Evolution AB (EVO) update + some thoughts on a serial acquirer
Evolution AB (EVO), which was one of Fintwit's darlings (especially among European investors), is now trading at the lowest valuation since its IPO. EVO sparked passions among the investment community (myself included, as I bought my first shares on January 14, 2020 at 301 SEK) because the unit economics of the business are great and – let's not fool ourselves – the stock compounded at almost 90% since its IPO. When a stock nearly doubles in price every year, it is hard not to underestimate the risks of the business. From November 2021, the narrative changed dramatically. Following a series of anonymous accusations, allegedly from the competition, claiming that Evolution’s games could be accessed from banned countries such as Iran or from illegal online casinos in countries where gambling is banned, investors are beginning to question the terminal value of the company. I have no doubt that the stock will not go back to trading at 50 times earnings as it used to, when investors did not pay as much attention to the issues raised in the various bearish reports. The stock has been flat for 3 years now and is currently trading at 14 times FCF, leading many to question whether this is really a good opportunity to invest in a business with a 62% FCF margin that is expected to grow its EPS above a CAGR of 15% over the next few years.
In this post I will try to give my view on EVO, and then I will also talk about why I am buying shares of one of the most promising, illiquid and least popular serial consolidators that I know.
As I mentioned in my original post about EVO (link), the company was founded in 2006 and was one of the first B2B suppliers of live casino solutions in Europe. Founders Jens Von Bahr and Fredrik Österberg saw an opportunity to improve user experience and forever transformed the industry. EVO has played a huge role in developing and redefining an emerging market that has grown exponentially over the last decade. Live casino has experienced its golden age because circumstances were favorable (improvement in data transmission capacity, the expansion of Internet access among the population, the technological improvement of smartphones and tablets...), but also largely thanks to the solutions and games developed by EVO. The success of online casinos compared to traditional land-based casinos is closely related to the gaming experience. Players tend to enjoy the online experience more because it is much more convenient and accessible, which has indirectly helped destigmatize the gambling industry and sparked an interest in a large percentage of the population that had not been interested in gambling before. Live casino has been so successful among consumers because it brings together all the benefits of land-based and online casinos in the same experience.
Live casino currently represents a key product in the offering of any first or second tier casino operator and EVO is the undisputed leading supplier of B2B solutions, with a European market share above 70% and a US market share above 90%. EVO makes money in the form of fixed fees by providing dedicated tables for certain clients, but mainly through commission fees, which are a percentage of the casino operator's monthly net gaming revenue (NGR). EVO's variable revenue stream will grow the more players join a table and the larger the bets are placed. While EVO’s average take rate is typically 10% to 12%, commissions fees can range between 8.5% and 17% depending on client size and traffic potential, as well as game type. Customers are charged fixed fees for dedicated tables that can range from €5,000 to €20,000 per month. A top-tier operator may require 25 - 30 dedicated tables. Depending on the type of game, dealer and working hours, EVO can generate revenues of between €50,000 and €100,000 per dedicated table per month (between fixed and commission fees) with operating margins greater than 60%, with hardly any incremental operating cost or incremental CapEx for each new player that joins the game.
So, if the business model is so enticing, why isn't there much more competition? Why does Evolution hold such a dominant position?
The cost of setting up a studio, of course, does not represent a barrier to entry for new competitors in itself. Due to the nature of the business model, the payback period per studio does not exceed two years. Whoever develops more powerful intellectual property than the competition will dominate the industry. Given that more than 90% of live casino is made up of Blackjack, Baccarat and Roulette, these games are increasingly perceived as commodities and not unique, which is why the product offering of casino operators has become more and more similar. The remaining 10% is what makes the difference. Evolution’s scale is key to leading the industry because game development poses a significant cost, especially considering that releases have a relatively short lifespan and therefore game development must be a recurring expense. EVO is the leader because it has the largest customer base. By growing beyond a critical mass of users, it enjoys irreplicable economies of scale and can improve its offering by being able to allocate more resources. The cost per user of developing new intellectual property is exponentially lower than what competitors face. Every year EVO releases more than 100 new games and new editions of previous games, whereas a decade ago they released only 10 games per year, which is precisely where many small competitors are now.
So why have I sold all my shares?
