CryptoLogic's Future Too Uncertain

Cryptologic (CRYP) is a 21st century play on the old sin stock concept. They develop the software for online gaming sites -- mainly casinos and poker rooms.

Pros

Historically high margins and returns on capital

Rock-solid balance sheet -- no debt

Cash balance ~$77M ($6/shr) & tangible assets ~$37M (~$3/share)

Largest share of the European poker market

Casino revenues (the largest segment of operating results) up 1Q 2007

Operating leverage fix @ around $18M -- revenues above this flow directly to bottom line

Establishing relationships in China

Licensee roster: World Poker Tour, William Hill, Holland Casino, Playboy

Dividend ~ 2%

Cons

Appear to be losing European poker market share to competitors like Playtech, even excluding the loss of Betfair

Betfair accounted for a quarter of CRYP non-US poker business and they took their tech operations in-house.

Though they don't think other clients have the circumstances to do same, always a possibility

Anti-gambling US legislation has killed that market, which accounted for the majority of online gambling revenues

Recent $4M jackpot provision may have been accounting attempt to bolster results

Paid $11.8M for Norwegian poker site, Parbet.com, with $11.4 M being allocated to goodwill

2Q 2007 projected at a loss of $0.11/shr. Limited visibility on our end as to how they'll turn it around without access to US market. China at this moment is just a seed

New CEO -- bad time to bring in a new CEO in any case

Playtech is a formidable competitor and may continue to gain market share

Assessment

The company has a good track record of creating value for shareholders but there's a little too much uncertainty right now in my mind regarding their ability to compete in Europe & Asia. Playtech announced a very strong 1st quarter compared to Crypt even as they both face the same US headwinds. Playtech increased market share and have stronger licensees in Partygaming & Tribeca on the poker side as well as already running operations in China (where they are having limited success) and mobile phone gaming. I'm not sure what would be different to allow Cryptologic to fare any better in China so that part of the growth story is questionable. Playtech also has much better margins than CRYP and I'm not sure where it's written that CRYP has to return to profitability.

The safe money on this stock has already been made, when CRYP moved from the $15 range after the US gambling legislation last year to ~$24 currently.

If it falters back down near the previous lows then we'll take another look, but the poor business visibility is enough to scare me away.

CRYP 1-yr chart

Disclosure: none

Comments

[sophiework1:]

You forget one of the most importen things Holland GOVERMENT has signed up with CRYP and start sending trafic in September.

PLUS maybe you should look at the numbers ones again - the facts CRYP is very cheap now:

Based on the first quarter and addition of new licensees that will come online in 2007, CRYP should earn about $80 million in revenue in 2007. If excess cash is backed out and normalized margins are assumed, CRYP would currently be trading at less than 15x normalized earnings for a business with 20%+ returns on equity and very bright growth and reinvestment prospects. However, margins likely will not get back to normal until 2009. Under this scenario, the income statement for 2009 should summarize as follows (estimating 20% revenue growth in 2008 and 2009):

Revenue..................
Operating Income.........23,328,...
Operating Margin..........20.25%
NOPAT....................
Net Margin...................
End of Year Cash.........145,000,0...

Depending on the growth achieved after 2009 and the terminal multiple CRYP receives on its earnings (or the growth the market foresees and the multiple it assigns to those earnings), the value of CRYP 2.5 – 3 years should range as follows:

NOPAT......$19,828,800 Diluted Shares..14,000,000
Discount Rate..10.00% Excess Capital..$130,000,000

_________________Earni... Growth (6 Years after 2009)
Year 6____________0.00%__5....
Term. Mult.
10.00____________$22.6... 2 13.00____________$25.0... 16.00____________$27.45_$32.60__$39.03__$46.98__$56.75 19.00____________$29.8... 22.00____________$32.24_$39.03__$47.53__$58.08__$71.07 ________________Intrin... Value per Share at the End of 2009

The company's future and prospects should still be very bright at the end of 2009 and although it is probably more likely that CRYP would exceed 20% growth in the 6 years following 2009 than achieve no growth, even the no growth scenario (that also assumes dilution) gives a value close to today's price which should provide nice downside protection. CRYP will most likely be worth $50-60 at the end of 2009, which would provide for an annual rate of return of 25-40% over the next 2-3 years with little downside risk.

