The bad news: Prior to last Friday's +9% move, shares of Youbet.com (UBET) were nearly cut in half from July's high of $3.91, which we didn't expect given improved industry content relationships and the company's solid financial position (discussed in our prior posts, including this July post).
Also, yesterday, the company announced an accounting restatement related to YB's rewards program (see here, small non-cash impact). Shares retraced part of Friday's up move yesterday.
The good news: As David Dreman writes in his 8/19/09 Forbes column (here), "Markets are always perverse and unpredictable." That is, the market is irrational. How else can we explain certain financial names highly diluted by government ownership stakes seemingly trading on thin air? If interested on this latter topic, we point to some thought provoking pieces on Seeking Alpha regarding Citigroup (NYSE:C) (here) and AIG (here)....
And, more good news: we, as investors, can be rational and take advantage of market mis-pricing to profit so long as our fundamental analysis is correct (buy quality businesses cheap, sell them dear).
And, shhhh, more good news: maybe the market won't bid shares back up too quickly because we believe Youbet can now be active with company's share repurchase program (up to 10% of common shares outstanding, or approximately four million shares).
Our understanding is that the company was previously restricted by potential M&A activity related to discussions regarding the tote business -- but, no longer, since that process is on hold given other properties for sale in the market and management sees no reason for a "fire sale". We would be disappointed if Youbet does not report repurchase activity for 3Q09.
Although we would prefer for UBET to be trade closer to a 5% free cash flow yield (which we see as fair based on the company's established franchise as outlined in our initial post), or approximately $4.50 to $5.50 (assuming reduced 2009E FCF of $10 million to $12 million), we also prefer management to repurchase shares on the cheap.
Buying back stock at $2-3 is far more accretive than buying in shares at $4-5. For example, if Youbet uses $10 million of free cash flow over the next twelve months (above current net cash of $5.6 million) to repurchase shares at $2, we estimate that annual EPS would increase by approximately $0.02. If Youbet instead repurchases shares at $4, then EPS might increase by about 7/10 of one cent.
The other week, a reader posted interesting comments to our 8/6/09 pre-results post ("UBET Slides...") and, among other things, asked if our confidence has been shaken given industry handle declines. Our brief answer was that we believe franchise value remains significantly higher than current levels and is supported by current and expected free cash flows.
Yes, some investors threw in the towel on weaker than expected June quarter results (we discussed here) and the subsequent downgrade by Brean Murray, one of the few brokerage firms that has long covered the stock and knows both the company and industry well.
We are aware of key investor concerns such as
- increased competition from an aggressive Churchill Downs (NASDAQ:CHDN),
- lower wagering yields (related primarily to new content), and
- the poor economy.
We address these points on our blog here, including a detailed market share summary.
It's true that the ADW market is competitive, but this is nothing new -- nearly all businesses face competition, especially now. YB successfully managed through 2008 with reduced content and competition. We expect the company's franchise to allow Youbet to manage through the balance of 2009 and into 2010, even as the weak economy pressures industry handle. We imagine YB's new CFO (also announced yesterday) -- who appears experienced and capable -- will carefully manage customer acquisition/retention costs to maintain and potentially improve margins over time.
We believe our core thesis is intact: over the past decade, Youbet established an asset light business model with a leading online wagering franchise – brand, customers, platform, marketing partners, and track relationships – that is difficult to replicate.
An important part of this thesis is that Youbet’s online business should generate steady, growing free cash flow combined with a high ROE/ROIC. Increasing net cash balances should allow owner-oriented management to return cash to shareholders over time (hopefully, during 3Q09 via share buyback!). We also believe growth is achievable given the secular shift to online wagering, especially whenever the economy rebounds.
We will change our tune if YB's management is unable to both maintain/increase market share and grow the bottom-line (as measured by free cash flow) over time. Capital returns to shareholders also remain a must.
Lastly, as noted above, valuation remains attractive in our view, and we could see shares fairly trading around $5 today assuming a 5% FCF yield on 2009E free cash flow. On a relative TTM basis, Youbet continues to trade at a significant discount to certain other niche franchise Internet businesses and gaming companies:
If Youbet traded at Blue Nile's valuation, shares would be at $8 today. We probably don't need to relay which one we'd rather own at current levels.
Disclosure: long UBET, BIDZ.