Olympic Entertainment Group (OEG) is a highly profitable casino operator. With a limited number of players in OEG’s industry and barriers to entry due to strict regulation, high returns and margins seem to be sustainable for the foreseeable future. Online gaming poses a threat, but also an opportunity to OEG’s activities. With the share price being reasonably priced, the company offers an attractive investment opportunity.
OEG operates casinos in the three Baltic States (Estonia, Latvia and Lithuania), Poland, Slovakia, Belarus and Italy. After the independence from the Soviet Union the gambling industry in Eastern Europe grew rapidly and relatively unrestricted. However, the deteriorating economic environment during the crisis in 2008-9 changed the industry abruptly. Overinvestment in the previous years led to a dramatic consolidation during the crisis. In addition, legislators introduced stricter regulations in order for the governments to better control activities. This and the economic depression led to a sharp fall in supply in a very brief period of time. In particular, this was the case in the Baltic States. For instance, the number of casino’s in Tallinn, the capital of Estonia and OEG’s home market, declined from 91 to 33 from 2008 to 2010.
Managing the crisis
After its IPO in 2006, OEG rapidly expanded until the beginning of the economic crisis. However, after realizing what happened in their markets, management was able to quickly adjust operating activities during the down years. During the crisis the company profited from the stricter regulations as many smaller market participants were forced to exit the market. The table below provides some key facts about OEG:
|Number of casinos||122||133||68||66||61||63|
|Total area of casinos (sqm th.)||34||38||26||26||24||24|
|sqm per casino||277||289||378||391||394||381|
|Rental costs (EUR m)||10.9||12.8||13.0||10.0||9.7||10.2|
|Salaries (EUR m)||41.7||47.1||32.0||30.0||30.5||33.0|
During the recession management almost halved the number of casinos by closing cash flow negative units. In addition, they discontinued their activities in Romania and Ukraine. At the same time, the company performed modifications in the remaining casinos, transforming most of them into casino-lounges. As a result of that, the area, where visitors can spend their time without engaging in casino games, was expanded. As a consequence, sqm per casino increased. Also the variety of goods offered in casino bars was increased significantly.
Based on decreased demand, and also to carry out the new concept, the number of slot machines was reduced in most casinos, which resulted in a decrease in fixed costs proceeding from gaming tax. In addition, the business hours of several casinos were decreased (all casinos were previously open 24h a day).
The rent costs of the Group were reduced as a result of closing casinos, and also because the rent prices of existing casinos were lowered – new agreements reached with the owners of various rent spaces had a positive effect on the cost structure.
The table below provides the major industry specific ratios for OEG with gross gaming revenue (GGR) being the sum total of all players’ contributions to all games minus the winnings paid out:
|GGR per table (EUR th.)||n/a||17.7||14.4||16.0||17.8||18.9|
|GGR per slot (EUR th.)||n/a||2.0||1.7||2.3||2.5||2.6|
|GGR per employee (EUR th.)||3.3||3.8||3.2||4.1||4.6||4.6|
|Salary per employee (EUR th.)||0.9||1.0||1.1||1.0||1.1||1.2|
|GGR per sqm||392||378||285||346||409||435|
|Rent per sqm||27||28||42||32||34||35|
Generally speaking, there has been a positive trend over the last years indicating higher overall profitability and efficiency. (With the number of sqm leased having been volatile during the fiscal years, “Rent per sqm” might be a bit misleading as I took the year-end sqm-numbers which might over-/under- estimate the actual rent per sqm by some degree.)
So this brings us to the company’s performance for the last seven years:
|Revenue (EUR m)||107.0||159.0||178.0||108.8||112.5||126.0||135.9|
|Op. CF Margin||39%||26%||7%||8%||19%||20%||26%|
OEG has approached its pre-crisis profitability level again. However, it has to be mentioned, that in 2005 and 2006 the company performed even better with profit margins in the mid-twenties. In 2008 and 2009 impairments weighted on the income statement and it seems that a large part of the investment activity in 2007 was immediately written off at the end of 2008. From the table above you can also see that cash flow generation is really good. During the last couple of years non-cash items (impairments) took away from income, but did (obviously) not affect cash flows.
