Owner-Oriented Investment Research and Commentary - Have a private comment or question? Email us at commonstocksense@gmail.com

Monday, April 27, 2009

Small-Cap Strategy: Time to Wager on Youbet.com

This post was previously published on SeekingAlpha.com on 3/23/09 - link here. All figures/values are as of 3/20/09.

Over the past year, the Russell 2000 Index sank 39%, similar to the S&P500’s 41% decline. Over the past three months, the Russell’s decline of 15% is slightly worse than the S&P’s down 12% performance. However, from the lows of last fall, some small-cap names have moved higher, including j2 Global Communications (JCOM), PetMed Express (PETS), and VistaPrint (VPRT). The common thread among these companies is that they are non-cyclical and benefit from favorable secular growth trends. In addition, they have healthy net cash positions, limited to no debt, high returns on invested capital, and – with the exception of VistaPrint – a long history of free cash flow generation. While economic uncertainty and global de-leveraging continues, a strategy focused on buying such companies should prove defensive and likely outperform the market. With everyone clamoring for cash, owning franchise type businesses that (1) have net cash and (2) generate significant excess cash arguably appears as attractive as simply holding cash, particularly given extremely high earnings and free cash flow yields.

One below-the-radar company that meets these requirements is Youbet.com (UBET, $1.58, $66 million market capitalization, www.youbet.com), which is poised to deliver Y/Y growth in revenue, earnings, and free cash flow for 2009 but currently trades for a song. The stock trades a significant discount relative to not only other gaming companies such as Churchill Downs (CHDN) and Penn National Gaming (PENN), but also niche franchise Internet companies such as Blue Nile (NILE), The Knot (KNOT), and Stamps.com (STMP), where growth is faltering amidst the recession.

Company Overview

Youbet.com is a legal, online advance deposit wagering Web site that has been in operation since 1997 and processed more than $3 billion in horse racing wagers (the “ADW” segment). The ADW segment collects a mid- to high-single digit percentage of each wager placed through Youbet. In addition, the company provides totalizator systems to approximately 100 horse racing facilities in North America and certain foreign markets (d/b/a United Tote, the “Tote” segment). Tote machines process pari-mutual wagers and payouts for race tracks, with United Tote collecting contract revenue from track customers based on total wagers handled by its equipment.

For 2008, Youbet generated revenue of $109 million (down 11% Y/Y), owner free cash flow of $12.1 million (compared to $0.5 million in 2007, defined as net income plus D&A plus impairment charges less capital expenditures), and earnings from continuing operations of $0.13 per share (versus a loss of $0.15). ADW gross revenue was $85.8 million (down 12% Y/Y) with income from continuing operations of $8.8 million (versus $1.6 million) and Tote revenue was $24.4 million (down 6% Y/Y) with a loss from operations of $2.0 million (versus a loss of $4.0 million).

What Happened – Why Did Investors Run for the Hills?

Over the past three years, Youbet was beset by a number of challenges, including (1) industry content/signal disputes, (2) failed acquisitions and related debt burden (tote segment and small media company), and (3) legal problems (investigation into customer wagering activity on cell phones across Nevada’s state line) that brought Youbet to shut down the company’s high-volume phone wagering unit. As a consequence, the company’s market capitalization is one third of what it was at the outset of 2006 and the stock lost nearly all institutional support.

Summary Long Thesis – The Elevator Pitch

The key overhangs of the past several years are largely removed and Youbet is now well positioned to deliver top- and bottom-line growth this year with consistent free cash flow generation that will continue to build cash on the company’s balance sheet. Moreover, over the past decade, Youbet established an asset light business model with a leading online wagering franchise – brand, customers, platform, marketing partners, and track relationships – that is difficult to replicate.

On 2008 results, UBET is trading at 12 times earnings (8% earnings yield) and only 5.4 times owner cash flow (19% yield). Applying a P/E multiple of 20 times to estimated 2009 EPS of $0.18 (consensus is $0.19), implies a share price of $3.60. A P/E of 20 may appear rich in the current environment, yet 20 is approximately one half that of the average forward P/E of 39 times for the niche franchise Internet companies (please see comp table below for detail). Alternatively, an owner free cash yield of 10% would imply a fair value of almost $3.00 today, or nearly double current levels.

Expanded Long Thesis – Why Should Investors Care about UBET Now?

