Evolution AB – An opportunity due to market noise.

Market leader with a high return on capital and competitive advantages stemming from an incomparable quality product/offering and constant innovation. A compounder with potential optionality in a stable and scalable business.

TL; DR (“too long; didn’t read”)

• Evolution is a B2B software gaming company.
• Gaming (casino) is evolving due to significant innovation in products.
• Online is taking share (like retail, movie streaming) catalyzed by better player experience, and improved access (technology, bandwidth, smartphones, online payments, etc).
• Evolution is the market leader with the “Steve Jobs” of the industry.
• Double-digit growth and returns on capital = compounder at cheap to fair price.

The Company

Evolution (EVO) is a multiple award-winning online software B2B gaming company with a focus on live casino table games. EVO is a Swedish company and is by far the current market leader in the industry. It thus supplies the “picks & shovels” to online casinos who in return pay Evolution a take fee (~10%) of their revenue. As a result, EVO participates in the upside (when players lose, and casinos make money) while losses (when players win) are absorbed only by their clients (the online casinos). At a brief glance an investor may dismiss this opportunity because it may appear to them to be a commodity product with no moat and a highly priced stock at that. On the contrary, I believe Evolution does have an important moat due to economies of scale and barriers to entry. As will be discussed size does matter, but more importantly it is the quality of product, industry disruption, network effects, and innovation led by the “Steve Jobs” of gaming that stands out and makes it such an interesting case.

Disruption – The Evolution of Gaming (pun intended)

Gaming is evolving and EVO is the sector’s innovator. To understand this change, consider how casino gambling occurred traditionally. The norm is shown in the following photo. People crowded around a table playing one of a small number of games offered by a brick-and-mortar casino (B&M).

(Source: Seminole Hard Rock Hotel & Casino Tampa)

COVID accelerated the move to online across all economic sectors. But even before COVID, online gaming was available and mostly looks like the below dull format at best. This format isn’t very attractive and unlikely to get participants excited for very long.

(Source: Svoy Dom Gambling)

The founders of EVO (Jens Von Bahr (currently Executive Chairman) and Fredrik Osterberg) also found this to be a poor experience and set out to make the online experience more authentic. According to this excellent blog post, as part of their pitch to investors, they made a video with one of the founders dealing the cards in a closet with a camera in the roof filming. Keep in mind that the live dealer format had only been made achievable due to the improvement in technology (tablets, smartphones) and increase in bandwidth. As with movie streaming, internet speed is important. As a result of these new speeds, various gaming suppliers (including competitor Playtech) started offering table games with dealers steaming live. Obviously, this is a lot more realistic which results in near casino excitement right on people’s screens. Depending on the live product, the dealer interacts with the players. For example, she monitors the live chat and responds and welcomes players. In one YouTube video, I noticed the dealer referring to people specifically by their chat ID.

An example of live blackjack is shown below. Surely more exciting but post COVID would it be enough to convert B&M players to online and keep them? Could this be topped?

(Source: Pokernews)

Evolution took it a step further by introducing slight variations to traditional games such as live “lighting blackjack” with multipliers in every game around. Note that this is played on a blackjack table with unlimited players with the lightning element acting as a side bet (a lightning fee is paid). When players win a hand, they are assigned a multiplier based on the hand value and randomly generated multiplier ranges. The multiplier pays if the players win the next hand. (Sounds more complicated than it really is).

But that is not the only type of blackjack available. Other versions include four optional sides (vs only two or none in land-based casinos I’ve experienced), a free double down bet, opportunity to quadruple down on any two cards (even after split), a game with no 9s and 10s, etc.

(Source: casinobloke.com)

Notice the implication these additions/variations have. Suddenly players have several options that are just not available in a B&M casino. This creates a premium and differentiated product to the traditional table games. Why play the same old boring blackjack/roulette/etc. that has been around for 100 years and not this new and exciting format?