2007 Jul 24 08:03 AM

[Davy V. Bui:]

Thanks for your comments. Analyzing a prospect from all sides is great for making investment decisions. As such, you've given the bull case and a clarification of my bear case follows. I'm paranoid by nature and always try to focus on what may go wrong.

I did list Holland Casino as one of their licensees. Keep in mind that management mentioned that the Holland Casino does compete with some of their other clients.

As for your analysis, it looks good if you're willing to grant assumptions that you've made (20% revenue growth, 20+% margins, etc.). My main point is I'm not convinced CRYP will return back to previous levels of profitability, which makes your income projections moot.

I base this possibility on a) the loss of the US market is a structural industry change, b) more companies now fighting for smaller pie and CRYP is not the strongest of these competitors, c) comparing their 1st quarter operating results to the industry leader, Playtech and d) they have a new CEO.

Reviewing Playtech's results from 1Q 2007, it's clear to me that Playtech's competitive position is getting stronger. Just based on numbers taken out of CRYP's investor presentation, Playtech is the better company, generating more net income on half ot CRYP's revenues. And now everyone's squeezed into the same market (mainly Europe), fighting for a smaller pie. CRYP has fixed costs around $18M so they need to hit a certain threshold or else find new markets. China is not going to be an easy market to crack open. Playtech has already beaten Cryptologic there, and are running Mahjong and other games with limited success. As any heavy downloader will tell you, Chinese internet connections are painfullly slow so that could hinder any online gaming growth there.

As for numbers, CRYP had $19.5M in revenue in Q1 2007. They've said that Q1 & Q4 are their strongest quarters, since the better weather draws players away from their computers. So you can't assume $80M in revenue by multiplying Q1 by 4. I would also say that you can't assume they won't lose market share. As a side note, interest income was substantial and accounted for 100+% of Q1 net income and without it, they would have posted a loss.

So if I'm looking at the bear case, what is CRYP worth if things go wrong? Taking total assets and dividing by shares outstanding ($188M / 14 M shares) = $13 /share. If we break it down, here's my liquidation value for the company, listing the recovery factor for each asset:

cash 100% $77,312
security 0 $-
short-term inv 90% $22,500
Acct receiv. 90% $13,644
Prepaid Ex 25% $2,654
user dep 0 -
PPE (applying year-end 2006 ratios to $20.3M)
computer 35% $2,221
furniture 50% $783
software 25% $970
R&D 40% $2,062
leasehold 30% $1,000
intang asset 85% $9,858
goodwill 0% $-

Total ass $133,004
per share: $9.50

If you wanted to value it as a going concern, I don't know if the numbers would jump up all that much. The only barriers to entry are hiring the right people (payroll) and developing customer relationships, so you could probably capitalize some arbitrary percentage of operating costs for marketing but it wouldn't make a huge difference and might just get you back to total assets / shares outstanding.

Finally, I don't necessarily assume that a company won't waste its cash. So if we got to the worst case scenario, would all that cash still be there? That's why management is such a strong factor in my investment decisions and CRYP's management is a big unknown to me.

Please note I'm not saying people should short the stock. It's very possible that they will perform as you expect. I'm trying to assess the probability of CRYP returning to previous levels of profitability and looking at the downside if they miss.

All that said, based on what I know now, I'd look at it again in the $18-$20 range, when the floor is closer.

- Davy Bui

2007 Jul 25 10:47 AM

[valueman:]

I've looked at both CRYP and PTEC, and I struck by the widely differing expenses between the two. It seems they do about the same thing, but PTEC has half the expenses as CRYP. Is this solely due to the fact that PTEC has its developers in Estonia and other developing countries? Or is there something else? I'd appreciate any further insights into the relative cost structures. And whether you think that the cost structure difference will persist. Why doesn't CRYP slowly move development to developing countries as well?

2007 Jul 30 12:33 PM