Following a management conference presentation on March 18, 2009, shares of UBET finally moved higher (up 25% for the week versus the Russell 2000 up 2%) – audio/slides can be found here. Investors are starting to understand the numerous reasons to own the name today:
  • Key overhangs removed. The three overhangs referenced above are largely removed: (1) for the first time in two years, Youbet expects to have a full slate of US racing content for 2009 (Triple Crown races, with caveat that some issues remain in Maryland, where Pimlico is located), (2) improved balance sheet with growing net cash position and emphasis on core online ADW business (Youbet Express), and (3) primary legal issues were resolved and impairment charges taken in the fourth quarters of 2007 and 2008 ($17.9 million and $11.0 million, respectively). Youbet no longer carries any goodwill on its balance sheet, all of which was incurred by the prior management team. For more information about new content, please see here.
  • Established franchise value with asset light business model in large market. More than a decade of marketing and R&D expenditures created a recognized brand with leading market share, scale, a loyal customer base, and a best-in-class wagering platform, supported by an asset light business model: excluding Youbet’s tote segment, annual capital expenditures to gross/net revenue is approximately 1-2% / 5-6%. Further, the secular shift toward Internet wagering should spur incremental growth and, while the horse racing industry faces challenges, the sport is unlikely to go away. North American wagering totaled $13.6 billion in 2008 with only an estimated 10-15% of wagers placed online.
  • Growth returns to core online business. Problems in recent years obscured relatively steady performance by Youbet’s online wagering segment. Even with reduced racing content in 2008 related to posturing by competitors and horsemen groups, Youbet Express generated flat Y/Y net revenue of $34.5 million (after license/content fees) with operating income of $8.8 million (26% margin on net revenue, 10% margin on gross revenue). The company successfully steered customers to alternate racetracks with higher yields to Youbet and leveraged co-marketing relationships with tracks such as Harrah’s Louisiana Downs and Boyd Gaming’s Delta Downs. Given new content agreements for 2009, as well as growth in handle per active customer, management indicated on Youbet’s 4Q08 conference call that January/February handle was tracking up more than 30% Y/Y (versus a “same track/same state” increase of 2% for 2008 and a decline of 2% in 4Q08). While the incremental margin on new content is lower, absolute contribution dollars should increase on higher volumes.
  • Owner-operator management focus. Insiders and affiliates owned 28% of Youbet as of December 29, 2008. New World Opportunity Partners (“NWOP”) owns 12.8% of the company and facilitated the placement of NWOP partners Jay R. Pritzker and Michael Brodsky onto Youbet’s board of directors in June 2007. Mr. Pritzker is the Managing Partner of The Pritzker Group and is part of the Chicago based Pritzker family, which has a century long history of success across multiple industries. Prior to his role with NWOP, Mr. Brodsky was the Chief Financial Officer of Away.com. He became CEO of Youbet on April 24, 2008 and subsequently hired several other executives to refocus the company around the core online business. With a large direct ownership stake, new management is running the business as an owner-operator with a goal of maximizing free cash flow and return on invested capital. In this sense, shareholders should benefit from management plans to use growing excess cash flow to repurchase shares, further pay down debt, and reinvest in the business. Potential acquisitions are a distant fourth option.
  • Evidence of owner orientation: cash building with high ROE. During 2008, a significant increase in cash earnings and a favorable working capital movement brought cash and cash equivalents to $16.5 million from $6.6 million, with total debt declining to $12.7 ($3.8 million net cash) from $15.2 million (net debt of $8.6 million). Youbet’s return on equity improved to 29% from not meaningful, and now – with a clean balance sheet – shareholder equity should increase on a consistent basis.
  • Share buyback activity likely. Youbet has an existing $10 million buyback program set to expire this month, yet refrained from purchasing shares in 2008 while working through balance sheet issues. Management negotiated a new bank deal in December and buying back shares now appears a probable use for excess cash. A newly authorized buyback program in April could prove a positive near-term catalyst for the stock (although preferable for the company to repurchase on the cheap).
  • Can’t ignore NWOP as potential interested private market buyer. NWOP first announced a 5.3% stake in June 2006 with an implied entry point in the $4.00s. The firm was probably attracted to Youbet’s established ADW franchise. In an October 2008 Schedule 13-D filing, NWOP indicated that the firm may seek to engage in various transactions with Youbet, including acquiring the entire company. Importantly, NWOP’s stake remains below the 15% level that, according to Delaware Anti-Takeover Law, would prevent Youbet “from engaging in a business combination with an interested stockholder”.