Evolution that “lead[s] the way in Casino gaming innovation” (judges’ comments EGR 2021) created an entire new genre – game shows! A new way of betting using some known titles (such as Monopoly, Deal or No Deal), internal brands (such as Gonzo from NetEnt), variations of known regional games and new ones. See this video to witness some of the new games being launched and an intro on how and why they were created.

Regarding Monopoly Live shown on the next page, if you click on the link (next to ‘source’) you will notice that players won 2920x their initial bet. Someone had bet EUR 175 on 4 rolls and turned it into EUR 500k+. That kind of excitement and engagement is unheard of. People are live streaming their gambling (eg. these 2 guys) with viewers watching others play and commenting in their streaming chats live!

Evolution categorizes its games under four groups: a) Live Casino, b) Live Game Shows, c) First Person, and d) Slots. Each group as numerous games and can be found here.

(Source: Evolution)

(Source: Evolution YouTube Channel)

The point of this section was to show how online gaming is changing and finally providing serious competition to land-based casinos. Land-based casinos will need to up their game. Building a box with some tables and slots is no longer enough. Las Vegas will survive because of the entire experience built around gaming with spectacular hotels, clubs, restaurants, and amazing shows to watch. But many casinos will end up like Blockbuster. Basic free parking and a few drinks just won’t cut it anymore. This also means higher operating expenses, and CAPEX for land-based casinos if they want to remain relevant.

As with retail and movie streaming, this shift to online is beneficial to the customers. Some of these include:

• Unique games – eg. Monopoly Live with real human hosts and virtual characters (see photo above) and Lightning blackjack’s side bet with multipliers (that change randomly in size with every round) result in unique games that players will seek out.
• More games and options – There are an unlimited number of seats and Evolution in particular supplies a large package to casinos which players can access via a lobby. Compare this to a land-based casino where the player must walk around a limited number of games with a limited number of seats and having to wait or play behind someone else.
• Convenience – Comfort of playing from home any time, under any conditions (COVID, snow, extreme heat, etc).
• Multiple new ways to play with friends. Some examples:
  • Together at 1-person’s home
  • Remotely via shared screen.
  • As a team, friends can pool funds to share winnings/losses.
• Social and potential comradery (or competitive) element. Note the display of the chat on the left of both Monopoly Live and Lightning Blackjack. Here the winners are listed, and the total won by players, as well as player chat posts. Plus, it is easier for players to ask the live dealer questions without the fear of looking foolish. So, interaction may even be higher versus B&M where participants may be shy, feel intimidated or for whatever reason remain silent.
• Ability to quickly switch tables/dealers. Players can step into whichever table is hosted by a dealer of their liking. And if they don’t like them, they can easily just switch. This also results in a potential attachment/likeness of certain dealers that brings players back to play either because they feel they will win vs the specific dealer or they just like their character. And even if their favorite dealer isn’t around the large number of tables and games will satisfy a player (vs a traditional casino which for whatever reason (eg. time of day) may have a limited variety of games and tables available).

(Source: EVO’s 2020 Annual Report)

• Some people do not go to casinos to avoid the social stigma associated with gambling.
• Smaller minimum bets. Land-based casinos have table minimums which may be above the amount a player is willing to risk for their entertainment.
• Some casinos are low-end with suspicious-looking clientele. Players thus avoid bad-looking crowds/crime.
• Potentially lose less money (or with luck win more money) versus a traditional casino. According to toplivecasinos.net the below games offer the highest return to player (RTP) among live dealer games. (99,51% of the No.1 game means that the casino is expected to win 0,49% of the gambled amount). Note that 4 out of the top 6 belong to Evolution. This means more games available to players at good RTP versus land-based casinos.
  • 1st place: Infinite Blackjack by Evolution: 99,51%.
  • 2nd place: First Person Blackjack by Evolution: 99,21%
  • 3rd place: 2 Hand Casino Hold’em from Evolution: 99.18%
  • 4th place: Prestige Mini, Mini and Grand Baccarat Live by Playtech: 98.94%
  • 5th place: Golden Baccarat Live by Playtech: 98.77%
  • 6th place: Free Bet Blackjack by Evolution: 98,45%

For the above given reasons and more, online gaming is gaining market share in an industry that continues to grow and could expand beyond current expectations.

