Evolution AB: This Bargain-Priced Compounder Has Massive Upside Potential

seekingalpha09-24

Evolution AB has become undervalued after three years of stock-price stagnation.My reverse DCF valuation calculator suggests that the market is implying low-single-digit FCF/share growth over the long...

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EVVTY Stock Chart (TradingView) I believe that this multi-year consolidation/pullback will soon come to an end, and here are the reasons why. Evolution AB, which offers live casino games to online casinos, is a \"compounder\" stock with high returns on capital, high margins, solid revenue and earnings growth, and a good capital allocation strategy. On top of that, its valuation is now attractive, implying lots of upside potential. As a result, I rate EVVTY stock as a Strong Buy. On another note, I recognize that there are regulatory risks involved in the gambling industry, but it's a risk I'm willing to take at current prices. It's possible that investors were spooked by a falling EBITDA margin in the recent earnings report, but management believes the drop is short-term in nature. Therefore, the long-term outlook looks fine. How Does Evolution Make Money? For those who are unfamiliar with the business, I'd like to provide a quick description. Evolution offers live casino games. Put simply, If I operate an online casino but don't want to create my own games, I'll go to Evolution and its games on my site and then share revenue with the firm and pay it fixed fees. This is where most of Evolution's revenue comes from. This seems like a good business model to me. Casino companies save time by not having to create their own games, and Evolution earns recurring commission revenue as it gets new customers - all without having to run its own casinos. The High-Quality Business Model Is Proven By The Numbers I generally ignore a good business \"story\" if it's not backed up by hard numbers. Luckily, Evolution AB has amazing financial metrics. Let's take a look at some of them. High Return On Equity Starting with return on equity, a metric liked by Warren Buffett, it comes in at a very high 30.8%, as you can see in the image below. For me, anything over 20% is high. You'll notice a large drop in 2020, which can be attributed to Evolution's acquisition of NetEnt in late 2020 for around €1.9 billion (I'm using Euros because Evolution reports its financials in Euros). The good news is that since then, ROE has been trending higher every single year, which is a great sign of improving efficiency/profitability. Evolution AB Return On Equity History (Finbox) Steady Revenue, Earnings, and Free Cash Flow Growth Evolution's business is as steady as it comes. Every year, its revenue, earnings, and free cash flow increase, highlighting the relative predictability of its business model. Keep in mind that the figures in the chart below are in USD, so there may be some discrepancies with what other sites report depending on what rate they convert the currency at. However, the point is to look at the trend. Another good thing is that earnings and free cash flow are generally in line with each other, meaning there are no funny adjustments going on to create a large gap between the two. Data by YCharts High Profit Margins Evolution's low-cost business model allows it to have high profit margins, including a 100% gross profit margin. It also sports a net income margin of 56.5%, an operating income margin of 62.6%, and a levered free cash flow margin of 62.8%. If you can't already tell, these numbers are exceptional and have only been increasing over the long term. Evolution Profit Margins History (Finbox) Its ability to convert operating EBITDA into operating cash flow is also improving, with the operating cash conversion margin well above 80% in Q2 2024. Evolution Cash Flow Metrics (Investor Presentation) The Capital Allocation Strategy Rewards Shareholders A company that generates cash and doesn't reinvest it or return it back to shareholders is not ideal. Evolution is not one of those companies. It intends to pay out 50% of its cash flow as dividends, invest in organic growth, and use 100% of the spare cash after dividends and organic investments for M&A, buybacks, or extra dividends. And it wants to maintain a net cash position. Currently, it has a substantial cash position of €674.9 million with no debt aside from lease obligations. Evolution Capital Allocation History (Investor Presentation) As its cash flows increase, so will its dividend, and the share count should also trend lower over time from buybacks. This is a recipe for long-term success. The Valuation Is Too Low I'll be valuing Evolution AB using a reverse DCF calculator that I've created. Essentially, it calculates an implied growth rate that the market is expecting, and then you can decide if the stock can exceed that implied growth rate (which would make it undervalued) or not (which would make it overvalued). A more comprehensive guide can be found here. Here are the valuation inputs:  TTM FCF per share: $6.31 (per Finbox, in USD) Cost of equity (also per Finbox, calculated using the CAPM model): 8.5% Terminal growth rate: 2% Share price: $97.94  I used 2% as the terminal growth rate to align with the long-term inflation expectation from the Federal Reserve and as an estimate of long-term global economic growth. I'm aware that 2% is likely a conservative terminal growth rate after just 10 years for a growth stock like Evolution, but I'm also doing it to highlight just how undervalued it is. The Valuation Calculation Looking at the screenshot below, we can see that the market is currently pricing in that Evolution AB will see its FCF per share increase by 1.855% per year for the next 10 years and then grow 2% per year after that in perpetuity. EVVTY Stock Reverse DCF Valuation (Author) Of course, this seems ridiculously low, especially given the company's historical growth (its 3-year levered FCF CAGR is 39.2%). Looking forward, the consensus from five analysts pegs Evolution's 2026 free cash flow at €1.535 billion compared to the current figure of €1.154 billion as of Q2. That implies a 2.5-year CAGR of about 12.09%. And the per-share results could be even better if Evolution repurchases shares at a good price. All of this suggests that Evolution can easily surpass the implied growth rate suggested by my reverse DCF calculator, implying lots of upside potential. The Risks Involved Evolution Gaming faces regulatory risks, as some countries may want to change gambling laws to protect consumers, which can hurt the firm. Potential regulation changes could include making it more challenging for companies to obtain licenses, increased taxation, or outright bans. For instance, in Germany, the implementation of the State Treaty on Gambling in 2021 (Glücksspielstaatsvertrag) came with more stringent requirements for online gaming firms. Here's an example of a stringent rule from this law: customers can't deposit greater than €1,000 per month on gambling platforms. Rules like this (and others that came with this development) can obviously hurt Evolution Gaming, but it seems that the firm has easily navigated regulatory headwinds every year, as shown in the financials. Another risk is slowing revenue growth, which some investors may not like. Evolution's operating revenues grew by \"just\" 15.3% in Q2 2024, which compares poorly to its 3-year revenue CAGR of 33.7%. Next, there's the falling EBITDA margin. In Q2, its EBITDA margin fell to 68%, as you can see below. However, this doesn't concern me, as this was the result of higher expenses due to expansion efforts. The long-term trend is stable, and management still expects an EBITDA margin of 69-71% for the full year. Nonetheless, I will be monitoring the EBITDA margin going forward, and if it keeps falling, that can become a problem. Evolution EBITDA Margin History (Investor Presentation) The Takeaway Evolution Gaming has become an undervalued compounder stock. It has high margins and returns on capital and steady growth that is expected to continue. What I like is that it wants to return its free cash flow to shareholders through dividends, buybacks, organic investments, and M&A. I believe that this is a recipe for success in terms of long-term stock price appreciation. Next, the declining EBITDA margin should be short term in nature, at least according to management. Plus, although there are other risks such as regulatory risks and slowing growth, the growth rate is still good, and the low valuation more than offsets these risks. My reverse DCF calculator suggests that the market expects it to grow its free cash flow per share by 1.855% for the next 10 years and by 2% per year after that. I think most investors will agree that those expectations are modest, giving them a solid margin of safety. For the reasons stated above, I rate EVVTY stock as a Strong Buy.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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