GVC Holdings — Update 19 November 2015

We see four key benefits of the merger:

We believe there is an excellent business and cultural fit between GVC and bwin. Both are leading online sports betting operators who then cross-sell casino, poker and other games, with over 80% of revenues arising in Europe. Sports betting generated 49% of GVC’s net gaming revenue (NGR) in 2014 and 39% of bwin’s, but including the cross-selling the sport labels generated 86% of GVC’s 2014 revenues and 60% of bwin’s. Both businesses also have standalone B2C casino and games brands. We believe that CasinoClub accounted for c 14% of GVC’s 2014 revenues. bwin’s well-established games labels include partypoker, partycasino, Foxy Bingo and Gioco Digitale, which together generated €196m or 32% of bwin’s 2014 revenues. bwin also has a nascent US business (€25m of 2014 revenues). bwin’s ‘Other’ businesses in 2014 included the non-core Kalixa, WPT (since sold) and InterTrader plus some third-party B2B revenue.

The online gambling industry is consolidating due to inherent economies of scale in the business model, particularly as a growing number of markets have regulated and/or introduced new taxes (eg the UK’s 15% point of consumption [POC] tax from 1 December 2014). Large mergers in progress include Paddy Power/Betfair and Ladbrokes/Gala Coral as well as GVC/bwin.party. Other major deals over the last 12 months include CVC’s acquisition of SkyBet and Intertain’s acquisition of Jackpot Joy, as well as William Hill’s approach to 888 (rebuffed). bwin’s revenues have been declining (see Exhibit 6) and annualising the Q315 results for both companies gives revenues of €781m (£550m) for the enlarged group, compared with the €836.7m shown in Exhibit 1 for 2014. Even allowing for this, we believe that GVC bwin combined will be the fifth biggest online gambling operator (Exhibit 2).

The enlarged group will be more diversified than GVC alone, both by product (with sports, casino, poker and bingo) and geographically, with new marketing and cross-sell opportunities. In our April 2015 Outlook report we estimated that GVC derived c 30% of revenues from Turkey and 75% from its top four markets (Turkey, Germany, Greece and Brazil, all unregulated ie no formal licenses). In contrast the enlarged group is licensed in more than 15 jurisdictions and derives c 55% of pro forma revenues from markets that are either regulated or taxed, with the largest individual unregulated/untaxed market on a 2014 pro forma basis being 8% (Turkey).

Both GVC and bwin managements believe that there is a significant opportunity to exploit the strength of bwin’s sports and games brands in new markets in Asia, Latin America and Africa. We also expect bwin to re-enter the Greek market in 2016 (notwithstanding the capital controls currently in place), where GVC is well established though its local marketing partner (bwin generated revenues of €32m in Greece in 2012 before it withdrew). Management believes the potential return from currently unregulated markets (‘dotcom’ markets with no formal local licensing system) is significantly higher than from nationally regulated and/or taxed markets, due to there being no incremental compliance or tax costs. Thus the enlarged group intends to maintain a geographically “diversified risk profile”.

We believe that GVC has demonstrated its ability to effectively manage regulatory risks over the past six years and to generate substantial returns for its shareholders. It does not intend to withdraw from any of bwin’s regulated markets but does intend to “focus its marketing resources only on those nationally regulated jurisdictions that generate the greatest return”. Returns from dotcom markets “will generate additional resources and help provide the enlarged group with a competitive advantage relative to other operators that are unable or choose not to enter such markets” (prospectus page 71).

GVC plans to:

Integrate GVC’s sportsbook onto the bwin.party platform

bwin’s technology platform is well invested, highly scalable and already handles much larger volumes than that of GVC. GVC will begin to migrate its sportsbook as soon as possible after completion; once complete it will close its own platform. It intends to build a best-in-class trading and risk team: raising the average sports margin by itself makes a meaningful difference to NGR (eg GVC’s average sports margin across 2013-14 was 9.7% and bwin’s 9.45%, Exhibits 5 and 6; if bwin’s had been 9.7%, it would have generated an additional €6m of high-margin NGR). GVC also plans to improve the profitability of the bwin sportsbook in other ways including: greater use of CRM systems to cross-sell the Sportingbet and bwin brands; more return on investment (ROI) focused marketing and IT; more third-party casino content on the bwin sports platform; and a more entrepreneurial culture, with clear lines of authority and incentives.

