Betting on a Proven Winner

Evolution AB

Photo by Aidan Howe on Unsplash

People have been gambling since before written history. There's evidence of six-sided dice from Mesopotamia from around 3000 BC. Forced to guess, I'd say people will still be gambling in 3000 AD. That's why I like Evolution AB.

The Business

Evolution AB develops, produces, markets, and licenses online casino games to gaming operators. Evolution is not a casino or a gambling operator, but a supplier of online casino games to operators like DraftKings, FanDuel, 888, and William Hill. The company was established in 2006 and was one of the first providers of B2B Live Casino solutions in Europe.

Today, the company operates studios across Europe and North America and offers a huge product portfolio. Evolution Gaming has been named Live Casino Supplier of the Year 10 times out of 10 at the EGR B2B Awards.

Their customers include more than 600 operators including most tier 1 online operators and several land-based casinos.

Live Casino and RNG

Evolution's games are split into 2 categories: live casino and random number games (RNG).

Live casino drives the majority of Evolution's revenue and is much harder for competitors to replicate. These are live, online versions of casino games like poker, blackjack, roulette, or baccarat that are produced in one of Evolution’s studios. This segment is responsible for over 80% of Evolution's revenue.

RNG games are essentially online slot machines. There are also versions of roulette or craps in this category, without the live dealer. Evolution is involved in this segment because of previous acquisitions of RNG companies. This is not an important segment of Evolution's business, so I’m not going to focus on it much.

How Evolution Makes Money

Evolution mainly makes money in 2 ways:

1. Commissions

2. Dedicated Table Fees

Every operator using Evolution games pays a commission on the winnings from the table. Evolution doesn't disclose what the commissions are, but the consensus is that Evolution keeps somewhere around 10%.

Dedicated table fees are paid by operators who want a table dedicated to their users only. Dedicated tables can be totally customized for the gaming operator. That means they can decide what the studio environment and graphics look like, the colors used, what uniform the dealer wears, what language is spoken and more. The gaming operator pays Evolution a fixed fee for this privilege, which depends on the type of game, how many tables are reserved and the active hours.

Growth

Evolution has grown total revenue and operating income consistently and at high rates in the past.

Growth Rates

Evolution is also growing the number of games being played and their headcount:

All of this growth has not been achieved by reducing margins or pricing. In fact, Evolution's net profit margins are increasing, and essentially all of their net income becomes free cash flow:

So Evolution is growing and very profitable. So far, so good.

Management

Evolution Gaming was founded in 2006 by Richard Hadida, Jens von Bahr, and Fredrik Osterberg.

Jens von Bahr and Fredrik Osterberg own just over 10% of the company via Österbahr Ventures.

Jens Von Bahr remains involved as the Chairman of the Board and Fredrik Österberg serves as a board member.

The third founder, Richard Hadida is also still involved as Creative Director of Evolution Gaming.

Martin Carlesund is the CEO. He's been with Evolution since 2015, and owns more than $60 million in EVO shares.

Todd Haushalter is the Chief Product Officer. Haushalter has been in the gambling industry all his career and is obsessed with providing the best customer experience. He’s responsible for developing Evolution’s games and is the most important individual in Evolution’s C-suite. He's also invested in the company with over $10 million in shares.

So far, the management has done a good job, maintaining a ROIC of 20% or greater, and growing the company with a very healthy balance sheet. Evolution has had a negative net debt position since 2014. They currently have almost 900 million Euros of net cash on the balance sheet.

The Moat

I aim to hold companies that will grow and compound my money for long periods, so they have to have a competitive advantage. I think Evolution has a few.

Evolution is the clear market leader

Industry experts estimate Evolution's market share at 70%. They have the best games, highest quality studios and invest heavily in training their staff. The standard training period for a new game presenter is around 100 hours, followed by a three-month trainee period. When casinos outsource their online gaming to a provider like Evolution, they want the best. A sub-standard dealer or gaming experience reflects poorly on the gaming provider.