I’m going to side-track for this paragraph so feel free to skip: The counterargument could be that blackjack card counters will prefer a land-based casino as they can turn the odds into their own advantage. Well, there aren’t many card counters and obviously their absence from online just benefits EVO. More importantly the great majority of people are very poor players no matter how much information is available on the internet or disclosed by the casinos themselves. For example, the one legal casino in Nicosia (where I live) publishes the house advantage for all games both online and onsite. I have been a few times for pure entertainment and enjoyed the free drinks and won some money at blackjack. I’ve noticed all types of people sitting next to me. Locals, internationals, young, old, men, women, rich and poor and every single person was playing wrong. They all heavily played the side bets (~94-96% RTP) and they deviated from basic strategy (the mathematically optimal play). Some investors for ESG or personal reasons stay away from this industry. Gambling is inherent in human nature (Edmund Burke), and in my opinion countries need to regulate and legalize gambling. The proceeds (taxes, fees, etc) could be used for the good of society via investment in education and health care. People that can’t go to casinos find other equally poor things to bet on (dogecoin? AMC?) or even play illegally. At least with legalized gambling the government can collect fees, jobs are created, numerous supporting businesses are employed, and other benefits can result (eg. increased tourism).

Online Gaming Market

The global gambling market is expected to grow at around GDP levels, however, online is expected to take a significant share over time. The charts below are from H2 Gambling Capital that specializes in gambling industry data and intelligence. As shown, online is expected to double from around $60 bn in 2018/19 to $120bn in 2025. At the same time, global gambling will only increase by $100bn from $450bn in 2018/19 to $550bn.

Roughly 75-80% of the total global gaming market in 2019-20 comprised of land-based gaming which consists of land-based casinos and state-owned lotteries. So around 20% is online which is made up of 14% RNG (random number generator) and 6% live casino (or 30% of online). Assuming nothing changes then by 2025e, live casino will reach $36+ billion. Considering the appeal that live casino has, I believe this share could be much larger. Even slots players, who may not play table games, will be attracted to the much more exciting game show format. Online gambling itself could take a significantly higher chunk of the total market. Compared to online retail, by 2025, online gambling is expected to grow to 21.8% vs 24.5% for retail. I don’t see why online gambling should trail online retail. On the contrary I would expect the opposite. Furthermore, considering EVO’s games, I expect that new players will be drawn into the market that may not even be considered by the above estimates. To sum up, I expect that online casino will be larger and live casino (the most attractive part) to exceed expectations due to its offering.

(Source: H2 Gambling Capital)

(Source: H2 Gambling Capital)

The Steve Jobs of Gaming

As investors in businesses, we are always interested in good management. Visionary founder operators are every investor’s dream. At Evolution, we were blown away by one man: Todd Haushalter. He is the company’s Chief Product Officer and been with Evolution since 2015. In my opinion he is the Steve Jobs, the Jeff Bezos, of gaming. The gaming industry is his life and once you listen to him speak you realize the passion he has. His resume is extensive (LinkedIn) and spans for over 20 years at casinos in mostly Las Vegas and Macau with positions at MGM Resorts, Bally Technologies and Shuffle Master while starting out as a mere dealer years ago. (Though he was also making dice games in his neighborhood at age 10). He has skin in the game with an 82,8k shareholding and 250k in rights through warrant programs to 2024. As Todd has said in interviews, he went to Evolution because he saw the opportunity to have “a greater impact on the industry that [he] love[s]”. To better understand the person, take a look at the below quotes which were pulled out of one of the interviews Haushalter gave (emphasis mine):

(Source: EGR)

“I must have said that a thousand times in product meetings. This game should be so much fun you don’t have to be playing to be entertained by it. And that was always the goal. We have the highest RTP (return to player) of any supplier. We also have the longest rounds”.

