The Stars Group: Fox Buy-In Reflects Confidence In Our Thesis

About: The Stars Group Inc. (TSG)
by: Howard Jay Klein

We have followed TSG with a bullish outlook since its transformation from troubled Amaya in 2016.

Mr. Market was wary about the leverage and execution, but we like management's focus on scaling up fast in the online wagering space.

It has diversified from its overdependence on poker to stress on casino and sports betting as a key part of its future.

"Not everything that can be counted counts, and not everything that counts can be counted." - Albert Einstein

Note: A more detailed dive into this deal and its implications for the shares of The Stars Group (NASDAQ:TSG) will be discussed in greater detail on our House Edge marketplace site next week.

Yesterday Fox Sports Network announced it had acquired just under 5% of the equity of The Stars Group for $236m. The deal includes an option for Fox to buy up to 50% of the company after 10 years. Our take: The stake will build much sooner than that as the sports betting scramble currently underway ramps up with more states legalizing every year from this point forward (Below: Fox joins the TSG family with $236m buy-in. Source: Fox).

The news spiked TSG shares 14.98% to close at $20.11.

There could be some profit-taking activity today before the stock recommences what we see as a northward climb propelled by the accretive revenue, $70m synergy savings and EBITDA contributions from its latest acquisition, the UK's SkyBet with its 25m active customers.

Chart Data by YCharts

We have long been bullish on the stock since its transformation from the old Amaya and its regulatory problems. The new management acted promptly to exit its former management and its stock from the company. It then embarked on a focused strategy to pay off the remaining debt on its forerunner's $4.9b David eats Goliath purchase of Poker Stars in 2014. All that was left of the Amaya regime was a lingering lawsuit by the state of Kentucky, over Poker Stars customer complaints about payouts. The suit was based on a creaky 19th century law and demanded $800m in refunds. Though most legal experts saw Kentucky leaning on a slender reed, it was part of the detritus of the old management the new Stars Group had to deal with. Vindication came late last year with a court ruling that threw the case out.

With its decks cleared, and its balance sheet looking a lot cleaner, TSG went on an acquisition spree, picking up companies in Australia, doing a test deal, beefing up its EU presence, and above all, most recently in April of 2018, paying a hefty $4.7b for the UK's SkyBet and BetEasy platforms.

A bit of history

As early as July of 2016, we wrote on SA that we liked the new TSG's management moves. The stock traded at $15.38 that day.

In a July 2018 article, we noted that the stock, then at $25.85, gave investors two clear paths. One, if rattled by the massive debt TSG was taking on, more patience was needed, or else take the money off the table and sell. Two, if you saw beyond the admittedly scary debt load, hang in, better things lay ahead for what we believed was one of the most savvy young managements in the online wagering space - a sector with no shortage of such managements.

But we guided higher, much higher. This was largely because watching the new management team scaling the company yet still working on huge gross margins, we saw lots of light shining from a much closer end to the tunnel. We put our PT at $50 by Q2 of this year.

Our thesis was simple. TSG we wrote is a transaction stock. There was a pattern. During 2017, it came close to a merger deal with sports book giant William Hill PLC (OTCPK:WIMHF) [WMH:L] of the UK, but the Hill board scotched the deal in a last minute change of heart. But during a series of earnings calls thereafter, TSG executives were very clear that transactions were on their mind. They would either buy or be bought by either an equal or strategic competitor.

Like other observers of the sector, we thought concern about using debt rather than R&D to scale up was justified on many fronts given the premium TSG had paid for SkyBet/BetEasy acquisition. Yet at the same time, we saw much less risk in the strategy of using debt to build scale than did Mr. Market. So as the entire gaming sector took hit after hit in the second half of 2018, we stuck with our bullish outlook (Below: SkyBet: Accretive. Source: TSG)

What we saw beyond the debt load from an industry centric point of view was a strategy that made very good sense going forward. The company's core property, Poker Stars, was essentially flat and had been in early stages of global decline primarily in its EU stronghold. But the company acted fast to restructure its marketing tool kit by building its loyalty programs, and instituting tournament events both live and online to boost average daily volume. It also diverted effort and resources to building its online casino business to offset its poker decline.