There is an issue on the balance sheet I need to highlight. Fixed assets (PPE) mainly consist of gaming equipment (slot machines and gaming tables) and building fit-outs. The carrying amount of PPE was only EUR 19.6 m at the end of 2012. At the same time the cost base was EUR 98.8 m meaning that approx. 80% of PPE has been written off already. So this raises the question whether capex has been deferred during the last years (see below). To calculate ROIC, I have used the cost base instead of the carrying amount (ROIC 16%). Taking the carrying amount would have led to a ROIC for 2012 of 35%. So the true ROIC number might be located somewhere in between these two numbers.
The management used the crisis to improve the company’s market position by acquiring smaller competitors and entering new markets like Slovakia in 2008 and Italy in 2012. In 2013 they accelerated the expansion. During the first nine months of 2013 they added 21 casinos to their portfolio increasing the total number to 83. Most of the new casinos are located in Latvia, which is the most profitable of their markets. Apart from that, the company just received licenses for sports betting in the three Baltic States. OEG is currently operating in 7 different markets (as of Q3 2013):
|Market share||Operators||Market position||% of total revenue||Operating margin|
OEG possesses a leading position in most of its markets. The company generates 63% of its revenue in the Baltic States. These are also the most profitable markets given that effective gaming tax rates are between 9% and 18% of revenue. In contrast, in Poland gaming taxation is 50% from GGR and in Slovakia 29%. The operating margin of the Polish segment enhanced substantially from 8% (9M 2012) to 16% (9M 2013). The management does not outline where this improvement comes from, but it could be due to positive effects steaming from regulation (see below). I am also not sure why the profit margin in Slovakia is quite low despite having a lower gaming tax rate than in Poland. I can only assume that costs are higher due to the recent investments made in the country.
After the successful restructuring, I regard the following risks as most important:
In general, gambling services are highly regulated. The gambling law within the EU is not harmonised. Therefore, differences exist in each European country (A good description about the differences in regulation and taxation can be found here). Over the last couple of years, there has been a trend in the CEE countries towards a stricter regulation. Overall, for high standard and well financed operators like OEG this has been positive as many competitors have been unable to develop their operations to meet the administrative and financial requirements. In addition, unlike OEG many competitors used to focus on number of venues instead of location quality resulting in poorer image and profitability. Today, except from Belarus strict legislation provides an effective entry barrier for new competitors.
For instance, the Polish Government passed a law that outlaws gambling except in casinos. Some years ago most bars had installed slot machines. This situation is currently changing providing operators like OEG with a competitive advantage. In addition, the number of licenses in any city is restricted and determined in accordance to the number of inhabitants. So it is difficult for new entrants to enter the market.
However, stricter regulation also needs to be supervised. For instance, OEG left the Romanian market, because many market players did not comply with the legislations and were not monitored by the authorities. As a result, OEG’s competitive position weakened and they pulled out of the market.
Though the recent streamlining of legislation has helped OEG, there is a risk that future legislation might harm the company’s business model. For instance, the relatively low gaming tax environment in the Baltic States might change, if there is a harmonisation of gambling law in the EU.
In addition, in some countries regulation has been detrimental to OEG’s interests. For instance, OEG had to leave the Ukrainian market after the government supposedly banned casinos. A compensation claim with the Ukrainian state is still pending. The company tries to mitigate this risk by diversifying its operations over seven different markets.
2. Online gambling as a potential substitute for land based casinos
Like for most bricks and mortar retailers the internet is also a threat to land based casinos. However, from my perspective the difference between online gambling and e-commerce is that the former will become more and more regulated by the authorities. Many countries have already begun to block websites or payments from unlicensed offshore online gaming operators. The stricter the regulation of online gambling becomes, the better for established operators like OEG, who can make use of their brand name/reputation for their online activities.