“Crazy time [a highly successful Evolution product], that was the mission. Make something so fun that it’s so engaging that you’ll just watch it. And if you want to play that’s fun too. “

“In design meetings someone will says what if we teased players that you could have won big. I say no. You have to be honest. You could juice this one game up and make a few more bucks but this will hurt the roulette business, the blackjack business, [etc]. Honest, clean, predictable. People can sniff it out over time. Within gaming we have the social responsibility of being honest with players.”

Haushalter gave two must see presentations at iGaming Next 2019 and 2021 which are available on YouTube (here and here). What is evident from those presentations is that Haushalter took that original vision by EVO’s founders and took it to places they couldn’t even imagine. He understands what they need to do to stay on top and what the potential threats are. Haushalter discusses in those presentations how EVO’s competition is not Playtech and other companies currently in the industry but the likes of Amazon, Disney, Coinbase, Robinhood and even Take-Two Interactive. And to me this makes perfect sense. Coinbase and Robinhood are dominated mostly by speculators (shouldn’t we call them gamblers?) as they buy what are referred to as s**tcoins on Coinbase and stock options on Robinhood. Amazon already has a captive audience via Prime while Take-Two Interactive already has a ‘play’ casino in its highly successful Grand Theft Auto franchise.

Furthermore, Haushalter has said “We spend a lot of time thinking about the players we don’t have” and his thinking on this is clearly on a different level. In an interview he brought up a variety of angles such as lotteries (an $80 billion market in the US alone), live television, and land-based casinos. “Evolution Gaming is now online on phone and computer. Why can’t land based casino people not have access to lightening roulette and have to play the same boring roulette that’s been in existence since 1900s. Why be stuck in the same old games.” Keep in mind that regarding live television, Sweden has a history with the TV game Bingolotto so I wouldn’t be surprised if Haushalter is thinking about how to penetrate the TV space. Pierre Lindh (managing director at iGaming Next) has said that Swedes didn’t even consider Bingolotto as gambling.

The Evolution Advantage

The company has several advantages which result in a moat:

• Already highlighted: the huge market, increasing TAM and Todd Haushalter.
• Best in class multiple award-winning offering that is the result of focusing on player satisfaction. The brand they have built means they are approached by every online casino that doesn’t want to miss out on carrying a well-known game. At the EGR B2B Awards 2021, the company was named “Live Casino Supplier of the Year” for a 12^th year in a row. With group brands NetEnt and Red Tiger, the firm won 5 awards in total across live, slots, RNG and mobile. Both NetEnt and Red Tiger that were acquired by Evolution have won multiple awards over the years (NetEnt awards link, Red Tiger awards link). Evolution won the most awards (5). Relax Gaming (no live offering, owned by listed Kindred Group) won 4 awards, Kambi (listed, sports) 3 awards, and Betradar (sports) 2 awards. The rest of the participants did not win more than 1 award.
• Most popular games. According to ”Scuttlebutt in Europe”, EVO had 44 of the top 50 most played live casino games, followed by Playtech (4 of 50) and Pragmatic Play (2 of 50). Note that in 2015, Evolution’s revenue was EUR 76m versus Playtech’s EUR 570m B2B revenues. Five years later in 2020, EVO generated EUR 561m versus Playtech’s EUR 495m (B2B). The top 3 games were Crazy Time, Lightning Roulette and Monopoly Live. Based on the number of YouTube videos a search generates on those games, it is evident that they are indeed extremely popular.
• Zero marketing (no client acquisition costs). Annual growth over 2016-21E has been in the range of 51-91% yet the company has no need to spend to acquire customers unlike typical high growth business that investors are used to. This is because the spending is done by EVO’s clients, the online casinos.
• Personnel experience and size. A nice Silicon Valley app is no longer enough to survive in gaming. EVO not only hires staff, but also trains them. The training is not that simple. The dealers not only need to fully understand the mechanics of the games but also be able to work/deal quickly and efficiently and without error. High RTP means high volume is necessarily for the business to be profitable. Dealers must do all this as well as be friendly and develop the skills to “sniff out scams”. At the same time Evolution needs to monitor all these employees (which is the biggest operating cost). Every new game presenter is trained for 100 hours before a 3-month trainee period begins. The company has over 12k employees while it states a full-time equivalent of around 8k (due to many croupiers working part-time). Dealing with thousands of employees over several years results in managerial and training experience which may not be so easily duplicated. Also having thousands of dealers allows EVO to offer customized experiences (and dealers with language skills).
• Size matters (offering, costs).
  • Not only having popular games but having a significant number of them is an advantage. A large selection and variety of types translates into more options for online casino clients who stay longer, bet more and thus result in more profit for both the online casino and EVO.
  • Bigger budget means more spending and experimenting on games that maintains the company’s lead. As per Haushalter, EVO spends more on risk tools alone then the entire development budgets of small competitors.
  • Dealers are paid a salary and when the majority of operations are in Latvia, Georgia, and Malta these obviously are not high. These fixed costs are spread across hundreds of players versus 5-6 players at a traditional casino or a smaller online competitor with fewer clients. Note in 2020, salaries increased from 111m to 120m (or 8%) while revenue increased by over 50%!
• Network effects. People use Facebook, WhatsApp, Instagram, LinkedIn because their friends, relatives or contacts do. Similarly, players want to try the games which are talked about and popular. The more people playing EVO’s games, the more likely an online casino will sign up with them. The larger they get, the more games they develop, and the cycle continues.
• Switching cost. Besides the “take”, an online casino pays a set-up fee and a monthly dedicated table fee should they chose that option. The dedicated table is reserved and used exclusively for the specific casino. This table is customized based on features, characteristics, environment, hours, game type and language. So essentially the clients make an investment which they will forfeit if they leave. Evolution on the other hand can repurpose any given up tables for other clients.