First of all, I will say that EVO is not part of my buy & hold strategy because I underestimated some risks that I believe can seriously hurt the terminal value of the business. That does not mean that EVO can't deliver a very good IRR if you know how to take advantage of the stock's volatility. Since I sold my shares, the stock has continued to fall (just a matter of luck, as quite the opposite usually happens). Q2 results did not live up to investors’ expectations and Evolution is now trading at the lowest levels in recent years (14 times FCF, taking into account that it will make about €6 FCF per share in 2024). It is rather funny that, as I am writing this arguing why I have sold all my shares, I am now considering buying again – this time, however, with a different time horizon in mind. Investing in listed companies is the most stimulating game ever created. Only when you are flexible, know how to adapt to circumstances and realize that the stock market is there to serve you, and not to guide you, that is when you begin to enjoy this game.
But let’s go back to the point: EVO is not a company that I would want to keep in my portfolio for many years to protect my family's purchasing power for two simple reasons: the business depends on a very small team, which is the key for the development of new IP and, therefore, for the company’s future. In addition, regulatory risks are becoming increasingly relevant.
EVO has a privileged competitive position because they were pioneers in the industry, but managed to keep their distance from the rest of the competitors during all these years by having the best talent (and I am not referring to the croupiers). Current CPO Tod Haushalter is, by far, the most important person for EVO’s present and future. He started back in 2000 working as a croupier for London Clubs International in Las Vegas and is now considered the Steve Jobs of the industry. Even before joining Evolution, Haushalter developed and patented numerous games and innovations for different casino operators. Since his arrival in 2015, Haushalter has been mainly responsible for games as popular as Crazy Time, Mega Ball, Dream Catcher, Monopoly Big Baller, XXXtreme Lightning Roulette or Funky Time, among many others. These games have received numerous awards and have been extremely important in securing contracts with top-tier operators around the world. Basically, with EVO’s intellectual property, operators attract new customers who had no prior interest in gaming or gambling, increasing cross-selling opportunities. But even more importantly, these new games help retain users long enough to pay back acquisition costs, especially in an industry where the first 24-48 hours following the first experience are crucial in terms of customer retention. I am not crazy about the fact that Evolution’s advantage over competitors and its pricing power (EVO charges operators the most in the entire industry, by far) rely so much on innovation and, consequently, on Todd Haushalter and those around him. Relatively new competitors like Pragmatic, which have mainly focused on copying Evolution's latest releases as quickly as possible, are recruiting former EVO staff to try to bridge the gap between the two companies. In fact, Pragmatic acquired Extreme Live Gaming, which was founded by Darwyn Palenzuela, who was Evolution’s CTO from 2006 to 2011. What if Todd Haushalter decides to go another direction? Market share can change relatively quickly, and it does not matter how relevant you have been, but how relevant you will be in the future. Some shareholders claim that Haushalter has no intention to leave Evolution, but no one can say that will not happen with certainty. One might argue that Apple has done extremely well since the death of its founder. Spoiler: Evolution is not Apple. Todd Haushalter may or may not end up embarking on his own path or switching to the competition at some point, but it is one of the issues that would not let me sleep well at night.
In addition, regulatory risks will always be an inherent part of the business, regardless of whether a higher or lower percentage of revenues come from regulated markets in the future (there are three types of markets: regulated, gray and black). EVO has no direct business relationship with players, which in theory means (at least for now) that it has no legal responsibility over who uses its products or where they do so. It is the operators or aggregators that EVO works with who are actually liable. EVO's biggest problem is that 60% of revenues come from unregulated markets – markets where online gambling is still not overseen by regulators and there are no laws in place, but also markets where gambling is explicitly illegal. What is the risk here and why are investors now valuing EVO at 14 times FCF? If you ask me, I think the market is valuing that part of the business as if it were zero. The best thing that could happen to EVO would be either to go back to private or, if they still wanted it to be a listed company, the percentage of revenues coming from regulated markets should increase significantly, but this scenario is very difficult to reverse. As long as Asia remains the world’s largest gambling market and EVO provides its products there, it will be extremely difficult for the company not to be indirectly linked to black market activity. This is because the Asian market is completely fragmented and operators (which are mostly small-scale) rely on aggregators to contract B2B suppliers. Essentially, aggregators are EVO's commercial network in Asia. EVO claims it is very difficult to know for sure, without direct contact with operators, whether they are operating in good faith and in accordance with the law. As if this were not a sufficient risk, any scandal related to black markets that can indirectly affect the company can also hurt its operations in different geographies. Regulators may decide not to extend EVO's license due to its activities in other markets even if they are legally not responsible for determining whether the casino operator is doing its job properly. Regulators do not have to prove anything, they can make unilateral decisions.