We believe the final point is very important – bwin’s sale process has taken a year and the business had shrunk materially over the previous three years (see page 6), post the merger of bwin and PartyGaming in March 2011, (which some observers believed suffered in part from a lack of cultural fit between the two businesses). In a recent interview with eGaming Review (2 October) bwin’s CEO Norbert Teufelberger said that “one of the deciding factors in bwin.party’s decision to side with GVC was the shared DNA of their sports betting operations…GVC formulated a clear vision for growth, which is something we were lacking last year”.

Improve casino, poker and bingo

GVC believes that it can improve the profitability of bwin’s casino and poker operations by reorganising the business and refocusing on key markets. Measures are expected to include increased use of CRM systems and a focus on higher-return development products. GVC’s small volume of poker player liquidity will be pooled onto bwin.party’s poker platform.

Exploit B2B capabilities

bwin has been growing its B2B revenues from a low base and in its interims reported a strong pipeline of new external customers. GVC provides B2B services to EPC Holdings for its Turkey-facing business. GVC management believes there is scope to grow the B2B revenue streams by offering products and services (most probably sports betting) to a limited number of large customers – ie it is only worthwhile if new customers are material in size.

Deliver at least €125m of recurring annualised cost savings by the end of 2017

GVC expects to achieve cost savings and synergies of at least €125m on a run rate basis by the end of 2017, compared with the 2014 cost base. This will be a key measure of the financial success of the deal. The €125m (gross, pre-tax) is a substantial target and compares with pro forma 2014 clean EBITDA for the enlarged group of €146m (Exhibit 7). GVC’s plan was reviewed in detail by bwin’s management and advisers before they recommended the bid.

About 20% of the €125m (€25m) is expected to come from bwin’s own cost-saving initiatives (at the interim stage bwin reported that it was running ahead of its €15m target for 2015). The other 80% will come from the integration, with a run rate of 58% of the total (€72.5m) to be achieved by the end of 2016 (assuming the deal completes on 1 February 2016). The synergies will be recurring, while the costs of achieving them (€60m in restructuring costs) will be one-off, with over 95% being incurred before the end of 2016. Key areas of cost saving and synergies include:

The €125m of synergies does not include anything for improvements in bwin’s casino and poker operations, yet GVC’s management believes there are substantial opportunities to reduce costs and improve efficiency. On the other hand, there is some risk that the deal may produce negative synergies such as customer attrition when the GVC brands are migrated onto the bwin platform, but we believe management expertise with previous integrations means that the risk is modest.

Potential disposals

bwin is already in the process of selling a number of non-core businesses and had raised over €37m by the time of its interim results in August (including the sales of Win, Winners, Betbull and WPT). It has examined various options for Kalixa, its online/mobile payments business (2015 revenues estimated at c €35m). There has also been press speculation of acquirer interest in other parts of the business. However, GVC’s CEO Kenny Alexander has reiterated that they plan to run and grow all the businesses, although they would consider any approaches if they were at the right price and in shareholders’ interests (analyst conference call, 16 November).

Management has a strong record of growing its sportsbook and casino businesses through both acquisition and organically (Exhibit 5), as detailed in our Outlook report dated 1 April 2015. Since August 1 2012 GVC has delivered a total shareholder return of over 270% (prospectus page 68).

The enlarged group will be headed by GVC’s CEO Kenny Alexander and CFO Richard Cooper, who have been with the group since 2007 and 2008 respectively. In total GVC directors will hold 3.6m shares in the enlarged group worth £14.0m (at 384p). bwin’s CEO Norbert Teufelberger will become a non-executive director on completion and play an active role in the integration. Additional experienced non-executive directors are also being recruited.

GVC’s management plan involves taking the best people from each side to head up the various functions and geographies. A new incentive plan (LTIP) will be put in place, replacing GVC’s existing dividend bonus arrangements, and manager’s incentives will be aligned to the enlarged group’s target profits/cash/conversion (the target is for 80% cash conversion once the restructuring is complete). The directors’ large individual shareholdings align their interest with those of other shareholders and mean there remains a substantial incentive for them to resume high dividend payments as soon as loan covenants and trading levels permit (see Dividend intentions on page 8).

