32Red — Update 21 September 2016

32Red is an online casino, poker, bingo and sports operator. Its brands include the award-winning 32Red.com online casino, 32Red Sport, 32Red Bingo, 32Red Poker and Roxy Palace. Its main market is the UK, where it has historically focused all its marketing budget. Regulated markets (mainly the UK, plus Italy) account for c 75% of net gaming revenue (NGR), above the sector average. 32Red is based in Gibraltar where it has c 110 employees. It is licensed and regulated in the UK, Gibraltar and Italy. It listed on AIM in 2005 and directors still hold 43% of the shares.

32Red has an excellent growth record (Exhibit 2) and adjusted to a post-POCT1 world in 2015 much better than many stock market commentators had expected, with reported EBITDA broadly flat at £5.2m (2014: £5.4m) despite an incremental £4.4m of POCT costs (pre-POCT EBITDA rose by 67%). H116 EBITDA more than trebled to £4.5m (H115: £1.2m), helped by the Roxy Palace contribution and near elimination of £1m of losses in Italy. H116 normalised EPS was 3.9p, more than the total for 2015 (of 3.8p). Our 2016 full-year EBITDA forecast is £11.0m (2015: £5.2m) and we expect 41% growth (to £15.5m) in 2017. Our forecasts allow for some margin impact from the extension of POCT to free play from August 2017, although the exact method of implementation is still the subject of an HMRC consultation. Cash at 30 June was £6.4m net of player balances, slightly down on December 2015 (£8.6m) due to a working capital outflow (bonus payments, Roxy deferred consideration) and the payment of a special dividend of 3.0p per share in March 2016. We expect net cash to increase to £18.0m by December 2017. The interim dividend rose by 18% to 1.3p. 32Red also has a history of returning funds by way of periodic special dividends.

32Red shares rose from 38p to 116p in 2015 and peaked at 174p in March 2016 before the Budget announcement re POCT on free bets prompted some profit taking. Since then the price has largely moved sideways. We believe that the rating is not reflecting the group’s excellent track record, brand strength, regulated bias and growth potential. The UK peer group average 2017e EV/EBITDA is 8.7x versus 32Red on only 6.0x, yet we believe that high-growth online operations should be much more highly rated than low-growth, land-based ones. We consider that 32Red could easily justify a 2017e multiple of 9.0-9.5x, implying a share price of 188-198p (average 193p), while our DCF produces a value of 247p per share (10% WACC, 2.5% terminal growth).

In common with other online gambling operators, 32Red’s main risks are regulatory. It focuses on regulated markets, but licence conditions and tax rates can change. Some 25% of revenues come from unregulated markets, which could introduce licensing regimes (eg the Netherlands). 32Red is dependent on its platform providers Microgaming and Kambi, but both are well-respected B2B providers and outsourcing gives 32Red high-quality competitive products without the need to maintain large internal development teams. 32Red could be affected by the loss of key personnel or by an ill-judged acquisition, but management knows its industry well and the recent acquisition of Roxy Palace has been very successful. 32Red is based in Gibraltar and may be affected by Brexit depending on the way that the UK’s ongoing relationship with the EU unfolds, but it holds local gambling licences (UK, Italy) and the Gibraltar government has been keen to stress its support and flexibility. Currency is not a major factor for 32Red since most of its revenues and costs are in sterling.

In a competitive UK market, 32Red stands out as a small but long-established business with a high level of brand awareness and customer satisfaction. 2015 was something of a watershed, with the group successfully overcoming the challenge of POCT and having the confidence to refocus its marketing to accelerate organic growth, while at the same time beginning to participate in gaming industry consolidation with the £8.4m acquisition of Roxy Palace (which is highly earnings accretive in 2016e). 32Red’s key opportunity is to increase its UK market share from the present 3% while expanding in Italy (on track to break-even in 2016e) and in other overseas markets. With directors holding 43%, their interest is fully aligned with that of other shareholders, and rising dividends have periodically been accompanied by special payouts. Key investment considerations are:

32Red believes it is the 11th most recognised UK online casino brand, despite its relatively small size, helped by its pure casino focus, offline marketing (eg TV, sponsorships) and high levels of customer satisfaction. Excluding the major sports betting operators it believes it is number five.