It embarked on a test tube deal with India's largest distributor of lottery tickets to bring the Poker Stars brand platform to the states in that nation where it was legal. It bought into the Australian market in February of 2018 with a $117m buy of 62% of CrownBet Holdings PTY. Australia is the second largest sports betting market on the globe. In 2017 its revenues reached A$240m with EBITDA of A$7.9m.

All this gobbling sent TSG's long-term debt to $5.4bn as of the end of 2018. But it is in this year that the accretive EBITDA from these deals will begin to filter their way into the TSG's results, and we believe recognition by Mr. Market that despite its buying spree, TSG has focus, direction and execution skills that are worth far more than its share price indicates.

Clearly Fox Sports agreed. The platform the companies will build is to be called FoxBets, and will go active in US markets where sports betting has been legalized and where TSG can accumulate skins.

Rupert Murdoch, 88, has long been known as a buyer of assets at high premiums that the market has often head scratched about. Yet as famed NFL coach Bill Parcells has noted, when it comes down to making a call on a team's performance, it's simple. "You are what your record says you are."

Murdoch's record is on balance, solid and visionary.

Apparently Disney (NYSE:DIS) was a believer, having bought Fox's TV content assets for $71bn in its recent deal. Going forward, the Murdochs have placed their bets on news, sports and live events, happily leaving the world of scripted content to the ever shrinking sector of giants like Disney and AT&T (NYSE:T) and the technological streaming services like Netflix (NASDAQ:NFLX) and Amazon (NASDAQ:AMZN).

Sports betting is clearly in their crosshairs with this TSG deal since it fits the new Fox strategy: it's live, it's sports, it's direct consumer to business contact.

And it is out of that reality that we think TSG's head is in the right place. What it is about is creating an ecosystem of direct customer from source entertainment service clothed in the real money betting experience. High margin, high volume, global spread. Still in the process of converting debt to accretive EBITDA, TSG has some run ahead before it will begin producing the kind of earnings that propel the stock to historic highs. But we believe it is much closer to that ignition point than may be apparent now.

The accretion of earnings and reduction of debt may proceed at a pace difficult to measure against Mr. Market's continuing concerns about the entire sector. Yet we think the ramp-up of earnings and the steady reduction in debt we see for TSG prompt us to keep guidance at $50 by the end of Q2 or Q3 this year. We concede this can be seen as wildly bullish, so I caution readers to understand that I am coming at this PT from an industry centric point of view - not specific in terms of applying traditional stock appraisal metrics here.

I am seeing the light speed race on sports betting across the globe. I am hearing from industry colleagues who now see sports betting and online poker and casino games becoming a regular part of millennial leisure spend. "Inside the business, strategists are learning, that to survive, they need to have a profound, online presence. This goes for brick and mortar casinos, race tracks, lotteries. It's coming on us hard and fast," said one head of a tech wagering supplier company.

I think the rebalancing of debt moving to EBITDA and TSG's core positions in poker, online casino games and its burst in sports betting give it that ecosystem that spells superb earnings results in the next 18 months.

(Above: On the move across multiple real money platforms: Source: TSG)

TSG: A quick capsule of key numbers

  • 2018 revenue: $2.02b
  • Gross profit: $1.5bn
  • Operating income: $313m
  • EBITDA: $781M (in line with guidance)
  • Adj. EBITDA margin: 32%
  • Estimated EPS: 1Q19: $0.59
  • EV/EBITDA: 18.69
  • Quarterly revenue growth: 81.20%
  • One-year high was reached June 21 2018 at $38.90
  • One-year low came in December 2018 at $15.46

What we are seeing of course is top-line growth powered by acquisitions that translate to costly scale-up. So if you are a believer that in this sector, rapid scaling up by a management also committed to steady deleveraging, you have what we believe is a formula for an exponential increase in the value of a stock. We base our PT 20% above the 2018 high because we believe the company needs a full 18 months of digestion time for its acquisitions to fall to bottom-line performance and by extension a much higher valuation.

In the end, it's all about execution. TSG has talked a good game and, at times, delivered only talk because much of it was based on its internal strategic engines of knowledge about the online gaming markets. But now I believe it is past the eating stage and into digestion, this is a stock with a very attractive entry point story right now.

Disclosure: I/we 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.