GVC Holdings — Leaping into FTSE 100

GVC’s acquisition of Ladbrokes Coral (LCL) has created a global, multi-brand gaming business, for which we estimate pro forma FY17 revenues of £3.26bn and EBITDA of £652m. With the caveat that there are numerous variables in our pro forma figures, we forecast FY18 pro forma revenue growth of 4.4% to £3.4bn and EBITDA of £747m.

We estimate that the pro forma FY17 revenue split between GVC and LCL was c 25/75%, with the EBITDA split c 32/68%. As detailed in our financial forecasts, the contribution from LCL is expected to decline from 2019 as a direct result of the FOBT stake limit. In FY19, a c £60m decline in EBITDA should be largely offset by £25m synergies and growth from other parts of the enlarged business.

As detailed in the financials section, we forecast net gaming revenues (NGR) of £3.40bn in 2018, remaining flat in 2019. The lack of growth in FY19 is a direct result of weakness in UK retail (LCL) and specifically the impact of the FOBT stake limit, which is offset by a forecast 7% growth in the original GVC. For FY20 we forecast that LCL will return to growth from its depressed base in FY19, while GVC will continue its steady trajectory. Overall, we expect FY20 group revenue growth of 3.6% to £3.54bn.

GVC anticipates at least £100m cost synergies from the deal, to be staggered and back-ended over a four-year period. The most significant savings are expected from technology and data (c £44m), which we believe relates to the expiration of the Playtech contracts (2020 and 2021). Given both GVC’s and LCL’s extensive experience with complex integrations, the £100m annual cost savings target appears conservative. We also note that GVC has not guided to any specific capex or revenue synergies (cross-selling etc). These are therefore not included in our estimates but, judging from GVC’s history with the bwin acquisition, we believe revenue and capex synergies could amount to c £40-50m over the next few years.

While there are many moving parts in formulating a pro forma model, the largest variable is the outcome of the Triennial Review and the decision on FOBT stake limits. Given recent recommendations by the Gambling Commission and other industry speculation, our forecasts assume the middle £20 limit, which will affect financials from FY19 onwards (and increase net debt in FY18 by £585m due to the contingent value right [CVR]). As highlighted below, under this scenario, we anticipate 24% EPS accretion in FY19 compared to standalone GVC figures. We note that even in the worst case £2 scenario, our figures indicate EPS accretion of 10% for FY19.

GVC’s board and executive team has a considerable depth of experience in online gaming, as well as proven capability at extracting value from acquisitions. For the enlarged group, the team has been further enhanced with key additions from the LCL management team. Specifically, CFO Paul Bowtell and COO Andy Hornby come with detailed knowledge of both the UK retail sector and the complexities of handling a large integration (Ladbrokes with Coral).

GVC has always believed in management and employee incentivisation, and we would expect a new option plan and significant performance-based bonuses going forward.

Given the vagaries of the ongoing Triennial Review, the acquisition of LCL was structured with three distinct tranches, in order to reflect the different possible outcomes for FOBT stake limits. As we discuss below, the value of the final tranche (CVR) is still to be concluded and the total possible valuation range for LCL is £3.1-£4.0bn.

While our core forecasts assume a £20 stake limit scenario, we show the full set of possibilities as originally agreed by GVC:

As demonstrated in Exhibit 10, LCL’s closing share price on 28 March was 173.5p, which includes a 32.7p cash component, 129.4p of new GVC shares (based on 918p per GVC share) and an implied 11.36p remaining for the CVR.

The consultation period for the DCMS’s Triennial Review concluded in January and, as discussed above, the major focus has been on the stakes and prizes offered on B2 machines, or fixed-odds betting terminals (FOBTs), which offer games such as roulette. These are mainly located in betting shops and have a maximum stake of £100 and prize of £500. According to the Gambling Commission, there were a total of 8,531 betting shops and 33,611 B2 FOBT machines at September 2017, generating £1.8bn a year of revenue. Across the betting shop sector, the FOBT machines are split 65/35% between B2 (previously £100 limit) and B3 (£2 limit).

The initial conclusion of the review is that the stake limits for FOBTs would be cut to between £2 and £50. Recent industry speculation suggests that the outcome will be either £2 or £20, or indeed a variation of the two (eg £2 for slots and £20 for roulette), which would have a significant impact on profits. We have based our core forecasts on the £20 stake level, although we also include a worst-case £2 limit scenario. Clearly, a variation of both scenarios would produce something in between.

For LCL, B2 machine revenues comprise c £500m per annum. Taking into account some substitution into lower-staking B2 or B3 content, we believe that, pre-mitigation, a £2 limit would reduce revenues by c 50% and a £20 limit would reduce revenues by c 25%. These figures correlate with estimates provided by PPB for its Paddy Power betting shops, detailed in our October 2017 sector report, UK gaming sector: Winning against the odds.

We would expect the eventual impact to be less negative as operators are likely to mitigate through substitution, alternative development etc. There are a number of ways that LCL would be able to recover lost revenues: (i) customers switching from B2 to B3 games; (ii) customers playing for longer; (iii) switching spend to OTC or online; and (iv) market share gains, if independent shops are forced to close.

In terms of profits, we estimate that any revenue shortfall would result in a 70% drop through to EBITDA. This is due to the fact that fixed costs in retail betting are high and the largest variable cost is the 25% tax on machines. As a result of these dynamics, we would expect significant shop closures over the next few years, with a third of LCL shops closing under the £2 scenario (c 1,000 shops) and 400 shops closing under the £20 scenario.