CEO Ed Ware is the creative driving force behind 32Red, which he founded in 2002 after nearly 15 years with Ladbrokes (latterly as MD of Ladbrokes International). Operations director Pat Harrison joined in 2004 and before that he spent 23 years at Ladbrokes. Jon Hale has been CFO/finance director at 32Red since 2006; his previous experience included the Sports Cafe Group (where he was finance director between 2001 and 2005) and Capital Corporation (an operator of high-roller casinos). The final member of the executive team is Matt Booth, chief commercial officer. He joined the 32Red board in November 2013 having spent the previous six years at Betfair; prior to that he was head of marketing at 32Red between June 2006 and January 2008. The 32Red team is one of the longest established in the industry.

32Red’s mission statement is to “provide a unique, trustworthy and award-winning online casino experience, thrill and excite every player in a stylish, responsible and fun manner”. There are three pillars to its stated growth strategy: (1) grow its brands in its core UK market; (2) expansion in new regulated markets; and (3) “continue to do what’s right for our customers” (its service quality is a key differentiator).

32Red achieved an organic CAGR of 25.5% in NGR for the three years 2012 to 2015 and we forecast c 20% CAGR for the three years 2015-18, as it increases market share in a growing online casino market on the back of its targeted returns-based marketing. Adding in Roxy Palace, our forecast 2015-18 NGR CAGR is 23%. This has not been at the expense of margins: 2012-15 EBITDA growth was 48% if £4.8m of POCT in 2015 is stripped out, and was over 20% on a reported basis (to £5.2m). For 2015-18, we forecast an EBITDA CAGR of 54% (to £18.0m) despite the impact of POCT. Shareholders have been rewarded with dividends that doubled from 1.4p per share for 2012 to 2.8p in 2015. On top of that, 32Red paid special dividends of 2.5p in August 2013 and 3.0p in March 2016, the latter reflecting the outstanding 2015 trading result.

32Red acquired the Roxy Palace online casino for £8.4m in July 2015. Roxy brought in an established brand and over 230,000 registered players; it earned £1.6m of EBITDA on NGR of £10.1m in 2014. Roxy operates on the same gaming platform as 32Red (Microgaming) and thus 32Red was able to rationalise the operation by the end of 2015, keeping the brand separate but saving over £1m in costs in 2016. This is augmented by revenue synergies from cross-selling, the exchange of marketing know-how and wider table and game bet limits. Overall, we estimate that the EPS accretion from Roxy is over 30% in 2016.

The online gambling business model has significant economies of scale and this, along with the challenge of new licence conditions and taxes in regulating markets, has prompted significant consolidation notably among the larger sportsbooks (Paddy Power Betfair, GVC/bwin, Ladbrokes Coral). There has been some M&A in the casino and bingo space but less to date, and the fragmented market still offers opportunities. Aside from casino, we believe that other gaming verticals could be of interest to 32Red such as bingo, where over 50% of NGR (and sometimes up to 90%) comes from slots. 32Red is financially strong, with £6.4m of net cash at 30 June. We believe that acquisitions would mainly be bolt-ons, probably financed with a mix of cash and shares, with likely investor appetite to support deals particularly given the success of Roxy.

32Red derives over 90% of its NGR from online casino, with online sports, bingo and games accounting for the rest. As with other operators, mobile has become an increasingly important channel and accounted for 50% of casino revenues in H116, up from 42% in H115. About 75% of revenues come from regulated markets, mainly the UK and Italy. 32Red’s marketing budget has historically all been UK-focused, but it has passively attracted customers in other English-speaking markets (eg Canada) while Roxy brought in a slightly more international player base (eg Sweden and Holland). 32Red entered the Italian market in 2012 and that business grew NGR by 33% in H116 and moved close to break-even; we expect it to be profitable in 2017, helped by an improving product range.

32Red currently employs about 110 people in Gibraltar, of whom almost half work in operations (customer support, payments, security and compliance), c 40 in marketing and c 10 in IT and finance. Having invested in the 32Red brand over so many years, it takes customer support extremely seriously, to build trust and rapport, and also has a separate VIP team.

32Red outsources its gaming and sports platforms to third-party B2B providers who have the scale to maintain large IT teams for games and software development, odds setting, risk management and so on, leaving it to focus on marketing and brand management. However, in April 2016 it launched a new, internally developed, responsive ‘front end’ to its website, which is much more personalised and provides a seamless experience between desktop and mobile, something most other casino operators cannot match. It also gives 32Red much more real-time data and other analytics.