GVC’s NGR more than trebled between 2012 and 2014, and while this was partly attributable to the acquisition of Sportingbet in March 2013, the deal was highly accretive and GVC’s normalised EPS (excluding exceptional items) increased by 58% over the two years, to 61.4c/share. We refer the reader to our regular GVC Update reports.

GVC’s growth has continued in 2015, with H115 NGR up 15% and clean EBITDA up 14%, despite adverse exchange rates and the imposition of the UK POC gaming duty from 1 December 2014. Its trading update for the nine months to end-September reported that NGR was up 11%, with sports revenue up 3% despite below-average sports margins (in line with the industry) and gaming revenues up 18%. This implied Q315 NGR of €62.0m, up 3% despite a strong World Cup comparative.

bwin’s revenue declined from €802m in 2012 to €612m in 2014, mainly reflecting its shift in focus from ‘volume to value’ (including a shift towards nationally regulated markets) and a general decline in the poker industry. Despite cost cutting, EBITDA margins fell from 21.4% to 18.0% over the same period partly due to increased costs (tax, fees and compliance), relating to newly regulating markets. However, bwin’s progress in non-core asset disposals and cost-saving initiatives has been running ahead of plan in 2015. H115 clean EBITDA rose by 2% and would have been 24% higher but for the effect of the UK POC tax and new EU VAT charges. The trading update for the nine months to September reported that clean EBITDA for the period was 5% higher at €79.8m, implying 9% growth in Q3 to €32.5m, despite the additional taxes, on Q3 revenue of €133.4m (10% down).

The prospectus presents a pro forma income statement as if the deal had completed on 1 January 2014, showing revenue for the enlarged group of €839.0m, and clean EBITDA of €145.9m.

As GVC is an Edison research client we cannot make forecasts. However, for the purposes of illustration, Exhibit 7 adjusts the 2014 pro forma numbers for the lower Q315 revenue run rate for the combined group and for synergies and cash as described below. We have not made any other changes to the base numbers.

Revenue: based on Q315 results, the enlarged group has a revenue run rate of €781m (GVC €62.0m annualised, Exhibit 5; bwin €133.4m, Exhibit 6). Assuming the deal completes on 1 February 2016, bwin will be included for 11 months of 2016 so, for the purposes of illustration, we have shown pro forma revenue of €737m in year one.

Clean EBITDA: GVC expects to achieve a run rate of 58% (€72.5m) of the total €125m synergies by the end of 2016 and the full savings run rate by 18 months after completion (August 2016 on the current timetable). bwin’s 2015 interims confirmed that its savings are already running ahead of its own €15m pa target off the 2014 base. So for a hypothetical illustration we have assumed that 70% of the year-end savings run rate is achieved across the year as a whole (ie 70% of €72.5m in 2016 and 70% of €125m in 2017). This takes pro forma clean EBITDA to €233m in 2017. Clearly the actual outcome will depend on a number of factors, including the rate of revenue growth (or decline), operating margins, any new gaming taxes and the level of net synergies obtained.

Clean PBT: the pro forma group has a relatively high depreciation/amortisation charge of €41.2m (excluding bwin’s amortisation of acquired intangibles) and financing costs of €59.7m. The prospectus adjusts 2014 financing costs by €56.5m to reflect the additional interest costs (including capitalised costs) on the €400m Cerberus loan (see below). This leaves pro forma clean PBT at €34.5m, after amortisation of own work but before amortisation of acquired intangibles and exceptional/one-off items. We cannot make any forecasts, but management has said that it expects to refinance the Cerberus loan (which bears a 12.5% interest cost at current rates) in 2017 if underlying cash flows strengthen as it expects.