As the company manages its cost base with progressive shop closures and cost savings, we estimate that over two to three years, the eventual EBITDA impact will be c £100m for a £2 FOBT and £50m for a £20 FOBT stake limit.

As detailed above, we have based our core scenario on a £20 FOBT outcome, although we also demonstrate a scenario based on the worst-case £2 limit.

Overall, we forecast pro forma NGR growth of 4.4% to £3.40bn in 2018, rising 0.3% to £3.41bn in 2019 and then increasing to 3.6% growth in 2020.

Once the impact of FOBT stake limit has been absorbed, we assume flat revenues in LCL’s retail division, which will be offset by higher online growth in the rest of the business. (H2 Gambling Capital has estimated that global online gaming growth is 7% CAGR to 2021.) In particular, as the UK online market matures, we anticipate that GVC will seek revenue growth from other markets (as evidenced by the recent acquisition in Georgia). Altogether, we anticipate long-term group revenue growth of c 2-3%.

For EBITDA, we forecast £747m in FY18, falling to £743m in FY19. The decline reflects the impact of the FOBT stake limits, which is offset by online growth and the £25m expected synergies. For FY20, we forecast a return to margin expansion (£810m EBITDA), as the company should begin to benefit from cost efficiencies and shop closures.

As demonstrated in its recent FY17 results, standalone GVC has continued its strong growth trajectory, with continuing NGR (excluding Turkey) up 17% in 2017 to £814.5m. This was largely driven by a 20% growth in sports brands NGR and a 10.8% sports margin. The platform migration following the bwin acquisition is now complete in all key territories and current trading into Q118 is also strong, with daily NGR growth of 16%. The FIFA World Cup is expected to contribute to continued momentum and we forecast GVC revenue growth of 12% in FY18 (€1,035m or £895m). Despite the lack of major football tournaments in 2019, we believe the company will continue its strong momentum and we forecast FY19 NGR growth of 7%.

Despite incremental gaming taxes and higher marketing spend (from 21% to 25% of revenues), GVC’s EBITDA margin increased from 21% to 26% in FY17. Management has confirmed that marketing should remain at these levels ahead of the FIFA World Cup. Nonetheless, as the company continues to deliver technological efficiencies, we expect continued margin improvement and our EBITDA margin forecasts are 27.5% and 28.0% for 2018 and 2019 respectively.

In March 2018, GVC announced that it had acquired a 51% stake in Crystalbet in the Republic of Georgia for €41m cash, with a commitment to acquire the remaining 49% in 2021 (for a maximum of €150m cash). Crystalbet is currently the largest online sportsbook, and the second largest online gaming brand overall in the Republic of Georgia. We include £25m revenues and £8m of EBITDA for 2018 in the consolidated accounts.

Our pro forma estimates have translated 2017 GVC accounts at €/£0.88 and, for 2018 onwards, we have used a €/£ exchange rate of 0.86.

For FY18, we estimate revenue growth for LCL of 2.6% to £2.5bn, with the growth driven primarily from the group’s online divisions. We expect a continued 3% decline in UK retail in 2018, not helped by recent fixture cancellations (snow related) and other general weakness on the UK high street. Our EBITDA estimate for 2018 is £505m, which represents a 20% margin.

After 2018, the Triennial Review will have a substantial impact on future financials, with the FOBT changes expected to be implemented from 2019. To place the FOBT threat in context, we estimate that approximately 65% of LCL’s FY17 revenues are derived from its retail business, of which the vast majority is in the UK, and that approximately £500m revenues are currently derived from FOBT machines.

We detail our key assumptions:

Our income statement forecasts include a high level of restructuring and one-off costs, totalling £234m in FY18, £60m in FY19 and £36m in FY20. In addition to previous costs associated with the Coral deal, these include:

GVC has outlined a minimum of £100m of cost synergies, which appears extremely conservative, particularly in light of both GVC’s and LCL’s impressive track record with complex integrations. We also note that these estimates do not include any revenue and capex synergies, which could amount to c £40-£50m (not in our forecasts). We highlight the key features of the synergies:

To finance the cash portion (£632m) of the acquisition, GVC has secured a debt financing package, consisting of a six-year, multi-currency £1.4bn first lien term loan and a £550m multi-currency, revolving credit facility. Proceeds will also be used to refinance some existing LCL debt. This loan is in addition to GVC’s existing £300m term loan.

Beyond the key issue of the Triennial Review and the FOBT stake limit, there are a number of sensitivities that investors should consider.

The most straightforward way to value GVC is via a peer group comparison. Exhibit 13 compares it to the leading UK gaming operators, together with selected international players. Within this group, we believe the nearest peer is PPB, which also has a high-performing online sportsbook and a significant retail presence in the UK.

For the £20 scenario, GVC trades at a discount to PPB – a 5% EV/EBITDA and 19% P/E discount for FY19. We note GVC’s higher debt profile, suggesting an EV/EBITDA comparison is probably more appropriate at this stage. Catalysts to close this valuation gap would include positive evidence of a successful integration, including concrete cost and revenue synergies.

We have also performed a DCF with a terminal growth rate of 2% and a terminal EBITDA margin of 20%, vs 22% in FY18e. Using a WACC of 8.5% produces a value per diluted share of 1,036p; flexing the WACC between 8.0% and 9.0% gives a range of 936-1,152p. Our core 1,036p DCF valuation equates to 11.3x EV/EBITDA and 14.1x P/E for FY19e, which is slightly above its closest peer, PPB on an EV/EBITDA basis, but still at an appropriate discount on a P/E basis (given the debt profile).