32Red’s main technical and content provider is Microgaming, one of the longest-established online and mobile gaming software providers with over 2,000 employees/consultants, based in the Isle of Man and South Africa. It provides 32Red with a highly scalable gaming platform, over 500 games, live dealer casino, bingo and poker. Its MPN poker network is the third biggest network behind 888 and PartyPoker, according to pokerscout.com. 32Red has just agreed a new five-year contract with Microgaming, from 1 November, which gives it improved commercial terms and increased flexibility to add other suppliers’ games to ensure that it can offer the most popular titles. 32Red also has some proprietary games, notably those associated with its three-year exclusive licence with ITV, which has just been extended to include an Ant & Dec Saturday Night Takeaway slot game, in addition to the current I’m a Celebrity...Get Me Out Of Here! game.

32Red Sport’s platform is provided by the listed B2B provider Kambi (headquartered in London), which also counts other leading online casino operators such as Unibet, 888, Rank and LeoVegas among its customers. The 2014 agreement has recently been renewed and runs to December 2019. On 29 August 32Red aired its first TV advert promoting the sports book and it has a 12-month deal to advertise around live sport on Sky.

We believe that 32Red’s customer base is mainly ABC1 and splits roughly 70/30 male/female, a slightly higher female proportion than most of the sports-led casinos. Around 75% of players are aged under 45 and unsurprisingly much of its marketing is targeted to the younger male demographic. The average bet size is about £2.50, but we assume the usual 80/20 rule applies for VIPs versus recreational players, in line with other casino operators. The last disclosed gross gaming yield per active player was £510 in 2014, close to the £513 average over 2010-14.

32Red is the core brand and we believe that management devotes a higher proportion of its marketing budget to television, sponsorship and other UK offline channels than most of its pure online casino peers. For example, it has a history of high-profile football sponsorships and recently announced a three-year shirt sponsorship deal with Leeds United. It also sponsors a number of high-profile horse races including the All-Weather Championships (over 250 races from October to April each year) and, from this year, the King George VI Chase (Kempton, Boxing Day).

The acquisition of Roxy Palace brought in an established brand with a slightly more recreational and international customer base, providing new cross-sell opportunities. We also believe that 32Red could use it to experiment with a slightly different look and feel, perhaps introducing more social elements. 32Red also has a number of sub-brands including Dash, Nedplay, Golden Lounge and Casino Splendido, which are mainly used to retain or reactivate players (since casino players on a losing streak may be tempted to try elsewhere).

32Red introduced a new bespoke marketing model in mid-2015, having spent 18 months developing it to take advantage of the latest data analytic tools. It is much more behavioural and predictive, segmenting customers from the start to enable 32Red to fast-track quality players, improve deposit rates and win back lapsing clients. Together with the new front end it allows much more personalised marketing. Also at its heart is a shift in attitude from merely monitoring the difference between a player’s cost of acquisition (CPA) and lifetime value (LTV) – important as that is – to measuring the return on investment (ROI). Exhibit 6 shows that marketing spend pays back within 90 days in terms of revenue generated from new players alone. Each six months of spend has generated an average return of 2.35 times, eg the H115 spend of £5.3m generated a 210% ROI or £11.1m of revenue from new players. Spend since then has not completed its 365-day ROI maturity period.

Italy is an attractive market for 32Red, being fully regulated and growing, with good mobile penetration, albeit that it is very competitive. The market was worth €1.05bn in 2015 and in Q116 online casino grew by 38% to €106m, after 31% growth in 2015 (source: AAMS). Lottomatica is the largest operator with a market share of almost 15%, followed by Sisal, William Hill and Snai.

32Red obtained a nine-year Italian licence in April 2012 and originally launched in December 2012, hoping to build an early footprint after online slots were legalised. However, competition from unlicensed operators (avoiding the 20% gaming tax) proved problematic, as did the cumbersome process of getting new games approved by the Italian regulator AAMS. 32Red effectively relaunched in 2015, upping the marketing budget and increasing the number of active players by almost 50% to 12,774. The benefit of this has come through in H116, with NGR up 33% to £1.1m and EBITDA close to break-even (H115: EBITDA loss £1.0m). We believe the new agreement with Microgaming will enable 32Red to broaden its product offering in Italy, which will be very helpful.