Valuation – Attractive on Absolute and Relative Basis

On 2008 results, UBET is trading at 12 times earnings (8% earnings yield) and only 5.4 times owner free cash flow (19% yield). The delta between earnings/cash flow multiples relates to reduced 2007-08 capital expenditures for the tote business relative to D&A that is being run through the income statement. With less emphasis on this segment, forward capital expenditures should remain low and, over time, the difference between net income and cash flow should diminish. In addition, Youbet paid less than a million dollars in taxes last year because of net operating losses that should shield taxes for perhaps another two years (approximately $24 million remain). However, an estimated tax rate of 35% applied to $12 million in owner cash flow would still produce excess cash flow of $8 million, for an implied 12% yield to shareholders. Only modest growth for 2009 and cost containment at United Tote should bring higher earnings and cash flow with more attractive forward yields. The summary table below illustrates UBET’s valuation discount relative to select gaming and niche franchise Internet companies.

  • On a P/E and owner cash flow basis, UBET trades at a meaningful discount relative to gaming companies CHDN and PENN despite a much lower capital requirement and higher ROE (calculated using Youbet’s 2008 income from continuing operations).
  • While acknowledging different business models and risk factors, UBET trades at a large discount to other niche franchise Internet companies, NILE, KNOT, and STMP, despite similar operating margin profiles and capital requirements. These companies trade at an average of 35 times 2008 earnings, and 21 times both 2008 owner cash flow and operating income, compared to UBET at five and nine times, respectively. Youbet’s 2008 ROE of 29% edges out Blue Nile’s 28% and significantly exceeds The Knot’s 2% and Stamps.com’s 12%, although the cash rich balance sheets of these companies admittedly skew ROE downward.
  • Coincidentally, Youbet management highlighted UBET’s valuation discount in the conference presentation last week, appropriately using gaming suppliers/pari-mutuel operators and Web-based transaction companies (please see link referenced previously).
  • A comparison to niche franchise Internet companies can be justified given the similar operating and capital requirements noted above. Arguably, while some of these companies may have pricing power in certain parts of their business (e.g. display advertising, subscriptions), whereas Youbet might be perceived as a price taker (e.g. volume game), these differences are not readily apparent in margin or ROE metrics.
Potential Explanations for Valuation Discount

Shares of Youbet have been tainted by past execution challenges, legal/regulatory risk, content/signal risk, competitive risk, and economic/secular concerns. The risk factors warrant careful analysis, yet a few brief points:
  • Streamlined business enables consistency. By reigning in costs and strengthening the balance sheet in 2008, Youbet should deliver more consistent operating results that drive more consistent share price performance. In addition, management is running the tote segment to maximize cash flow and continues to explore “strategic options”, including a potential sale.
  • Legal framework supportive of online wagering. While the industry is complex, the secular shift toward the Internet is unavoidable and widely viewed as a means to preserve/grow the horse racing and breeding industry.
  • Content distribution critical for tracks. In 2008, some track owners learned that limited ADW distribution (i.e. not through Youbet.com) resulted in lower handle and purses for horsemen. Therefore, broad Internet distribution is critical for tracks and should mitigate signal risk, especially as on-track attendance comes under pressure in today’s economic environment.
  • Youbet’s franchise checks competition. The ADW market is dominated by four major players: Youbet, Churchill Downs, Television Games Network (TVG, recently acquired by UK’s BetFair), and XpressBet (Magna Entertainment, which is currently in Chapter 11 bankruptcy proceedings). Assuming 12.5% of 2008’s North American handle was wagered through the ADW channel, Youbet’s $438 million in handle (down 9% Y/Y) would put its implied share at 26%. Youbet’s customer relationships, comprehensive product offering, and low cost operating model, as well as exclusive online partnerships with ESPN.com and CBSSports.com should mitigate the competitive threat.
  • Horseracing dates to ancient times and will survive recession. The slow economy is weighing on wagering activity. However, the sport has existed for millennia, employs a large number of persons (horsemen, breeders, owners, etc.), and generates estimated global handle of $110 billion.

Conclusion – Risk Factors Mitigated and Overly Discounted in Current Valuation

Youbet plays an increasingly significant role within the industry and will benefit from the continued secular shift toward the Internet. While risk factors are real, mitigating factors provide comfort that the company’s business has staying power, particularly given operating improvements in 2008 and better fundamentals for 2009. As the Street begins to appreciate the company’s ability to generate steady, growing free cash flow combined with a high ROE/ROIC, the current valuation discount could quickly narrow.

Jeffrey Walkenhorst

Disclosure: Long UBET and JCOM.

© 2009 Jeffrey Walkenhorst

No comments:

Post a Comment

Note: Only a member of this blog may post a comment.