Cryptologic Pre-Earnings (Non-)Assessment

Aug. 7.08 | About: CryptoLogic Limited (CRYP)

On the eve of Cryptologic’s (NASDAQ:CRYP) earnings release, I am posting my report on the company. In the end, I just chalked this one up to the “too hard” basket. I just can’t get a comfortable handle on their future business prospects and that combined with the illiquidity of the stock means I’m taking a pass for now. Note that I wrote the report in mid-July.

Cryptologic Limited (CRYP)

Cryptologic is an online gaming software provider servicing e-casinos, online poker rooms, etc. Casino gaming comprises ~70% of revenues, online poker ~20-25% and other income fills it out on a fluctuating basis. Since the passage of the UIGEA in the US, the vast majority of revenues come from Europe, with the Asian market strategy still in its nascent stages.

Intrinsic Value: $15.50 - $21.50 per share

Accumulate: ????

FUNDAMENTAL METRICS

Share Price (07/14/2008): $12.99

  • Market Cap: $166M
  • Dividend Yield: 3.7%
  • TTM P/FCF (5-yr): 29.1 (10.4)
  • Greenblatt ROIC (3-yr avg): 1% (26%)
  • Debt-to-Equity: 0
  • Total Liabilities to Equity (ex-goodwill): 0.45 (0.48)
  • TTM P/E (Forward P/E): 39.27 (10.92)
  • P/S: 2.38
  • P/B (tangible): 1.64 (2.01)
  • PEG Ratio: 0.47

RISKS

  • Cryptologic and others are subject to considerable political risk.
    1. The UIGEA act passed in the United States, which effectively shut down the world’s largest online poker/gambling market.
    2. In the UK, house profits will be subject to a 15% tax, much higher than in other jurisdictions.
    3. Cryptologic regularly mention possible regulatory roadblocks in countries such as France and Italy.
  • Cyptologic’s position in the industry, as the middleware between the consumer and the branded casino site, sometimes puts the company in the position of competing against its own clients.
    1. For example, a client, Sportech PLC via the Littlewoods gaming sites, is a client who has recently announced the termination of their agreement with CRYP in favor of migrating to 888 Holdings PLC, who also happens to have an agreement with Cryptologic for online casino games.
    2. The company has also noted possible competition between Holland Casino and other clients.
  • The company’s online poker segment is struggling at the moment. Last year, the company lost the contract of Betfair, who took their software support in-house. This reduced the liquidity (which is vital to online poker) of the poker room by 33%. Management has projected that growth in the poker segment will only come by adding new licensees (or possibly acquiring them).
  • While the company no longer generates any US business, they still carry a large amount of assets in USD. Management states that the company is naturally hedged through it’s foreign currency operations while keeping assets in dollars but by my quick calculations, CRYP is somewhat long US$.
  • Cryptologic introduced two new CEOs in quick succession. Apparently, the previous CEO agreed to helm the company upon its move to Ireland, then abruptly left due to homesickness. Brian Hadfield took over late last year and while my impression is favorable over the previous CEO, a company racked by uncertainty due to legislation doesn’t need to create any more by playing executive musical chairs.
  • The company faces an impressive competitor, Playtech PLC (London). While CRYP saw revenues fall 29% and operating margins fall off a cliff from 22% to 2% in 2007, Playtech managed to increase revenues and hold operating income (but not margins) steady during 2007. They also garner 21% of revenues from Asia-Pacific, far ahead of Cryptologic and have solid market share in online poker.
  • Fairly weak position in Asia, which doesn’t appear to be generating any revenues for the company. Cryptologic has recently made a series of investments in small gaming companies in China, Singapore, South Korea and first reports are promising but caution is warranted. The prior CEO was overly bullish on Asia and current management has backed of the previous goal of 10% Asian revenues by mid-2008.
  • Cryptologic returned to positive operating (OCF) and free cash flow (NYSE:FCF) in Q1 2008. However, the company drastically cut CapEx to $664k (down 80% YoY & covering 60% of amortization) to achieve positive FCF. Any sustained decline in CapEx could leave CRYP in a weakened competitive position.
  • The company disclosed material weaknesses in their internal reporting controls in their 2007 annual report. As a small company, they may struggle with the onerous reporting requirements that come with listing in Canada, England and US.
  • CRYP trades relatively low volumes on the NASDAQ exchange, averaging 74,000 shares daily volume. Low liquidity may affect investor ability to maximize entry & exit prices or use derivatives to hedge risk. It doesn’t take a stretch of imagination to see the company de-list from the NASDAQ eventually as the company is headquartered in Ireland, develops in Canada and does no business in the US.