32Red operates in growing markets, with positive structural drivers. New ways to gamble have proved to be incremental rather than cannibalistic and over the past three years mobile has taken over from desktop as the key driver of growth. We believe that it is the most effective new player recruitment tool for most operators and that, in addition, players who play on more than one device typically spend up to 2.5 times as much as players who play on only one device (see our Mobile Gambling: Injecting new life report dated October 2015).

The total European gambling market is estimated to have been worth €95.5bn in 2015. Within this the online market (desktop and mobile) was €16.6bn or 17% of the total, up from only 4% in 2005 (source: LeoVegas March 2016 prospectus, H2GC). 32Red’s main market, online casino, accounted for 24% of the €16.6bn or €3.95bn, with sports betting being 36%, lotteries 15%, poker 12% and other games 13%. The online casino market is forecast to grow at a 9.2% CAGR between 2015 and 2018, in line with the overall online market (with land-based growing at just 1.6%).

According to the UK Gambling Commission the UK online casino market was worth £2.13bn (gross win) for the 11 months to September 2015 which would be £2.32bn (€2.75bn) annualised. This is much larger than the €1.54bn estimated by H2GC within the European €3.95bn above, perhaps because of a differing treatment of slots play in bingo-led sites. If we assume 28-30% bonus rates then the UK market NGR (which is what most operators report) is worth £1.62-1.74bn.

On this basis we estimate that the UK market leaders are the sports-led William Hill, bet365 and Paddy Power Betfair with 9-11% each. The largest pure gaming operator appears to be Sky Vegas (although public information is limited), while we also include Intertain as its bingo-led sites are mainly slots (although we classify Gala Bingo as bingo). 32Red’s share is about 3%, yet its brand awareness is 62% (Exhibit 10) suggesting that it has plenty of scope to continue to increase market share on the back of its recent step-up in marketing.

There are many small operators with sub-1% market shares in the UK, which are also looking to grow aggressively, including Scandinavia-listed companies LeoVegas, Mr Green and Cherry, although their games portfolios are to some extent less suited to UK players. Another new entrant is BGO (backed by Playtech) while private operators also include Casumo, which has introduced some innovative social gaming features into its real-money casino offering. Overall, the market is highly competitive, but its fragmented nature also implies further acquisition possibilities for 32Red.

Regulatory risks: licence conditions and tax rates could change in 32Red’s markets. For example, HMRC is currently consulting on the precise way that POCT will be extended to free play from August 2017, which is likely to change game play and impact margins (we allow for a 2-3 point increase in our effective POCT rate). 32Red is a member of the Gibraltar gaming association, GBGA, which is still challenging the basis of POCT in the courts. In April HMRC issued an informal working paper on VAT becoming chargeable on advertising services bought in the UK by Gibraltar-based companies, but it is difficult to know how it would work or quantify any effect.

32Red does not operate in regulated jurisdictions where it does not hold a licence, eg Spain or France. 32Red derives about 25% of its revenues from countries that are unregulated; some, such as the Netherlands, are in the process of introducing regulation (which could introduce new costs or taxes), while others are yet to regulate (eg Canada). 32Red publishes on its website a list of countries from which it does not accept bets, including the US.

Competition: 32Red operates in highly competitive markets and some competitors are much larger than itself with much bigger marketing budgets. However, 32Red’s management is extremely experienced and has built a strong brand presence.

Economy: gambling has historically proved resistant to economic slowdowns, but not immune, although the structural growth in online gambling outweighed economic pressures in the last major slowdown of 2007-08.

Technology and platform risks: 32Red is dependent on its platform suppliers Microgaming and Kambi to deliver its gaming and sports, but both are long-established and well-respected B2B providers. The new and extended contract with Microgaming, just signed, allows 32Red to use alternative suppliers to add other popular games if required, removing a minor previous negative. 32Red is exposed to internet-related risks and needs to adapt to technological change.