Historically, most gray markets tend to become regulated markets. The most heavily indebted countries have an interest in regulating the gambling industry because gambling tax revenue is an easy way to increase their budgets. It is also true that very rarely a gray market has turned black. Moreover, EVO is so geographically diversified that no country banning gambling can pose a serious problem for the company’s revenues. In my opinion, the main risk for Evolution is not so much that a previously unregulated market goes black, but rather that an unregulated market (or even a regulated one) comes out with unfavorable regulatory changes to operators, aggregators and B2B providers. In Germany and the UK, where gambling is completely legal, measures have already been put in place to control the amount of money users can spend (monthly deposit and stake limits). A regulated market is no guarantee for Evolution if the regulation is not favorable itself. New regulations in established markets could have a ripple effect on other countries where EVO is present.
The US and Latin America still hold huge potential for Evolution, but I have to concentrate my portfolio only on companies that control their own destiny and have time on their side. Being the undisputed leader is not enough when regulation will always be your biggest competition. Based upon these conclusions, I decided to sell all my Evolution shares to buy more from Judges Scientific (JDG), which now holds the third position in my portfolio. JDG is one of the most promising, illiquid and least popular serial acquirers I know of.
Since going public in 2003, the company has grown organically and through selective acquisitions, paying between 3 and 7 times EBIT. David Cicurel (current CEO) and his team excel at capital management and, as a result, many shareholders who have trusted the team for years are now millionaires. The stock of this mini conglomerate of businesses that lead their respective market niches has had historical returns of 26% CAGR, and is one of the few serial acquirers that has done almost as well as Constellation Software. Even after a 100-fold increase in just 20 years, Judges Scientific remains one of the least followed serial acquirers.
The company was founded by David Cicurel in 2002, following a career focused on corporate restructuring operations. In 2003, Cicurel listed Judges Scientific on the AIM of the London Stock Exchange after raising capital from friends and family members, as an investment vehicle to acquire majority stakes in small and undervalued public companies. Cicurel’s initial goal with Judges was to increase the value of undervalued companies through turnaround proposals in order to later sell those shares at higher multiples. However, the stock market appreciated remarkably in a short time and the strategy stopped making sense. David Cicurel had luckily come across Fire Testing Technologies, one of his first acquisitions, which would end up turning Judges Scientific’s roadmap upside down. FTT was then (and still is) a leading global manufacturer of instruments that measure the fire resistance of different materials, with a diversified portfolio of products that are mostly used by universities, fire research institutes and international test centers. FTT has become a global reference after having spent more than a decade participating in the development of many of the fire resistance instruments used in international standards. David Cicurel was aware that companies in the scientific instrument sector were mature and well-established. They were also not very capital intensive and large cash generators, had very high returns on capital employed, tailwinds, pricing power and, being niche businesses, they did not draw too much attention to attract new competition. That is the real beauty of this type of business – it is not that barriers are excessively high, but rather that other markets are just larger and more glamorous. I cannot imagine a recent Harvard or Stanford graduate dreaming about designing a better calorimeter, or any other instrument that measures the heat release rate, than those by FTT, which delivered less than a million pounds in EBIT back when it was just acquired.
With FTT, David Cicurel also realized that the ‘buy and build’ strategy under a decentralized model made much more sense than acquiring companies and subsequently restructuring the whole business in order to achieve certain changes. This new model reduced risk and allowed Cicurel and his team to focus on what they did best: M&A operations. Thanks to the lack of competition in the market (and this is the key to the investment case), Judges was able to acquire FTT, a business with returns on tangible capital employed above 50%, for 5 times EBIT. To date, JDG has made only 23 acquisitions but, along with high single-digit organic growth, they have served to increase FCF above a CAGR of 25% since its IPO. That's not a lot (Constellation Software made 29 acquisitions in the first quarter of 2024 alone), but Judges' returns on incremental invested capital are above 20% because it can acquire good companies at very attractive prices. Few have the knowledge and ability to acquire such technical and complex businesses, and few know how to leverage the advantages of each individual one as JDG does. Scientific instrument businesses have different end markets, so it is not usually possible to share industrial assets and intellectual property, or take advantage of cross-selling opportunities. A good example of this is the recent acquisition of Bossa Nova Vision, which develops polarization imaging systems and cosmetic testing instruments, for $1.6 million or 4 times EBIT.