It's hard for casinos to do it themselves

Chris Mayer shared a quote from an industry executive on casinos doing online live casino games themselves. Here it is:

Economies of scale

In the same way that it’s hard for casinos to get enough scale to make running online games themselves realistic, the bigger Evolution gets, the harder it’s going to be for the competition to catch up with them. Let’s look at an example:

Evolution’s “Crazy Time” is one of the most expensive live games ever developed for the iGaming industry. It’s been a global hit since 2020. No other live casino operator has the budget to develop something like this.

Now consider the fact that in the US, live games have to be produced in the state they’re being played in. That meant that offering Crazy Time in the US was incredibly expensive. However, in December of 2023, Evolution offered it in New Jersey. In June of 2024, Crazy Time came to Pennsylvania and West Virginia. No even comes close to being able to do something like this.

Evolution has network effects and switching costs

From the player's side, they want to play with other people and their friends. Because Evolution is the biggest live game provider, their games are the best place to do that. They also offer so many games that players don’t have to leave the Evolution lobby to find what they want.

From the gaming operator's side, Evolution provides everything - hardware, software, video, the employees, and they handle the user data, giving the operators a complete live casino offering. Add in the fact that they allow operators to customize tables - which costs thousands of dollars, and the fact that the most popular games are exclusive to Evolution and it becomes very hard for them to switch providers.

The network effects feed into data advantages:

In 2022, Evolution started using the “smart lobby”. This is the home screen that players see when they enter Evolution’s suite of games, and that they return to when they switch. Here’s a quote from management on it:

Our new smart lobby is modeled after what you'd find on YouTube or Netflix. It is powered by an artificial intelligence (AI) recommendation engine that gets smarter every time a player enters the lobby. Our goal with the new lobby is simple: to help players quickly find a game they love. AI recommendations, videos, filters, recent views, searches, and more help players find just what they're looking for, even when they don't know what it is. The new lobby has been in development for years and will serve us well for years to come. The long-term value of customizing the lobby for each player cannot be underestimated.

Evolution is already the dominant provider of online casino games. More people playing their games will only strengthen the data set that the smart lobby has to pull from. That will make the recommendations better, pulling more people in. The flywheel here is obvious.

What may be less obvious is that Evolution can use all this data to not only recommend games to play, they can also use it to decide what games to make. Netflix does this with shows - they know what people want and make shows to provide it. Evolution can do the same thing with online casino games.

Regulation

Evolution operates worldwide and is subject to various regulations. The company is an expert at navigating through all of these hurdles. In addition, their good reputation and serious dedication to security helps them gain regulatory approval. The more regulated the online casino environment becomes, the harder it will become for new entrants to catch up to and compete with Evolution.

Risks

Every company has risks and Evolution is no exception. I see two main ones: regulation, and concentration.

Regulation

Yes, I just put it above in the moat section, but it's also a risk. Each country, state, and local body can regulate gaming. Evolution operates globally, meaning they have to deal with and are exposed to a lot of regulation.

Europe is a pretty established market, with clear regulations in place. There are countries developing new laws that would put more regulation on Evolution, but I see no reason they can’t deal with it.

In the US, each state regulates gaming. As it stands right now, live games have to be produced in the state in which they are being played. In addition to the license to offer games, each individual game also has to be approved by the regulating body. Because of this, expansion in the US will likely be slow for Evolution.

In Asia, the regulations are much grayer. Evolution generates revenue in Asia by offering games through already-licensed operators.

Overall, I still think regulation is a benefit to Evolution. It makes their reputation and experience even more valuable, and it puts up substantial barriers to new competition. I look at it this way - if gambling is being regulated, that means whoever is doing the regulating wants it to happen. Usually this is to sell licenses, collect taxes, etc. If they didn’t want gambling happening, they’d just outlaw it. More regulation isn’t necessarily bad news for Evolution.

There are concerns swirling over Evolution providing games to “aggregators” who go on to sell to unlicensed operators, increasing “know your customer” laws, as well as US states and other governing bodies looking into Evolution. This is a massive company, with a good reputation, run by people with significant ownership and experience in the industry. Given EVO's past record, I see no reason to doubt their leadership's ability to continue navigating the regulatory environment responsibly.