Brexit: 32Red is based in Gibraltar (where 96% of people voted to remain in the EU) and would be affected if Gibraltar followed the UK out of the EU (eg many employees commute across the border from Spain) or indeed if it became part of Spain (eg currency). However, 32Red holds local rather than EU licences (UK, Gibraltar, Italy) and the Gibraltar government has been keen to stress its flexibility and desire to support its gambling industry as the terms of the UK’s ongoing EU relationship unfold.

Company-specific issues: 32Red would be affected by the loss of key personnel or by an ill-judged acquisition, but management knows the industry very well and the recent acquisition of Roxy Palace has been highly successful. We believe its currency risk is small since most of its revenues and costs are in sterling.

Gambling companies are generally valued on an EV/EBITDA basis, although we have also performed a DCF. Exhibit 11 shows the main UK-listed peers, of which we consider the closest to be the online gaming operators 888 Holdings and Stride Gaming (although Stride is bingo-led). GVC and Paddy Power Betfair are sports-led, Ladbrokes, William Hill and Rank have large, low-growth, land-based estates as well as online operations, and Playtech is software/B2B.

32Red has one of the highest EBITDA growth rates over the forecast period and is a pure online operator with 75% of revenues from regulated territories, yet it is rated at a material discount to the group. We believe that the stock market has not yet caught up with its step-up in scale and earnings momentum and that a re-rating is due. We also believe that high-growth online operations command a higher multiple than low-growth, land-based ones. Overall, we consider that a 2017e EV/EBITDA of 9.0-9.5x for 32Red can easily be justified, which would imply a share price of 188-198p, average 193p, 46% above the current share price. Arguably the strength of the brand, strong regulated bias and management’s track record could justify a greater premium.

By way of reference, we also show a number of international gaming operators in Exhibit 11 including LeoVegas, Mr Green and Cherry, which have already entered the UK online casino market, and Intertain (to be renamed Jackpot Joy), a leader in UK bingo-led gaming. However there is a wide range of multiples reflecting individual circumstances and thus we do not make any direct read-across.

For our DCF we have run forecasts through to 2020 with revenue growth moderating to 10% in 2020, 5% in 2021 and a terminal growth rate of 2.5%. Our forecast EBITDA margin for 2018 is 20% (2016e: 17%) and we assume this is then maintained, with a terminal 20%. We have used a WACC of 10% and arrived at a value of 247p/share, 86% above the current share price. Flexing the WACC between 9% and 11% produces a range of 218-286p/share, while alternatively using a 22% terminal EBITDA margin (and 10% WACC) would produce a DCF of 264p.

Online gambling revenues depend on the number of active customers and the amount they spend (LTV). Typically, there is a sharp drop-off in the number of new depositing casino customers who are still playing after the first two months (many having been attracted by initial free play/bonuses), but thereafter the decline slows to leave a loyal player base, with later additions adding incremental layers. On average, we estimate that around two-thirds of NGR in one year comes from players recruited in previous years, illustrating the stability of the core base and also the importance of good customer service and brand or retention marketing.

Marketing is 32Red’s biggest cost at c 32% of NGR (this excludes free play/bonuses, since NGR is stated after free play/bonuses, which we estimate are typically 28-30% of gross win). This illustrates the importance of effective data analytics and ROI measurement, particularly since the average revenue generated by a new player over the first three months is a good indicator of their LTV. Other cost of sales (COS) items include platform and software licensing fees, payment processing and progressives (contributions to jackpots). These are all mainly variable costs and we believe the COS percentage will be lower in 2017 due to more favourable terms under the renewed Microgaming contact. We also expect the admin cost ratio to trend down slightly as the group scales up. We therefore expect EBITDA margins to increase from 17% in 2016e to c 20% in 2017e and 2018e despite the effect of the extension of POCT to free play in August 2017.

Introduction: 32Red has an excellent growth record (Exhibit 2) and adjusted to a post-POCT world in 2015 much better than many stock market commentators had expected, with reported EBITDA broadly flat at £5.2m (2014: £5.4m) despite an incremental £4.4m of POCT costs (pre-POCT EBITDA rose by 67%). We believe that it has taken market share from small operators that were less able to weather the new tax. With the Roxy Palace integration only completed towards the end of 2015, H116 showed the first real synergy gains, together with further benefits from the more aggressive ROI-based marketing, with EBITDA more than trebling to £4.5m (H115: £1.2m) and normalised EPS of 3.9p exceeding the 2015 full year total (of 3.8p). Q316 l-f-l NGR is reported to be up 6% against strong comparatives, despite a weak casino win margin in July which has since started to return to more normal levels. We initiate with a 2016 full-year EBITDA forecast of £11.0m, more than double the 2015 result, and expect another 41% growth (to £15.5m) in 2017.

