 73.5p (+17%)
• No. of shares: 82 million
• Market cap: £60 million

Half-year Report

This is still in my "too difficult" tray, but having covered it a few times before, I want to acknowledge the positive outlook statement in this H1 report:

The Company is confident that revenue, EBITDA and cash generation will show a material improvement in the second half of the year.

It has been transitioning away from one-off revenues and trying to build its higher-quality recurring revenues.

H1 recurring revenues did indeed increase compared to the prior year (from £7 million to £7.6 million), but one-off revenues were poor, as expected.

In H2 so far, Castleton has been chosen by the National Housing Federation as "the preferred supplier for Housing Management Solutions".

I continue to maintain a balanced view on this one.

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Honourable mention: Finally, I note that GAN (LON:GAN) issued an "ahead of expectations" trading update (link) and said that the outlook for 2019 remains "highly positive". Its revenues in 2019 will be more than double the revenues in 2018.

It has great exposure to the burgeoning US online gambling space, but it's in the B2B category which I find more difficult to analyse. Could be worth a look.

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Out of time for today, thanks everyone!

Graham