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Tuesday, November 10, 2009

Youbet Update: Growth Potential and Cash, Cash, Cash = Nice Combination

We've been meaning to provide slightly more color on Youbet (UBET, $2.20), which reports 3Q09 results tomorrow afternoon. So, here we go -- following up on our brief post regarding Breeders' Cup and Equibase data last week, and our online gaming update the other week.

We met briefly with Youbet management back on October 1st at the Thomas Weisel Consumer Conference in New York and watched CEO Goldberg's presentation - link to PDF here. The presentation and our conversation emphasized several key points:

  1. Horse racing industry content disputes should be thing of past (we noted previously in initial post) and improved relations now sets stage for increased online penetration
  2. Addressable market opportunity remains large, particularly relative to other online market segments where penetration is significantly higher
  3. Youbet is working toward the launch of "casual" horse betting games in an effort to expand reach

Related slides from management presentation (click to enlarge) -- 2Q09 online (ADW) penetration jumped to 13% from 10% in 2008 (prior to content resolution):

Casual games will have a simple user interface:

Most points are not new information, but represent key parts of our thesis: that online wagering growth would return in 2009 on the back of new content relationships. Moreover, Youbet is well placed to capture more than its fair share of increased wagering while generating significant excess cash flow. We still think this is the case, but note that Y/Y handle (and revenue) comparisons among industry participants are not comparable as some players (e.g. Churchill Downs) benefit from especially easy Y/Y comparisons. In addition, one caveat was/is potential margin pressure related to new content and customer retention/acquisition, which remain risk factors to monitor.

In tomorrow's report, we look for continued growth with somewhat better margins Q/Q (net yield at/north of 7.0% with an operating margin north of 10% for the ADW segment) and break-even results for the economically sensitive United Tote segment. For reference, we discussed 2Q09 results 2Q09 results here.

With regard to points 1 and 2 above, potential to capture increased market penetration represents a key opportunity for Youbet. While acknowledging that horse racing market dynamics are arguably different than other online segments, we see no reason not to expect incremental penetration over time. Importantly, as noted in prior posts, Youbet's established franchise should allow the company to at least maintain market share. We estimate that if ADW penetration increased to 20% from an estimated 13% in 2Q09, the earnings power of Youbet's online segment might increase by 50% holding margins steady (risk factor, although top-line yields could compress slightly while realizing bottom-line operating leverage).

Recall that in both 2Q09 and the seasonally weak 1Q09, Youbet's ADW segment delivered earnings of $0.06 each quarter (untaxed because of large NOLs, which should offset taxes over time despite some vagaries in California tax law). Annualizing this figure, we have current year earnings of $0.24 for the ADW segment and, at 20% penetration, we have $0.36 per share. We can't help but mention that shares of Youbet are trading at only 9 times the former figure, assigning no cash value to the tote segment and no value to potential growth (e.g. higher penetration, new product launches, international opportunities, or changes in U.S. online gaming laws).

Finally, we continue to view Youbet's online segment as a predictable cash generating business. Even the tote business would be fairly predictable under different operating conditions. Although our current estimate of Youbet's 2009 free cash flow is lower than at the outset of the year, we expect the company to generate at least $10 million of excess cash this year, followed by another $10 million next year, and so on. Put another way, the the company's net cash position of $5.6 million at 6/30/09 should be at least $15.6 million at 6/30/10 assuming no share repurchases. Cash should keep piling up on the balance sheet (even with no growth), which we like.

Per our September post, we hope the company was finally active in 3Q09 repurchasing shares on the cheap. Aside from reinvesting cash in the core business to enhance growth (captured in operating and capital expenditures), we believe share repurchase remains a top priority for excess cash and we certainly expect to see buyback activity over the coming year (if able to repurchase at accretive levels). Strategic acquisitions are another potential cash use, yet we don't necessarily expect to see deals as Youbet already has an excellent platform from which to expand organically. Thus, we're left with one other potential use: paying a dividend, similar to PetMed Express (PETS, $16.35). We expect to see more cash rich Internet businesses initiate dividends over time and Youbet could seemingly join this club.

Separately, interesting industry news from Bloodhorse.com:

(1) Exciting Breeders' Cup race - video here on ESPN.com (provided by YB) - and handle up Y/Y - Breeders' Cup Handle $150 Million and Rising:
  • “The combined handle was actually 4% higher for the corresponding 19 races scheduled over the two days in 2008,” said Kenneth Kirchner, of Falkirk, wagering consultants to Breeders’ Cup Ltd. “International separate pool handle is up by more than $3 million over 2008.” Kirchner also noted that $2,172,266 was refunded to patrons that had wagered on Quality Road, who was scratched at the gate in the Breeders’ Cup Classic.
(2) U.K. horse auction shows continued interest in horse racing - Median Up 12.5% as Tattersalls Sale Ends:
  • The Tattersalls autumn horses in training sale finished its four-day run in England Oct. 29 with a median price that was up 12.5% from 2008. The gross revenue declined 11.3% while the average price fell 8.2%. The clearance rate rose from 78.8% last year to 84.9% this year.
  • The 903 horses that sold grossed 17,457,800 guineas and averaged 19,333 guineas. The median was 9,000 guineas. In 2008, 935 horses were sold for a gross of 19,690,300 guineas and an average of 21,059 guineas. The median was 8,000 guineas [we think one guinea = approximately one English pound].
  • “Quality horses have sold particularly well with buyers from all corners of the world, providing stern competition for the domestic buyers from both the flat and National Hunt fraternities”
(3) Kentucky sale somewhat better than expected: F-T Ky. Fall Yearling Sale Rebounds:
  • The Fasig-Tipton Kentucky fall yearling sale bucked the prevailing negative trends in the Thoroughbred marketplace to post increases of 9.1% in median price and 5.7% in gross revenue during its three-day run that ended Oct. 28 in Lexington.
  • In addition, the number of horses sold rose 2.4% while the average price grew 3.2%. The buy-back/no bid rate fell from 35.6% last year to 25.1% this year.
  • The 566 yearlings that sold grossed $7,895,400 and averaged $13,949. The median was $6,000. In 2008, the 553 horses that sold grossed $7,471,900 and averaged $13,512. The median was $5,500.
(4) Lastly, Why European Sales Are Stronger:
  • Another factor, Collins continued, is a European philosophy about racehorse ownership that differs somewhat from the American approach. “The experience of owning a racehorse for most people in Europe is an expensive experience, but it’s also a very positive one that they enjoy,” he explained. “They continue to buy horses not because they think they are going to make money, but because they really love racing."
  • "I’m in no way minimizing the importance of purses because one of the things you do hear in Europe is ‘Oh my Lord, our purses are terrible.’ But people keep doing it (buying horses) because they enjoy the sport. For some reason, the expression ‘sportsman’ seems to have become a negative term here (in America) as if a sportsman is some kind of an idiot. But sportsmen are people who love racing and are in it for the sport. They looking forward to sharing their experience with their families and friends and, to some degree, the general public."
  • "One of the things we have to address in America is the experience that people who own horses get out of racehorse ownership. It isn’t just about the purse money.”
We share the industry information because it highlights that the sport isn't going away anytime soon and still has many supporters around the world. As we noted back in March:
  • 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.

Happy investing,

Jeffrey Walkenhorst

Disclosure: Long UBET, PETS.

© 2009 Jeffrey Walkenhorst
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