Youbet.com: Growth Potential and Cash, Cash, Cash

We've been meaning to provide slightly more color on Youbet (UBET), which reports 3Q09 results this afternoon. So, here we go -- now we are following up on our brief post regarding Breeders' Cup and Equibase data last week, and our online gaming update the other week.

We actually met briefly with Youbet management back on October 1st at the Thomas Weisel Consumer Conference in New York and watched CEO Goldberg's presentation - link to PDF here. The presentation and our conversation emphasized several key points:

1. Horse racing industry content disputes should be thing of past (we noted previously in initial post) and improved relations now sets stage for increased online penetration
2. Addressable market opportunity remains large, particularly relative to other online market segments where penetration is significantly higher
3. Youbet is working toward the launch of "casual" horse betting games in an effort to expand reach

Related slides from management presentation (click to enlarge) -- 2Q09 online (ADW) penetration jumped to 13% from 10% in 2008 (prior to content resolution):

Casual games will have a simple user interface:

Most points are not new information, but represent key parts of our thesis: that online wagering growth would return in 2009 on the back of new content relationships. Moreover, Youbet is well placed to capture more than its fair share of increased wagering while generating significant excess cash flow. We still think this is the case, but note that Y/Y handle (and revenue) comparisons among industry participants are not comparable as some players (e.g. Churchill Downs - CHDN) benefit from especially easy Y/Y comparisons. In addition, one caveat was/is potential margin pressure related to new content and customer retention/acquisition, which remain risk factors to monitor.

In today's report, we look for continued handle growth with somewhat better margins Q/Q (net yield at/north of 7.0% with an operating margin north of 10% for the ADW segment) and break-even results for the economically sensitive United Tote segment. For reference, we discussed 2Q09 results 2Q09 results here.

With regard to points 1 and 2 above, potential to capture increased market penetration represents a key opportunity for Youbet. While acknowledging that horse racing market dynamics are arguably different than other online segments, we see no reason not to expect incremental penetration over time. Importantly, as noted in prior posts, Youbet's established franchise should allow the company to at least maintain market share. We estimate that if ADW penetration increased to 20% from an estimated 13% in 2Q09, the earnings power of Youbet's online segment might increase by 50% holding margins steady (risk factor, although top-line yields could compress slightly while realizing bottom-line operating leverage).

Recall that in both 2Q09 and the seasonally weak 1Q09, Youbet's ADW segment delivered earnings of $0.06 each quarter (untaxed because of large NOLs, which should offset taxes over time despite some vagaries in California tax law). Annualizing this figure, we have current year earnings of $0.24 for the ADW segment and, at 20% penetration, we have $0.36 per share. We can't help but mention that shares of Youbet are trading at only 9 times the former figure, assigning no cash value to the tote segment and no value to potential growth (e.g. higher penetration, new product launches, international opportunities, or changes in U.S. online gaming laws).

Finally, we continue to view Youbet's online segment as a predictable cash generating business. Even the tote business would be fairly predictable under different operating conditions. Although our current estimate of Youbet's 2009 free cash flow is lower than at the outset of the year, we expect the company to generate at least $10 million of excess cash this year, followed by another $10 million next year, and so on. Put another way, the the company's net cash position of $5.6 million at 6/30/09 should be at least $15.6 million at 6/30/10 assuming no share repurchases. Cash should keep piling up on the balance sheet (even with no growth), which we like.

Per our September post, we hope the company was finally active in 3Q09 repurchasing shares on the cheap. Aside from reinvesting cash in the core business to enhance growth (captured in operating and capital expenditures), we believe share repurchase remains a top priority for excess cash and we certainly expect to see buyback activity over the coming year (if able to repurchase at accretive levels). Strategic acquisitions are another potential cash use, yet we don't necessarily expect to see deals as Youbet already has an excellent platform from which to expand organically. Thus, we're left with one other potential use: paying a dividend, similar to PetMed Express (PETS). We expect to see more cash rich Internet businesses initiate dividends over time and Youbet could seemingly join this club.

Disclosure: Long UBET, PETS.

Comments

[flek:]

Hi jefrey,
let me say a thanks. I'm just getting into business. Found this post very informative and valuable.

Thanks.
Flek.

Nov 11 12:01 PM

[Stivman:]

I have been an avid horseplayer for 16 years (since I was 18). I'm also a Youbet shareholder because of it's solid core business and ridiculously low valuation due to severe mismanagement.

However, I must dispute the slide in the presentation that claims that the challenge is to engage younger people into a slots-like experience and go for simplicity. In my opinion, this strategy just doesn't make sense, and it has been a failure everywhere it has been tried.

If you want to offer a slots-like experience, use slots! Whenever racing has tried to turn it's game into a slots like experience, handle is embarrassingly low (see Breeders' Cup Head2Head wagers, even/odd wagers, or the most-recent "Jockeys Bet").

When you consider the games that younger people play - be it fantasy sports, MMOG, and even poker, the word "simplicity" does not come to mind. Let's look specifically at the NFL and fantasy football, a game that caters to all demographics, including women. It is highly complex, with gobs of information, multiple strategies, and other time-consuming research. The growth has been phenomenal.

What racing and Youbet should do is embrace the complexity that racing has to offer, provide information at low (or no) cost, and evangelize the distinguishing features of the game. Not try and mold the game into a "slots-like" experience.

Youbet is obviously going in a different direction. Oh well. The other problem with racing in general is that the cost to play is too high. Youbet doesn't have any control over that, but again, why try to create a slots like experience when any racing related content is going to cost 4x what the real slots experience costs (20% takeout on racing vs 5% takeout on slots). Will they pay that much more because it involves horses? Obvisouly not.

Nov 11 01:31 PM

[Stivman:]

By the way, I wanted to say thank you as well. I just got a little worked up there over Youbet's (and the racing industry's) overall strategy. Let's hope for good earnings today.

Nov 11 01:32 PM

[Stivman:]

And I guess all of this is academic because of the buyout.

Nov 11 06:06 PM

[Ali Mogharabi:]

being acquired by chdn for cash and stock. with mgmt and the board agreeing to this, it doesn't look like they were very confident in the company's growth potential. then again, with Brodsky as chairman initially as ceo), everyone knew that he'd start slightly turning it around and sell it at 100%+ change in price to benefit many parties, including new world opp. but with more than 65% of this $2.84/share deal (based on today's closing price) being the CHDN stock, it'll be pretty risky to stick with it and hope to get a better deal. up nicely in AH, but will prob see some selling starting late morning. Good company, structured well with very good strategies (unlike a few yrs ago), but the current environment has forced shareholders (old & new) to lose patience. Selling this at around $2.60 - 2.70 doesn't appear to be a bad deal.

Nov 11 09:02 PM

[Jeffrey Wal...:]

CHDN is trading near/at all-time low on various valuation metrics (i.e. multiples of earnings and cash flow). If we assume CHDN is solid, durable franchise, the stock will once again trade at historic multiples at some point. On this basis, CHDN is really worth $45-50 per share which puts UBET's value at $3.70-4.00 per share. CHDN was in the high $30s just a few weeks ago. Also, note that CHDN pays a $0.50 per share annual dividend, which I expect the company can maintain even after issuing more shares to UBET shareholders.

Nov 17 03:09 PM