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Tuesday, September 8, 2009

Surprise! Youbet.com Back in the Bargain Bin

The bad news: prior to Friday's +9% move, shares of Youbet.com (UBET, $2.25) were nearly cut in half from July's high of $3.91, which we didn't expect given improved industry content relationships and the company's solid financial position (discussed in our prior posts, including this July post). Also, today, the company announced an accounting restatement related to YB's rewards program - link here, small non-cash impact. Shares are now retracing part of Friday's up move.

The good news: As David Dreman writes in his 8/19/09 Forbes column, "Markets are always perverse and unpredictable" (link here). That is, the Market is irrational. How else can we explain certain financial names highly diluted by government ownership stakes seemingly trading on thin air? If interested on this latter topic, we point to some thought provoking pieces on SeekingAlpha.com regarding Citigroup (here) and AIG (here)....

And, more good news: we, as investors, can be rational and take advantage of Market mis-pricing to profit so long as our fundamental analysis is correct (buy quality businesses cheap, sell them dear).

And, shhhh, more good news: maybe the Market won't bid shares back up too quickly because we believe Youbet can now be active with company's share repurchase program (up to 10% of common shares outstanding, or approximately four million shares). Our understanding is that the company was previously restricted by potential M&A activity related to discussions regarding the tote business -- but, no longer, since that process is on hold given other properties for sale in the market and management sees no reason for a "fire sale". We would be disappointed if YB does not report repurchase activity for 3Q09.

Although we would prefer for UBET to be trade closer to a 5% free cash flow yield (which we see as fair based on the company's established franchise as outlined in our initial post), or approximately $4.50 to $5.50 (assuming reduced 2009E FCF of $10 million to $12 million), we also prefer management to repurchase shares on the cheap. Buying back stock at $2-3 is far more accretive than buying in shares at $4-5. For example, if Youbet uses $10 million of free cash flow over the next twelve months (above current net cash of $5.6 million) to repurchase shares at $2, we estimate that annual EPS would increase by approximately $0.02. If Youbet instead repurchases shares at $4, then EPS might increase by about 7/10 of one cent.

Last week, a reader posted interesting comments to our 8/6/09 pre-results post ("UBET Slides...") and, among other things, asked if our confidence has been shaken given industry handle declines. Our brief answer was that we believe franchise value remains significantly higher than current levels and is supported by current and expected free cash flows.

Yes, some investors threw in the towel on weaker than expected June quarter results (we discussed here) and the subsequent downgrade by Brean Murray, one of the few brokerage firms that has long covered the stock and knows both the company and industry well. We are aware of key investor concerns such as (1) increased competition from an aggressive Churchill Downs (CHDN, $37.86), (2) lower wagering yields (related primarily to new content), and (3) the poor economy.

With respect to the first point, Churchill Downs gained an estimated 470 basis points of market share Y/Y in 2Q09 to reach 21.5%, while Youbet gained only 0.33 bps of share. TVG and Magna ceded share to Churchill Downs, as shown in the below graphic (click to enlarge):

With 2Q09 handle up 43% Y/Y, Churchill clearly did very well on the back of the Derby, besting Youbet's +13% Y/Y handle performance. We believe newly available content on Youbet cannibalized customer wagering on other tracks during the quarter (leading to lower same track handle), although YB performed better than peers TVG and Magna. Given a return to normalized content in 2009, we'll need to see how full-year handle/share results shape up for a better idea of winners/losers this year. We expect 3Q and 4Q to be more favorable for YB on seasonal track strength (e.g. Del Mar and Saratoga) despite fewer racing days at certain tracks.

On the yield question, as noted in our post 2Q commentary, YB's net yield of 6.9% was actually higher than the 6.3% realized in 2Q06 (when YB last carried the Kentucky Derby and other Churchill content). Going forward, we look for yield levels to remain around 7.0%, plus or minus. Despite the lower net yield in 2Q, recall that income from operations of $2.6 million (for online segment only) represented a 29.1% margin on net revenue compared to 28.5% in 2Q08 and 27.1% in 1Q09.

