Evolution AB: Thesis Still On Track

seekingalpha06-04

Evolution AB is a B2B provider of live casino solutions and RNG games in the iGaming industry.The stock has underperformed, but the fundamental thesis remains intact, with strong growth potential.Q4 ...

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Our initiation article describes in detail the company, its products, the growth of the online gaming market and Evolution's culture. Readers unfamiliar with Evolution AB should read that article first. We are frustrated by Evolution's recent stock price performance. While the S&P 500 is up 11% and most of the other stocks in our portfolio have shown similar or stronger gains, Evolution has lagged significantly, with a total return of -6% YTD. Chart 1: Total Return Performance of EVVTY and SPY Total Return of EVVTY vs S&P 500 (Seeking Alpha) Fundamentally, however, our fundamental thesis is largely intact. While revenue growth has slowed down and there are new geopolitical risks in the country of Georgia, these were communicated to investors previously. Evolution's advantages - strong economic moats as the dominant platform, continued secular growth of iGaming and a shareholder-friendly management team with an excellent track record - remain. We continue to rate the stock a BUY, with a target price slightly to SEK 1140 or USD 108. While this is similar to Evolution's current stock price, we rate the stock BUY as opposed to HOLD because of Evolution's strong qualitative characteristics and optionality. Updates from Q4 2023 and Q1 2024 Reports Evolution's Q4 2023 and Q1 2024 reports show that our thesis laid out in our initiation article is largely on track. Chart 2: Evolution's Financial Development Evolution's Financial Development (Evolution Q1 2024 Presentation) While revenue growth has slowed down, this has been communicated previously and revenue growth remains at a healthy 17%. EBITDA margins dipped slightly to 69% but still well within historical ranges. Weakness in the RNG sector remains, however, and while the last two quarters have seen RNG return to QoQ growth, the overall story is weak. Evolution is doing much better with its live casino business, and acquiring RNG companies was probably a mistake by management. North America Expansion Remains Intact Previously, we were worried that US expansion plans were not working out as well as anticipated due to the declining revenue trend from Jan-Sep 2023. However, this has reversed in the last two quarters, with North America once again returning to growth. This is particularly important because North America is a lucrative market, with higher revenue per user due to the strength of the US economy. In their Q1 2024 quarterly earnings call, CEO Martin Carlesund mentioned that Evolution just entered Delaware and built another studio in New Jersey. Chart 3: Evolution Revenue Per Region Evolution Revenue Per Region (Evolution Q1 2024 Presentation) Geopolitical Risks in Georgia Should Be Temporary Evolution dealers operate largely in countries with low labor costs, notably Georgia and Latvia This helps keep costs low and contributes to Evolution's high gross and net margins as low-cost labor is used to serve higher cost developed countries in Western Europe and North America. Chart 4: Evolution AB Employees By Country and Gender Evolution Employees by Country and Gender (Evolution AB 2023 Annual Report) Georgia (the Caucasus country bordering Russia, not the American state) is home to 38% of Evolution's employees. Georgia is currently undergoing political turmoil and street protests as the ruling Georgian Dream party attempts to pass through a \"Foreign Agents\" legislation that critics say argue will limit media freedom and jeopardize attempts to join the European Union. While some investors have sold the stock off on the Georgian protests, we see this is as a non-issue. Evolution AB benefits the Georgian economy by offering many jobs for unskilled laborers. Neither the ruling party nor opposition protestors have any good reason to kick out a Swedish company that is providing desperately needed jobs in a country with a 15% unemployment rate. In any case, as Evolution has employees in over 20 countries, it's not difficult for Evolution to hire new employees elsewhere to take over. Financials and Valuation PE and EV/EBITDA With a market cap of EUR 20.7 billion and TTM net income of EUR 1.1 billion, Evolution trades at a TTM P/E of 19x. An Enterprise Value of 19.7 billion and TTM EBITDA of EUR 1.2 billion leads to an EV/EBITDA ratio of 16x. We continue to think these metrics are reasonable for a high-quality company that should generate mid-teens revenue growth in 2024. DCF Valuation Using a 5-year DCF approach, we get a target price of SEK 1,140 or USD 108 using the below assumptions:  Annual revenue growth rate of 15% for the next twelve months and decreasing 1% per year thereafter to 11% by Year 5, or a revenue CAGR of 13%. This is in line with general online gaming market growth forecasts of approximately 12% as described by Polaris Market Research and cited in our initiation article. Evolution is currently growing faster than the general market, and we expect they can retain their elevated growth rate over the general online gaming market. 63% operating margins and 54% net margins in the long term. We assume current operating margins remain. Due to the introduction of global minimum taxes in 2024 (\"GLoBE\"), we assume a tax rate of 15% (up from current 7%) which reduces future net margins. Dividends are 50% of net income, as per Evolution's stated minimum dividend policy. The current share count of 211 million shares decreases by 0.5% a year as management buys back stock. WACC of 12% and a terminal PE ratio of 17x. Aswath Damodaran's cost of equity spreadsheet on his website lists global cost of equities for the Hotel/Gaming Sector as 10.16% and Software (Entertainment) as 12.58%, so our WACC is in-line with Damodaran's estimates. We note that our terminal PE ratio of 17x is lower than the current S&P 500 forward PE of approximately 21x P/E. We apply a lower P/E for conservatism's sake.  Table 1: Evolution Valuation Model Evolution Valuation Model (Author's Analysis) Conclusions We are frustrated with Evolution's weak stock price trajectory but believe the fundamental thesis is still intact. Evolution's management team has an excellent track record and continues with shareholder friendly actions such as buying back shares and paying out 50% of their net income through dividends. Investors focused on momentum, revenue hypergrowth or maximum returns will find Evolution's slowing revenues and stock price uninteresting. GARP-type investors with longer-term horizons, however, should see the recent share price weakness as an opportunity to accumulate more shares.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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