Non-recurring costs: the 2014 pro forma numbers already adjust for €56.5m of acquisition costs to give total exceptional costs of €70.9m. Additional cash costs include €60m of reorganisation costs, €4.2m of new issue costs and a €14.0m draw-down fee for the Cerberus loan (3.5%). All these costs are expected to arise in year one, apart from a small proportion (c 5%) of the €60m. So our hypothetical illustration shows a total of €146.1m of costs in 2016 (in practise GVC has incurred some of these in 2015), but these fall away to only €3.0m (5% of the €60m) in 2017. We believe it is likely that there will also be non-cash impairment charges in 2016, but these will depend on the (lengthy) balance sheet review that will take place post completion.

Cash conversion targets: GVC management focuses on cash conversion and dividends. In 2014 GVC generated €42.6m in cash (after working capital movements and capex) from clean EBITDA of €49.2m, an 87% conversion ratio. The prospectus says that GVC will seek to achieve a conversion ratio for the enlarged group, post restructuring, of at least 80%.

GVC’s has been notable for its high dividend payout policy (not less than 75% of net operating cash flow). In 2014 it paid €33.6m in dividends, or 79% of the clean net operating cash flow of €42.6m. GVC paid an interim dividend of 14c/share on 2 November 2015, bringing the total dividends paid in the year-to-date to 56c/share.

The combination of debt covenants under the Cerberus loan (page 9) and the material cash restructuring costs means that GVC will take a dividend holiday in 2016. However, GVC believes that by the beginning of 2017 the restructuring will drive substantial improvement in the enlarged group’s cash flow so that the Cerberus loan can be repaid promptly (to be replaced by less expensive debt as required). This will permit “the resumption of payment of dividends for the enlarged group at a level which is comparable with GVC’s quoted peer group of online gaming companies” (prospectus page 72). On the analyst call of 16 November, CEO Kenny Alexander said that GVC would pursue an “aggressive and progressive” dividend policy as soon as possible, hopefully from early 2017, and hopefully moving towards the current level of 56c/share (or close to it) subject to the rate of progress and overall debt levels.

bwin.party effectively put itself up for sale in November 2014, announcing that it had received several approaches, which it was evaluating, after the decline in its business and pressure from an activist shareholder. Both 888 Holdings and GVC subsequently submitted proposals. Initially bwin recommended the 888 offer, deeming GVC’s approach (at that stage in conjunction with Canadian-listed Amaya) as over-complicated. GVC returned with a revised, fully-funded proposal, which was accepted and recommended on 4 September (when 888 withdrew).

GVC’s offer comprises 25p in cash and 0.231 new GVC shares per bwin share. bwin has 826.4m shares outstanding or 865.4m on a fully diluted basis. With GVC shares at 384p, the offer values bwin at £980m.

bwin shareholders are being offered a mix-and-match facility (subject to the overall mix of equity and debt being unchanged) and will own 66.8% of the enlarged group. The size of the deal means that it will constitute a reverse takeover for GVC, subject to shareholder approval and effected by means of a Gibraltar Scheme of Arrangement. Planned completion is 1 February (long-stop date of 31 March) and the shares should begin trading on the standard segment of the Main List on 2 February, moving up to the premium segment (if approved) post the 2015 Annual Report.

To satisfy the offer, GVC will issue 195.2m new shares (worth £750m at 384p) and finance the remaining consideration with a new €400m (£284m) senior secured loan from Cerberus. The proposed equity placing and subscription of 35.5m new GVC shares (at 422p/share) will raise a net £145.1m and fund reorganisation costs and working capital as well as debt repayment.

The Cerberus loan is a fully committed senior secured loan, which carries interest at a 1% EURIBOR floor plus 11.5% margin (ie 12.5%), with a 3.5% commitment fee and 3% early-exit fee. It expires on 4 September 2017 and carries maximum leverage and cash flow cover and minimum liquidity covenants. The interest rate is relatively high, which we believe partly reflects the fact that it was arranged very quickly (after GVC dropped its joint approach with Amaya). In practice, if all goes to plan, GVC has indicated that it will aim to repay the loan early in 2017 (and replace it with less expensive debt as required).

Exhibit 9 shows the pro forma net assets for the enlarged group at 30 June 2015 (prospectus page 270). The scale of the deal for GVC is illustrated by the increase in net assets from €137m (standalone) to €1.395bn for the pro forma enlarged group.