Finally, Equibase reported on 9/4/09 that US wagers for the month of August were down 12.4% Y/Y, with YTD wagers down 11.1% Y/Y (versus July down 13.4% Y/Y with YTD wagers down 10.9% Y/Y). So, August was a bit better than July, which was a bit better than June, and U.S. horse wagering continues to outperform the ~15% Y/Y decline in Nevada state gambling revenue (see this link, which we previously shared). Also, the Daily Racing Form noted that "U.S. race days, however, were down 8 percent in August compared to last year, from 709 to 650, in part because of a drastic cutback at Ellis Park in Kentucky and a decision to hold five days of racing a week rather than six at Del Mar this year" (link here).

While some tracks are struggling amidst the weak economy, marquee tracks are holding up relatively well. Prior to heavy rainfall the other week, Saratoga posted fantastic figures through the first 18 days of the meet: attendance "up 8.4%, on-track handle up 12.3%, and all-sources handle up 4.8% from 2008 totals" (link here). Following a rainy weekend in late August, figures turned slightly negative: attendance "down 1.6%, on-track handle down 1.6%, and all-sources handle down 2.8% from 2008 totals through Week Five" (link here).

Del Mar is also faring well in the hard-hit, I-O-U state of California -- from Bloodhorse.com (link here):
  • Through the track's 30th program Aug. 30, Del Mar was averaging 17,560 patrons a day with an on-track handle of $2,281,188 in 2009. Compared to last year's figures, when the track was running six days a week instead of the current five-day schedule, the on-track attendance jumped 12.4% from the 2008 average of 17,560 [per day] at the completion of six weeks. The on-track average handle for 2008, $2,076,270, was 9.9% lower.
  • This year's attendance figure, 526,551, is up by 2.7% over last year (512,941) when Mondays are eliminated. The current-year handle, $68,228,273, is a 1.4% increase over last year's $67,276,836, under the same scenario.
Summary

It's true that the ADW market is competitive, but this is nothing new -- nearly all businesses face competition, especially now. YB successfully managed through 2008 with reduced content and competition. We expect the company's franchise to allow Youbet to manage through the balance of 2009 and into 2010, even as the weak economy pressures industry handle. We imagine YB's new CFO (also announced today) -- who appears experienced and capable -- will carefully manage customer acquisition/retention costs to maintain and potentially improve margins over time.

We believe our core thesis is intact: 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. An important part of this thesis is that Youbet’s online business should generate steady, growing free cash flow combined with a high ROE/ROIC. Increasing net cash balances should allow owner-oriented management to return cash to shareholders over time (hopefully, during 3Q09 via share buyback!). We also believe growth is achievable given the secular shift to online wagering, especially whenever the economy rebounds. We will change our tune if YB's management is unable to both maintain/increase market share and grow the bottom-line (as measured by free cash flow) over time. Capital returns to shareholders also remain a must.

Lastly, as noted above, valuation remains attractive in our view, and we could see shares fairly trading around $5 today assuming a 5% FCF yield on 2009E free cash flow. On a relative TTM basis, Youbet continues to trade at a significant discount to certain other niche franchise Internet businesses and gaming companies:
  • Youbet offered by Market at 9% TTM FCF yield
  • Blue Nile (NILE, $54.92) offered at 3% yield
  • The Knot (KNOT, $9.90) at 4% yield
  • Stamps.com (STMP, $9.05) at 6% yield
  • Churchill Downs at 4% yield
  • Penn National Gaming (PENN, $27.39) at 6% yield
If Youbet traded at Blue Nile's valuation, shares would be at $8 today. We probably don't need to relay which one we'd rather own at current levels. Meanwhile, we should also mention Bidz.com (BIDZ, $3.77), another niche franchise online company that presently trades at a very compelling 18% TTM FCF yield (please see our prior posts).

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long UBET, BIDZ.

© 2009 Jeffrey Walkenhorst
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