OEG was only able to start its online business in 2010. Reason for that was, that online gambling was either prohibited or there was no regulation of the online gambling in OEG’s target markets. Hence, as a regulated land based casino operator they were not allowed to compete against the growing number of illegal off-shore gaming sites.
This has changed now as OEG received licenses for online gaming in Estonia and Latvia
with online gaming in Lithuania staying prohibited and Lithuania. I could not find specific numbers concerning their online business in their annual report. So I believe revenue from this segment is still immaterial.
So far there is no indication, that OEG’s business is negatively affected by competition from the internet, but it’s certainly an issue which has to be followed. Currently, the land based casinos are taxed at a higher rate than the online gaming operators in almost all European countries. This results in a secular disadvantage for land based casinos. However, the Court of Justice of the European Union is expected to rule in the first half of 2014 on whether the substantially lower tax rate for online casinos compared to land-based casinos amounts to illegal state aid. A positive ruling for land based casinos could force European governments to overhaul their tax rates.
As already outlined the company has changed the concept of their casinos towards a place where customers spend their leisure time by not only playing games but also having some drinks with friends. Therefore, the threat from online gaming to become a direct substitute for OEG’s products might have been reduced.
3. Unsustainable growth
Like many competitors, OEG has suffered from pre-crisis overinvestment. Like many other CEO’s, OEG’s management was surprised by the abrupt change of the market environment in 2008. However, they were able to immediately react and to take the right steps. As the restructuring is completed, management has now started to increase the number of casinos again undertaking acquisitions in Latvia and Estonia in 2013. For me, this makes sense, as the company is continuously improving its market position in highly profitable markets. Though there is a risk that management will overinvest again, they should have learned their lessons during the recent depression.
Apart from that, Armin Karu, chairman of the board and founder of OEG, and another board member are together holding 65.3% of the shares outstanding. Armin Karu was the CEO until 2012 and managed the restructuring. So he should be sensitive to any excessive expansion plans coming from his successor.
Off-Balance Sheet Adjustment
OEG owns the Reval Park Hotel & Casino in Tallinn which is currently re-developed. Completion date is scheduled for the end of 2015 and total development costs are expected to be EUR 36.0 m.
Based on my understanding, all of the other casinos are leased. At the end of 2012 the company had outstanding operating leases of EUR 27.8 m (EUR 39.6 in 2011). Operating leases are not shown on the balance sheet, but are part of the company’s liabilities. Operating lease payments totalled EUR 9.2 m in 2012 (EUR 9.4 m in 2011).
1. Calculation of off-balance sheet debt amount
Based on the notes in the 2012 annual report, I make the following assumption concerning the payment schedule of the operating leases (in million euros):
|Operating lease payments||At 12/31/2012||Present Value @4%|
Based on the annual report, in 2012 the company concluded a loan agreement with maturity Dec 2016. The annual interest cost is 3month euribor+200bps, which seems to be a relatively low interest rate. To calculate the present value of the operating lease obligations, I take a 4% interest rate given the longer maturity of the leases until 2019. Based on these assumptions, the company has off-balance sheet debt of EUR 24.3 m.
2. Revised EBIT and EBITDA calculation
To calculate the revised EBIT number, we have to work under the assumption that the operating leases were capitalized on the balance sheet. Under this assumption they were handled as finance leases. Finance leases consist of an interest expense and a depreciation expense. For the EBIT calculation we only need the depreciation expense. To calculate the depreciation expense I have to come up with a lease term. For the lease term estimation, I assume that half of the lease obligations will expire in one year and the rest after seven year leading to an estimated lease term of 3.5 years. Hence, the 2012 depreciation estimate is EUR 6.9 m (=EUR 24.3 m/3.5).