But the past is history. What about the future? Cicurel is 70 years old and, although he constantly stresses how much he enjoys his day to day, he will have to pass the baton sooner or later. I am not that worried about this because the management team has soaked up the wisdom of Cicurel after years of working side by side. I believe that the people who are fundamental to the performance of the stock are more than cognizant of the company's culture. Also, in my opinion, it is only a matter of time (several years) before JDG becomes more and more like Halma plc. For it to happen, it is also important to note that part of the management team, besides having worked with Cicurel, have also held relevant positions in Halma itself (Mark Lavelle and Tim Prestidge have more than 23 years of previous experience in Halma). David Cicurel has stated on multiple occasions that JDG aspires to become the next Halma (which would also be the dream of any shareholder), but I believe that shareholders will obtain better returns during the process and not once the company reaches Halma’s current size. Let me explain. My strategy with JDG is very simple: accumulate the most shares at the lowest possible price (it is relatively common for the stock price to experience significant fluctuations) while JDG is still a small-cap company. I think the company is now in an ideal situation, because it is a much better business than it used to be thanks to the diversification of its subsidiaries and it still has huge reinvestment opportunities.
When Cicurel acquired FTT, he discovered that there were over 2,000 niche scientific instrument companies in the UK alone, mostly family businesses that were set up by founders in their 40s who, after 20 or 30 years, realize that there’s no one in their families willing to take over, so they decide to sell them. JDG is an acquirer with a great reputation among founders who are drawing up their retirement plan, and it is a guarantee that the previously agreed terms will always be respected, they will not tear the company apart or make major restructurings (even when the founders retire, many of the staff who worked alongside them from the very beginning are still there and depend on the business). As opposed to private equity firms, JDG aspires to become a permanent partner for the acquired businesses, and allow them to maintain their DNA without interfering in their day-to-day operations. Under its umbrella, new subsidiaries are provided advice and financial support (many struggle receiving financing from banks) while cooperation between them is encouraged to prosper within the group, but they still control their own destiny. 90% of this constellation of companies are family businesses with a revenue of less than £5-7 million and less than £2 million EBIT. As JDG, which is expected to deliver £37m in EBIT in 2024, grows and scales up the business, it will need larger acquisitions for them to really move the needle. When this happens, JDG will have to acquire larger businesses and inevitably reduce its hurdle rate. For larger deals, such as the acquisition of Geotek in 2022, JDG knows it will have to pay significantly more. Geotek, which designs and manufactures geotechnical instrumentation to assess the mechanical properties of soil and rocks, was a family business whose founder was 70 years old, but JDG had to pay £80 million (6-7 times EBIT) simply because it was a company with an EBIT of £11-12 million. As JDG increases in size, reinvesting all available cash while also achieving incremental returns on invested capital above 20% will become steadily more difficult. There will come a time when JDG is no longer a small cap company and, like Halma, will need to make a large acquisition every quarter or half year and pay 12-13 times EBIT, which is the very thing Halma is doing.
But JDG is still far from reaching that point. Cicurel and his team do not need large acquisitions very often and can continue to focus on smaller deals, which are what really drive the value for shareholders. Overall, I find the scientific instrument sector is an attractive industry to invest in, because tailwinds will drive the organic growth of the company’s subsidiaries for decades to come. The companies under JDG usually benefit from the expansion of higher education and also the constant desire to improve efficiency, productivity and people's safety (universities and testing centers account for 70% of total sales). Scientific instruments are critical and indispensable tools for progress in any field, so while demand for these products may be temporarily postponed, it never disappears (and this is very important for a business). The business model is highly dependent on global public spending but, contrary to what one may think, JDG’s organic growth was 14.5%, 20% and 14% in 2008, 2009 and 2010, respectively. There are still plenty of opportunities to reinvest available cash even though JDG’s EBIT has multiplied by more than 150 times in the last 20 years. In fact, JDG has just extended its multi-bank facilities to support its ‘buy and build’ strategy (link), not only in the United Kingdom, which was the initial focus, but also now in other international markets where there are thousands and thousands of small scientific instrument businesses.
*Note: Next month's post will be about a new long idea.