Evolution Gaming Group AB (EVVTY) develops, produces, markets and licenses B2B casino solutions to gaming operators.
It offers live casino studios, land-based live casino, mobile live casino, and live TV casino. Its customers include various games/gaming companies, including the well-known DraftKings (DKNG).
However, the main difference between a loss-making company like DKNG and a company like Evolution is profitability, as we will see. Evolution Gaming was founded in 2006 and is headquartered in Stockholm, Sweden.
We are bullish on the stock as it has a strong competitive edge, which allows it to create shareholder value, maintain a reasonable valuation and enjoy analyst support. This article will focus on the cold, hard, quantitative numbers that prove EVVTY is a solid company.
Evolution Gaming’s Competitive Advantage
Evolution Gaming is a company that we believe has a competitive edge in its industry. So how did we come to this conclusion? Well, there are several ways to quantify a company’s competitive advantage using just its income statement. The first method is to calculate the Earning Power Value (EPV).
Earnings capacity value is measured as after-tax adjusted EBIT divided by a company’s weighted average cost of capital (WACC), and reproduction value (the cost to recreate a business) can be measured as using the total asset value. If the earning power value is greater than the reproductive value, then a firm is considered to have a competitive advantage.
For Evolution, the calculation is as follows:
EPV = Adjusted Earnings EPV / WACC
$7.578 billion = $629 million / 0.083
Given that Evolution has a total asset value of $4.44 billion, we can say that it has quite a competitive advantage. In other words, assuming no growth for Evolution, it would take $4.44 billion in assets to generate $7.58 billion in value over time.
The second method to determine if a company has an advantage is to look at the trend of its gross margin. Gross margin represents the premium that consumers are willing to pay over the cost of a product or service. An expanding gross margin indicates that a sustainable competitive advantage is present. If an existing business does not have an advantage, new entrants will gradually take market share, leading to lower gross margins as price wars ensue to stay competitive.
In the case of Evolution, gross margins have remained stable at 100% over the past few years. Therefore, its gross margins indicate that a competitive advantage is also present in this regard.
Its 100% gross margin also allows for an extremely high free cash flow margin. Evolution Gaming’s FCF margin has steadily increased from 16.5% in 2016 to 56.1% over the past 12 months. This signals improved efficiency and high levels of operating leverage.
Most investors seem to be obsessed with profits. This is especially true for institutional investors who tend to overreact to the slightest shortfall. However, these earnings on paper can be very misleading, which is why we prefer to focus on free cash flow.
Over the past 12 months, Evolution has recorded $720 million in free cash flow, making it profitable by our definition. This indicates that the company does not have to rely on capital increases to continue financing its growth.
More importantly, its free cash flow has been on an upward trend in recent years, as it was only around $20 million in fiscal 2016. The company has surely come a long way. way. This upward trend means that the company’s free cash flow is reasonably predictable.
Evolution creates shareholder value
Large companies often have excellent management teams that can effectively allocate capital to profitable projects. Many professional fund managers tout the importance of meeting with a company’s CEO to assess whether that person is a good fit for the job.
However, we may be able to get a good idea of management effectiveness just by looking at the numbers. One metric we like to look at is economic spread, which is defined as follows:
Economic distribution = Return on invested capital – Weighted average cost of capital
The idea is very simple; if the return on invested capital is higher than the cost of this same capital, then the company creates value for its shareholders through well thought out projects. Otherwise, the company is destroying value and would be better off just investing the money in risk-free bonds.
For Evolution Gaming, the economic breakdown is as follows:
Economic spread = 20.3% – 8.3%
Economic gap = 12.0%
As a result, the company creates value for its shareholders, which requires management to allocate capital efficiently.
To measure Evolution’s risk, we checked to see if financial leverage is an issue. To do this, we look at its debt to free cash flow ratio. Currently, this number is 0.1. Also, looking at historical trends, the debt to free cash flow ratio tends to go down.
Overall, we don’t think debt currently poses a material risk to the business as its interest coverage ratio is 390 (calculated as EBIT divided by interest expense). In other words, it can cover its annual interest payments 390 times using its operating profits.
However, there is an industry-specific risk that investors should be aware of. Since online gambling can be harmful for people with addictive personalities, many governments have imposed restrictions on it.
Nevertheless, online gambling sites circumvent these restrictions by moving operations overseas where they cannot be prosecuted by foreign governments.
The Taking of Wall Street
On Wall Street, Evolution Gaming has a Moderate Buy consensus rating based on two buys and two holds given over the past three months. Evolution Gaming’s average price target of 1,396.25 kr implies an upside potential of 38.8%.
Evolution Gaming is a solid company with strong fundamentals. The company has a measurable competitive advantage and reasonably predictable free cash flow that has enabled it to create shareholder value.
Additionally, the company has very little debt and the support of analysts who expect a sharp upside from current levels after falling about 50% from its highs.
Its price drop leaves it at a price-to-free cash flow ratio of 26x for the 2022 financial year, while analysts expect €789.2 FCF for the year. We think this is a very reasonable price for a very profitable business in a high growth industry. Therefore, we are bullish on the stock.
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