Definitions: our definition of ‘normalised’ operating profit, PBT and diluted EPS excludes amortisation of acquired intangibles and share option costs. 32Red treats all amortisation as acquired since none relates to the capitalisation of internally generated costs. We take a more conservative stance and charge all amortisation except that relating to the Roxy Palace acquisition (£1.68m a year for five years, from 14 July 2015) since the remainder includes items such as licences, website development and some capitalisation relating to creative costs associated with designing and filming TV adverts. Exhibit 13 also shows ‘adjusted’ figures as reported by 32Red, for ease of comparison.

Interim results showed strong growth in the underlying business, augmented by the contribution from Roxy Palace (acquired on 14 July 2015). Excluding Roxy, NGR increased by 32% to £24.6m while the total reported figure was £30.4m, up 63%. 32Red casino revenue rose 24% to £21.2m helped by more targeted marketing, better retention post the launch of the new website front end and mobile growth (50% of H116 revenues versus 42% in H115). NGR from other products jumped from £0.7m to £2.3m including strong growth in sports over Euro 2016, while Italy revenues increased by 33% to £1.1m.

EBITDA increased by £3.3m to £4.5m. Of the increase, £1.0m came from loss elimination in Italy, which almost reached break-even, and the rest from economies of scale and the highly accretive addition of the Roxy player base. After depreciation, amortisation and a very small amount of interest receivable, H116 normalised PBT was £3.7m, up from only £0.4m in H115.

We expect H116 trends to continue through H216, with the gross profit margin benefiting additionally from slightly better win ratios in the second half of Euro 2016 and Italy expected to achieve break-even for the first time for the full year. We also expect EBITDA to benefit from lower admin costs in H216 versus H215 due to cost savings at Roxy plus a more normal level of staff bonuses (after the materially better than expected profit outturn for 2015). Overall, we forecast normalised PBT of £9.3m in 2016, up from £3.3m in 2015, setting a new base for organic growth.

We expect 32Red to continue to increase market share, to produce c 20% NGR growth in 2017 and 15% in 2018. Underlying EBITDA margins should continue to increase, to around 20% as the business scales up, helped by a move into profit in Italy and better commercial terms from Microgaming. A slight unknown is the exact impact of the extension of POCT (currently 15% of NGR) to include free play monies from August 2017; HMRC is currently consulting on the detail of its implementation. As with the bookies (who already pay POCT on free bets) it is likely that online casino operators will aim to mitigate the effect by offering enhanced odds rather than free bonuses, but we have allowed for a 2-3 point increase in our effective POCT rate. Despite this, our forecasts still produce well above average normalised EPS growth of 42% in 2017 and 18% in 2018.

Exhibit 3 shows 32Red’s dividend growth record, with the payout doubling from 1.4p per share in 2012 to 2.8p per share in 2015. In addition, 32Red has returned surplus funds by way of a special dividend twice, in 2013 and February 2016. The H116 dividend increased by 18% to 1.30p and we expect a full year payout of 3.3p, on top of the special dividend of 3.0p declared in February 2016.

32Red’s internal capital requirements are relatively modest since the operation of its gaming and sports platform is outsourced. Based on our forecasts, over 85% of EBITDA in each of 2016-18 converts to operating cash flow (allowing for some increase in working capital).

32Red acquired Roxy Palace in July 2015 for £8.4m (£2.0m in cash plus 10.0m new shares at 64p (with a one-year lock-in). £1.0m of the cash was paid in 2015, but despite this the group’s net cash (which we state excluding player balances) increased from £6.2m at end-2014 to £8.6m at end-2015. A further £0.5m was paid in January 2016 and the balance will be paid in December 2016. With employee bonuses also paid in H116, net cash at 30 June declined slightly to £6.4m. The cost of 32Red’s new ITV licences will be treated as an addition to intangibles in H216, but despite this investment we expect a strong net inflow in the period to take the December 2016 cash figure to £10.0m. We expect it to rise to £18.0m at end 2017 in the absence of any material acquisitions.