UPSIDE POTENTIAL

  • Historically strong business with 5-year avg of $16M in annual FCF, 3-year avg of 26% ROIC (despite last year’s 1% ROIC), and 20%+ operating and net income margins before UIGEA.
  • Rock solid balance sheet: zero debt and $75M unrestricted cash ($81M total)
  • Over 90% of revenue comes from recurring royalty streams generated by CRYP’s gaming software and marketing support.
  • Cryptologic seems to have regained its footing after a transitory 2007 which saw them post operating losses (ex-interest income) and burn through $11M in OCF. New CEO Brian Hadfield is targeting a return to pre-UIGEA levels by YE 2009.
  • Minimal exposure to the commodity exposure which is roiling much of the global economy.
  • No apparent exposure to auction-rate securities and other faux cash proxies. Management claims all cash is in AAA bank notes.
  • Minimal goodwill comprises 4% of total assets. Intangible assets are 8% of total assets. Tangible book value is $6.45 per share and seems very stable with minimal risk of massive writedowns or illiquidity.
  • There is a general sense that the UIGEA could eventually be modified or repealed as US political power shifts away from social conservatives. Congressman Barney Frank, chairman of the House Committee on Financial Services, is on record as wanting to repeal the act. If this were to happen, CRYP would noticeably pop on the news.
  • Investments in various small companies throughout Asia could open those markets up. Many Asian countries have a rich gambling tradition and could be a boon to the industry.
    • 568 Network (China)
    • Mikoishi (Singapore)
    • Jingle Prize (Asia)
    • Mahjong Time (Asia)
    • Mobilebus (Korea)

VALUATION

The valuation of CRYP hinges on two key points: 1) an accurate assessment of the company’s ability to re-attain the operating levels reached in 2006 and 2) an adequate margin of safety to account for the level of uncertainty in that assessment.

The company generated ~$6M TTM FCF but keep in mind that this includes 3 quarters from 2007, over which they generated slightly negative OCF. Assuming that Cryptologic has turned the corner and is on their way back to previous operating levels, I get the following rough intrinsic values (assuming 6% growth and risk-free rate of 5%):

  • 5-yr avg FCF $16M @ $21.75 per share
  • 2006 FCF $32M @ $43.22 per share
  • 2004 FCF $11.5M @ $15.53 per share
  • TTM FCF $6M @ $7.78 per share

I’m discarding the TTM FCF figure as the investment thesis is based on a continuation of the trend toward positive earnings and cash flow. In Q1 2008, the company generated $4M in FCF but with seemingly unsustainable low CapEx. Taking this into account along with the company’s seasonal revenue patterns (middle quarters are weaker) and management’s projection that CapEx will not exceed 2008 amortizations of $7M - $8M, I’d like to see 2008 FCF come in around $8 - $10M and trending up.

I’m also tossing out the 2006 FCF number for caution’s sake. If management is able to bring CRYP back to even just half of 2006 levels of cash flow & back inline with the 5-yr average, the stock is worth about $22 per share. Chopping the assumed growth rate in half reduces IV across the board ~$2.50 so we’re still looking at $19 per share IV.

For a margin of safety, CRYP is selling slightly above book value ($7.94 per share), including goodwill and intangible assets. Backing out goodwill but giving them credit for intangible assets (customer lists and online domain names such as casino.co.uk), book value is right around $7 per share with a substantial portion of that being cash. Caution may warrant looking at the stock as it gets closer to book value.

ASSESSMENT

At these levels, Cryptologic seems fairly attractive. I do have some concerns regarding their future earnings power and best-in-breed competitor, Playtech PLC. But at these levels, downside risk seems limited for the following reasons:

  • The airtight balance sheet means little immediate danger of ceasing operations.
  • Cryptologic has several high-quality licensees such as Playboy, the Dutch government, and World Poker Tour who probably will not take their software production in-house (as opposed to other licensees like 888 Networks). These licensees generally sign 3-year contracts so there is some visibility on future revenues.
  • Share prices are approaching book value, which unlike the financials, is not likely to sustain huge write-downs.
  • Pays a seemingly sustainable ~4% dividend.

PERFORMANCE MEASUREMENTS

  • Hit Management Targets
    • 2008 Goals:
      • Grow both casino & poker businesses (up 33% normalized & down 19% respectively in Q1 08).
        • Increase poker room liquidity.
      • 3 – 4 new licensees in Europe & Asia.
      • 18 – 20 licensees (up from 14 now)
      • Launch Holland Casino in latter-half 2008.
      • Achieve revenue from new gaming segment like their subscription-based casual games.
      • Release 3 game packs with 15 new games.
    • Long-term goals
      • YE 2009 targets:
        • Revenue: $104M
        • Earnings: $25M
        • While not an explicit target, OCF/FCF in 2006 were $41M & $32M respectively
      • Grow revenue + earnings by 20% YoY in Europe & Asia combined.
      • Net margins & ROE @ 20%
      • Casino.co.uk – generate $2 - $3M in revenues within 3 years ($1M annual revenues now)
  • 2008 FCF @ $8M - $10M.
  • Capitalize on various Asian investments and start generating revenue from Asia.
  • Maintain or increase dividend.
  • Flat or shrinking share count.

Disclosure: None