GVC and bwin together had net cash of €77.3m at 30 June. The total consideration to be paid is €1.40bn (€298m in cash and €1.105m in shares) and the acquisition and financing adjustments reflect this (adjusted for the write-off of previously recognised goodwill and intangibles and other cost adjustments). The pro forma enlarged group had net debt of €68.1m at June 2015 (cash plus processor balances less loans, borrowings, customer balances and prize pools). By the time the deal completes (scheduled for 1 February 2016) GVC and bwin will have generated additional operating cash flow, but will also have incurred a number of material cash costs, as disclosed in their interim results, including dividend payments (totalling c €39m), Romanian back taxes (€8.8m) and bwin’s acquisition of the remaining 28% of BES (€8.9m), in addition to their development spend, capex, tax and other items.

The prospectus explains the risks and sensitivities in considerable detail (from page 21) and includes a regulatory overview for markets affecting GVC and bwin (page 280). We believe that the key points include:

Risks relating to the transaction: as well as shareholder approvals the deal requires approvals (or waivers) in a variety of jurisdictions, none of which we expect to present any material problem. The move to a premium listing on the Main Market requires GVC to meet eligibility criteria, which the GVC directors believe is eminently achievable. GVC may not realise the targeted €125m of synergies, there may be unforeseen negative synergies or the costs of achieving the synergies may be greater than GVC expects. However, we believe the businesses are highly complementary and both management teams are very experienced and have already spent a considerable time working together on the integration plan.

Legislative and regulatory risks: GVC and bwin hold gaming licences in over 15 ‘regulated’ markets including the UK. However, “the supply of online gaming is not unequivocally legal” in all of GVC’s (and the enlarged group’s) markets. Unregulated markets, (where there is no formal licensing requirement yet in place) are supplied by GVC on a ‘dotcom’ or ‘point of supply’ basis from its licensed operations in eg Malta and are often described by analysts as being different shades of grey. Of GVC’s (and the enlarged group’s) main markets, Turkish authorities are of the view that online gaming is illegal, while in Germany and Greece the situation remains in flux, with new licensing regimes being implemented. GVC and bwin already pay gambling tax in Germany, and GVC in Greece (where it holds an interim licence), but the timing of any new licences, tax rates and products they will cover remains uncertain. For example, if new German licences excluded gaming products, this could adversely affect the enlarged group’s results, but we believe this is unlikely given the current intervention of the European Court of Justice (ECJ). GVC and bwin minimise regulatory risk by diversifying across a range of geographies, being extremely experienced in their markets, supplying their services from licenced jurisdictions and closely following regulatory developments.

The Cerberus loan reduces short-term financial flexibility: the terms of the loan could restrict GVC’s ability to restart dividends as early, or as high as it might hope. It could also restrict its ability to make minority or joint-venture investments (eg including potentially buying-out the other 85% of Betit in Q317). However, the pro forma gearing of the enlarged group is not high, the term of the loan is short and GVC has said that it expects to refinance the loan early in 2017.

General business risks: GVC and the enlarged group are exposed to general economic risks including the strength of consumer spending in different markets. It has some exposure to Greece, where capital controls were imposed earlier in 2015 that can severely restrict remittances and where further economic volatility could continue to affect consumer confidence (although GVC’s interims at the end of August reported signs of greater customer activity). Other general business risks include dependence on key executives and personnel; fluctuating sports margins; issues relating to IT and technology (including some reliance on third party providers); and competition (the group’s markets are highly competitive and rapidly evolving/consolidating). Both GVC and bwin managements have long experience in their markets and in managing such risks.

VAT: a small number of EU countries (eg Germany and Ireland) began charging VAT on gaming in 2015. Both GVC and bwin have been paying this, but there is some potential historic liability and some uncertainty regarding the basis of calculation (Ireland has clarified that it is based on NGR).

Currency: both GVC and bwin operate in international markets. About a third of GVC’s revenue is euro denominated and the two other most important currencies are the Turkish lire and, to a lesser extent, the Brazilian real, which it does not hedge. Both currencies have devalued materially over the past year. GVC has indicated that 40-50% of the enlarged group’s earnings will arise in euros (the reporting currency). In respect of the deal itself, GVC has a call option in place over €365m at £/€1.425.