Betfair: The Smart Way To Bet On Sports

Dec.22.13 | About: Betfair Group (BTFRF)

Betfair Group PLC (OTC:BTFRF) runs the world's leading betting exchange called Betfair. The product is very popular with sophisticated customers but struggles attracting the mainstream punter.

A betting exchange is different from the traditional bookmaker model in a few essential ways. The customers do not bet against the company but against each other. This relieves a lot of financial risk from the company but it also introduces the problem of liquidity.

Because liquidity in a wide variety of markets is vital Betfair has taken an approach that is friendly to sophisticated bettors. These customers act as market makers among other things. The company charges low fees and just modernized its API to enable customers to create trading programs and tools to enhance their experience. Because its hard to offer liquidity in a lot of different markets, I consider the company to have a competitive advantage over other bookmakers. It essentially benefits from a form of the network effect and taking away its leading position is not easily accomplished.

I like Betfair's business model. I can agree to the way management puts it:

We strongly believe that the Exchange remains the most

innovative product in our industry, offering better value

and greater flexibility than the traditional bookmaker model.

However the company did not entirely live up to expectations since its IPO. There are a few developments going on right now that make the company especially attractive:

The Bid

In April the company received an approach to take Betfair private. A number of proposals were put to the Board, all of which were rejected. As the Telegraph reported:

Richard Koch is not used to failure. The author, investor and 6.4pc Betfair shareholder puts his personal wealth at £140m, says his financial priority is "to become a billionaire" and has just published a book sub-titled "Ten Ways to Become a Great Leader".

So ask him why his bid for Betfair fell over and he looks genuinely perplexed. Mr Koch, 62, had teamed up with private equity firm CVC to table a near-£1bn offer for the betting exchange group and came within a nose of landing the prize

The company is trading at a market cap representing a market cap greater than £1bn right now so perhaps walking away from that bid was the right decision.

Payout Ratio

They are not easy to find but I like small companies with decent payout ratios. It reminds executives of the main goal of business. The Board considers the appropriate target payout ratio to be approximately 40% of underlying profit after tax in the medium term.

API Improvements

Betfair is investing to improve its products for its 'sophisticated' customers. Betfair has a number of high-value customers using third party applications and automatic trading programs, which utilize its Application Program Interface (NYSEMKT:API) to directly access the Exchange. Betfair recently launched a new API to allow these vendors to build out more sophisticated trading tools to provide an improved user experience for this important customer segment

Fixed Odds Betting

Betfair recently launched a traditional sportsbook to complement its exchange offerings. The number of customers placing fixed-odds bets in FY13 was up 85% on the prior year, driven by 129% growth in the UK & Ireland. Initial evidence suggests that the Sportsbook is complementary to the Exchange, with 24% of UK football customers in March and April placing bets on both the Exchange and

Sportsbook products.

Bingo & iPoker

In Q4, Betfair added Bingo to its product offerings and began the process of migrating customers to the iPoker network. This platform has greater liquidity than its previous network, particularly in newly regulating regions. This has caused an initial fall in customers but it provides customers with a better product and should lead to higher revenues in the longer term.

Regulatory positives

One of the problems with the online gambling industry is the the regulatory environment across Europe and the world. These are highly unpredictable, opportunistic (need some extra taxes, tax gambling) and different across countries or even states. Legislation continues to evolve with countries taking a range of approaches to the regulation of online gaming. Betfair continues to engage in these processes with the aim of achieving workable and fair regulation. Management reported it has recently seen positive steps towards the regulation of exchanges in Italy and Spain. Italy and Spain have some of the strongest soccer competitions in Europe and are vital markets next to Germany and the UK.

Cost savings

Betfair has a new CEO who is striving to accomplish a cultural shift. I was pleased to notice attention to detail when it comes to cost savings in the 2013 annual report.

Betfair delivered 'one switch' power modules to 1,000 desktops within the Hammersmith and Milan offices. These enable employees to switch off all power to their desk from a single switch. This cuts the continuous consumption of 'out of hours' energy drawn by phone chargers, PC power modules and other electrical items which continue to feed when not in use.

Betfair also has a strict travel policy which aims to reduce all travel within the business through actively encouraging use of videoconference and movie client application. In addition, Betfair does not operate a company car scheme. Instead the company promotes initiatives like:

• cycle to work

• provision of showers and locker facilities for cyclists

and runners

•global video-conferencing facilities

• economy travel across all European destinations

•use of public transport in city hubs

Valuation

When applying a discounted cash flow calculation I've come to the conclusion that the net present value of Betfair ADR is about $16. That means the company is about fairly valued right now. I've based my calculation on current cash flow and projected 10% growth for 10 year into the future. Keep in mind that 2014 is a Soccer World Cup year so this might be very conservative. I projected cash flow over an exceptionally long period because the competitive advantage derived from the business exchange model. A traditional bookmaker doesn't have that same competitive advantage. As always I discounted against the S&P 500.

Conclusion

Betfair is fairly valued right now. However this company is one to put on your short list and when it slides down or is pushed down because of bad news of temporary nature, take advantage. When acquired at the right price this is one of those compounding machines you can hold for a very long time. If there isn't enough liquidity in New York try the LSE.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.