Concentration

I already mentioned that Todd Haushalter is incredibly important to Evolution. He's the creative force behind many of their popular games. If he would leave the company, it would be a huge blow to Evolution. He's been there a long time, and has significant investments in the company, so I don't expect him to go anywhere, but it's worth being aware of.

Also, according to the most recent 10-k, in 2023, the top five customers (in terms of revenue generated) contributed 41% of Evolution’s revenue. I think the switching costs and the quality of Evolution’s products mitigate this risk, but it still exists.

Valuation and Shareholder Return

We have a very profitable company in a growing market with a competitive advantage and good leadership. Looks good so far. Now it's time to see what Evolution worth and what kind of return we think we can get.

According to Grand View Research, the global online gambling market size was valued at USD 63.53 billion in 2022 and is expected to grow at a compound annual growth rate (CAGR) of 11.7% from 2023 to 2030. Evolution will likely grow faster than the market. Given the past growth rates, 15% to 20% is reasonable.

Using a DCF, if we want a 15% return out of Evolution, assuming they grow 15% a year for the next 10 years, and sell at future PE of 30, we can pay €135 per share today. They currently trade below €100.

Going to a 20% growth rate and a PE of 35 gets us to a fair value of €262.

The market appears to be significantly undervaluing Evolution right now. Just take a look at the EPS vs the stock price:

Let’s assume that the market fails to recognize the value of Evolution and look at shareholder return.

Evolution has a policy that they return 50% of their net income as a dividend. Right now, the dividend yield is about 2.6%. Not bad.

They've also grown the dividend nicely in the past:

In the past, they've been reluctant to authorize buybacks. But the stock is so cheap, that management has started to buy back some shares. In the last 12 months, the buyback yield was about 1.5%, so that puts our total shareholder yield over 4%.

More buybacks are possible:

Let’s guess at what buybacks this year could look like -

• 2023 Net income was €1,071 million

• Projecting 15% growth gets us to €1,231 million

  • 50% of that will likely be a dividend

• Leaving Evolution €600 million or so to use in buybacks.

The market cap of EVO is roughly €20 billion meaning they could buy back 3% of the company this year. More if the price goes even lower.

That looks better. Given the growth of the company, the historical growth of the dividends, and the potential for buybacks, I think there's a very strong case for Evolution being a stock you buy today, then let it compound for years. If we get a multiple re-rating, that's icing on the cake. But if management keeps adding the buyback return to the dividend payout, I don't think we'll need it.

One more way to look at it - using Buffett's equity bond idea.

Using a ROE of 25%, and a future PE of 35, we find that over 10 years, we'll collect around half our initial investment back in dividends. By then, our investment in Evolution will be yielding about 7.5% in dividends. The IRR on the whole thing will be 19% per year.

Why is it cheap?

An incredibly important question! Here’s a selection of potential reasons for Evolution’s current valuation.

• “Evil” or “sin” stocks tend to trade at lower multiples.

• Fx headwinds - underlying revenue grew 24% in Q1 2024 but only 17% in reported terms.

• Taxes- tax rate increased from 7% to 15% in 2024.

• Unrest in Georgia - over a third of EVO’s workforce is based there.

• Significant investments in new capacity have caused some short-term pressure on margins.

• The concerns with regulation mentioned earlier.

None of these bother me as particularly concerning, or as long-term issues.

Conclusion

Evolution is a very high-quality company trading at a discount to intrinsic value. It has sustainable competitive advantages and exists in a duopoly with Playtech, although I think Evolution will eventually win out and become a near-monopoly. Evolution offers higher quality games and already dominates the live casino market with 70% of market share.

They have created a one-stop shop for gaming operators to provide the best online experience and a Netflix-like ecosystem for the players. As the dominant company, Evolution can invest the more money, resulting in better games. Evolution has been releasing around 100 new games a year - a number that the competition cannot even dream of.

The management has done a good job of capital allocation so far. They seem to be more committed to unlocking shareholder value with more buybacks in the future. Even if they don't, the continued growth of both the market and the company, combined with their 50% dividend payout policy will let us do quite well.

While Evolution doesn’t give us double-digit shareholder yield right now, 5-6% on a company that looks set to grow at 15% to 20% a year for the foreseeable future looks very attractive to me.