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Thursday, May 14, 2009

Youbet.com Alive, Kicking and Even Growing

Since our 3/23/09 Seeking Alpha post (link here), shares of Youbet.com (UBET, $2.47) are up 56%, which compares favorably to the S&P 500 up 15% and the Russell 2000 up 18% over the same period. Certain "niche franchise Internet companies" such as Blue Nile (NILE, $42.02) and The Knot (KNOT, $8.13) also rallied, up 63% and 17%, respectively, while others such as Stamps.com (STMP, $8.42) were flat to slightly down. We compare Youbet to what we call niche franchise Internet companies since they all have asset light business models with similar operating margin profiles and capital requirements (*Youbet's core online segment, excluding tote segment).

Back to Life

Shares of small-cap Youbet.com recovered from fire sale valuations of 2008 (20-30% free cash flow yields) created by company- and industry-specific issues that left the stock for dead. The market is now realizing that overhangs are removed and that Youbet is a viable, well-positioned, cash generating business. As a result, the extreme valuation discount is narrowing.

Positive Catalysts Over Past Two Months
  • 3/16/09 Introduction of "Conditional Wagering"
  • 3/26/09 Introduction of new international racing content
  • 4/01/09 Extension of share repurchase program
  • 4/22/09 Agreement to carry Calder Race Course (a Churchill Downs track)
  • 4/25/09 Agreement to carry Churchill Downs (namesake track)
  • 4/27/09 Agreement to carry first leg of Triple Crown, the Kentucky Derby - first time since 2006
  • 4/30/09 Seasoned management hires for business development/strategy
  • 5/01/09 Agreement to carry Arlington Park - first time since 2006
  • 5/13/09 Agreement to carry Preakness Stakes - first time since 2007 and confirmation that Youbet will carry entire Triple Crown this year
  • Press releases are available here with more information
In addition to the above developments, Youbet.com is supporting recently introduced Internet gambling legislation that would legalize online gambling. While placing wagers on horse racing is already legal, Youbet could potentially extend the company's platform into other gaming areas to grow the business. We note that timing on this front is uncertain and any new initiatives would entail execution, competitive, and legal/regulatory risk.

Results On Track - Growing Through Recession

Youbet.com reported results Wednesday after market close which reveal continued progress (link here). On the back of increased racing content, total revenue increased 16% Y/Y to $28.4 million while income from continuing operations was flat Y/Y at $1.2M. Reported GAAP net income per share was $0.03 versus $0.02 in the year ago period and income from continuing operations was unchanged Y/Y at $0.03. Higher content costs in the Youbet Express (online ADW) segment related to new content from Churchill Downs partially offset top-line growth and a $1.2 million operating loss in the United Tote segment eroded overall profitability. The increased content costs were expected and the company continues to explore a potential sale of the tote segment. Certain results from the ADW segment are worth highlighting:
  • Total wagers (handle) increased 30% Y/Y to $124 million with gross revenue of $24 million (+26% Y/Y) and net revenue of $9.1 million (+13% Y/Y).
  • Estimated "same-track, same-state" handle increased 4% Y/Y as the company succeeded in driving more wagers per customer. Youbet cited a "10% increase in average weekly unique wagerers and an 18% increase in average wagers from them over the first quarter of 2008, with the positive trend continuing into the second quarter of 2009.”
  • Gross profit increased 10% Y/Y and operating expenses were up only 8% Y/Y, leading to a 15% Y/Y increase in income from continuing operations to $2.6 million.
  • Income from operations represented a 10.5% margin on gross revenue, down 200 bps Y/Y, but was 27.1% margin on net revenue compared to 28.5% in 1Q08. We see the margin levels and absolute dollar increase as impressive given increased content costs.
  • Importantly, if Youbet operated only the ADW segment, EPS would have been $0.06 for the seasonally weak March quarter, illustrating the earnings power of the business. This is an untaxed figure since Youbet has approximately $60 million in federal and state net operating loss carryforwards that will prevent cash taxes for many years (note: in our first UBET post, we incorrectly stated only $24 million in NOLs).
Overall, the company generated cash flow from operations of $3.3 million and free cash flow of $2.6 million after capital expenditures. Owner free cash flow -- net income plus depreciation and amortization less capital expenditures -- was $2.4 million. Net cash on the balance sheet increased to $6.5 million, up $11.2 million Y/Y from a net debt position of ($4.7) million. Despite the steadily improving balance sheet, Youbet did not act on the company's share buyback authorization. We presume the inaction is related to restrictions surrounding potential strategic alternatives for United Tote.

Stock Still Attractive

To review, our Youbet thesis was as follows: 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.

Following the recent move, UBET is trading at 19 times 2008 earnings (5% earnings yield) and 8.6 times owner cash flow (12% yield). On 2009 estimates, the stock trades at 14 times earnings (7% yield) and 7.4 times owner cash flow (14% yield). We think growth in 2009 and a low cash flow multiple provide both downside and upside support for the stock.

Absolute valuation: on 2008 results, a 10% owner cash flow yield implies a fair value of approximately $3.00, while a 5% yield would imply a value of nearly $6.00.
  • We believe Youbet's core online business has durable competitive advantages and generates stable cash flow, which warrant further multiple expansion. The ADW segment generated income from continuing operations of $8.8 million in 2008. If we grow this income 15% in 2009 (consistent with 1Q09's performance) to $10.1 million and assign a 7% yield, implied segment value is $144 million or $3.40 per share.
  • Valuation of the United Tote segment is less certain given challenging industry conditions (lower wagers, pricing pressure), yet we estimate the segment contibuted approximately $3 million of owner cash flow in 2008. This cash flow, plus the unit's market position and marquee track customers (e.g. Churchill Downs) are worth something. Youbet carries the segment assets at approximately $23.5 milllion and, assigning Youbet's entire $11.2 debt load to the segment, produces an implied net asset value of approximately $12 million, or $0.29 per share. However, a 15% owner cash flow yield (7 multiple) implies segment value of $20 million, or $0.48 per share. A 50/50 segment valuation yields $16 million, or $0.38 per share.
  • Including net cash per share of $0.15, the sum of the parts valuation implies a total value per share of almost $4.00 giving no credit for potential expansion into new gaming markets (since timing and business models are uncertain).
Relative valuation: on 2008 results, UBET continues to trade at a meaningful cash flow and earnings discount to both gaming companies and certain niche franchise Internet companies.
  • Gaming: Youbet trades at approximately one third the owner cash flow multiple of Churchill Downs (8.6 times versus 29.4 times) despite much lower capital requirement (1-2% of sales versus 10%) and higher ROE (29% versus 8%).
  • Niche franchise Internet: On an earnings basis, Youbet trades at a fraction of multiples awarded to Blue Nile and The Knot (19 times versus 56 and 63 times, respectively, on 2008 figures where the first nine months of the year weren't so bad for retail/media). Youbet looks even better on a forward basis since the company is growing while the others are shrinking.
  • We include a comparable company analysis worksheet below.

We continue to believe that operating improvements in 2008 and better fundamentals for 2009 should drive multiple expansion as the market begins to appreciate Youbet’s ability to generate steady, growing free cash flow combined with a high ROE/ROIC. While we need to watch higher content and customer related costs, as well as execution around new ventures, we believe owner-oriented management is committed to profitably growing the franchise and returning increasing cash balances to shareholders over time.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long UBET.

© 2009 Jeffrey Walkenhorst
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