This brings us to the following revised EBIT for 2012 (in million euro):
|EBIT as reported||28.0|
|Operating lease payment 2012||9.2|
|Estimated depreciation expense||-6.9|
We can also calculate a revised EBITDA number for 2012 by just adding back the operating lease payments to EBITDA leading to an adjusted EBITDA of EUR 48.0 m.
As of September 2013 OEG had a cash balance of approx. EUR 37.5 m. Assuming that they need EUR 15 m for their operating activities, the company had free cash of roughly EUR 22.5 m on their balance sheet. Adding the operating lease liabilities of EUR 24.3 m to a low debt level of EUR 0.7 m,total debt was approx. EUR 25 m. With a current market cap of EUR 295.0 m, my estimation of enterprise value is therefore EUR 297.5 m.
Below you can find the valuation multiples based on the 2012 trailing numbers:
From my perspective, for a company generating high margins and returns, the above multiples do not present an overvaluation by the market. At the same time OEG is not super cheap as well. For the first nine months of 2013 OEG’s operating income increased by 15%. So based on the 2013 results, at least the EV/EBIT multiple should improve significantly.
Price-to-book is quite high. Here we get back to the issue with fixed assets which I already outlined above. The question is whether the carrying amount of PPE understates the fair value or whether the company has deferred capex during the last years?
To come up with an estimate of maintenance capex, I am using the Bruce Greenwald method:
|Increase in sales||190%||49%||12%||-39%||3%||12%||8%|
|Capex inc acquisitions (EUR m)||29.5||77.0||39.4||3.9||4.3||4.2||8.8|
|Growth capex (in EUR m)||37.9||28.4||3.9||-1.5||0.1||0.4||0.5|
|Maintenance capex (in EUR m)||-8.4||48.6||35.5||5.4||4.2||3.8||8.3|
Admittedly, the numbers fluctuate quite a lot. However, the average estimate for maintenance capex is EUR 13.9 m. From my perspective, this result makes sense. For the first nine months of 2013 capex was EUR 9.0 m (full year estimate EUR 12.0 m) continuing the increasing trend since 2009.
So currently, it seems that capex reverts to its mean and that the low capex level from 2009 to 2011 is not sustainable.
Based on the company’s Q3 2013 report, OEG achieved an operating cash flow margin of 24.0% in the first nine months of 2013 (25.0% 9M 2012). The company just released its total gaming revenue for 2013 which increased by 8.4% y-o-y to EUR 136.0 m. By extrapolating the “Other revenues” from the Q3 2013 report, I come up with a total revenue estimate of EUR 145.2 m for 2013. Based on a 24.0% operating cash flow margin, my operating cash flow estimation for 2013 is EUR 35.0 m (EUR 38.4 m in 2012).
Under the assumption that the company will not be able to grow in the future (which might be unrealistic), I expect OEG to generate a normalized operating cash flow of EUR 35.0 m. As a result, I get a normalized free cash flow estimate of EUR 21.1 m (EUR 35.0-EUR 13.9 m). Based on the current enterprise value estimate this leads to a 7.2% FCF yield (14.5% FCF margin).
At a first glance, OEG’s share is not a screaming bargain. However, putting this into perspective, OEG is a highly profitable and cash generative franchise. Though regulation poses a risk to OEG’s business model it proves as a recipe for high margins and returns. It is simply difficult for potential entrants to enter the market due to the restrictive legislation in most countries. After managing the crisis the company seems to be well equipped for a further enhancement of its already strong market position. In addition, there is ample room for sustainable growth which I have ignored in my valuation analysis. Apart from that, the company’s operations are well diversified over seven countries. As a consequence, the company can compensate for setbacks in single markets (e.g. exit from Romania and Ukraine) by good performance in other markets.
I will establish a 3% position for the portfolio with a share price limit of EUR 2.0. Please click here for more information on WertArt Capital and the virtual portfolio.
The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!