Risks

The three most significant risks are:

1) Regulation. Firstly, EVO’s market dominance may draw the attention of the authorities who determine that it is a monopoly. Secondly, extreme regulation could hurt the business. It is among the largest listed Swedish companies and very important to the industry so it is unlikely the company would be permanently impaired in future changes. Typically expected regulation in general is not a risk to EVO in my opinion. On the contrary regulation creates an additional barrier to entry (similar to financial services). Any additional taxes/costs due to regulation could temporarily reduce profits, however, would benefit the company in the long run. Legalizing gambling where prohibited would increase EVO’s profits and TAM as illegal activity (similar to prohibition, cannabis) transitions over. Thirdly, EVO holds licenses and certifications offering services in both regulated and unregulated markets. Unregulated markets are not necessarily illegal and competitors (eg. Playtech) also participate. Regulated markets are counties where online gambling is legal and there are specific laws in place. On the opposite end, we have “black” markets where gambling is prohibited (or highly restricted due to a government-controlled monopoly). In between are grey markets where countries have neither explicitly legalized nor prohibited online gambling, so players are free to gamble online but don’t benefit from regulation. Currently, only around 40% (page 6) of the company’s revenues are from regulated markets and this is where the bears focus their case against the stock. Should the company decide or is forced to completely exit unregulated markets then their revenue would decline significantly.

2) Failure to innovate / competition / key man risk. These all mean the same thing which is essentially a lack of new games that keep Evolution on top. The departure of Todd Haushalter would be a significant blow to the company as he has been the driving force. This appears to be unlikely as he has personally gained via his shareholding and options but also appears to have significant flexibility to lead product development and make key decisions. New competition could enter the industry or current competitors may improve their offering however considering some of the already mentioned obstacles it won’t be easy.

3) Evolution does something stupid that results in severe punishment by authorities and/or loss of customers. In November, a 100-page short seller report was commissioned by an American based competitor of Evolution that accuses the company of offering games to players in countries sanction by the U.S. The author claims to have interviewed anonymous current and former executives of Evolution that told him that the company is well aware of such activity. For insight, readers can access a recorded Clubhouse discussion among industry experts here and an interview with Paul Leyland (gaming advisor) here. The company itself has said: “We are a B2B provider that delivers content to operators. It is the operator who controls who ultimately plays,”, “The agreements with our operators are clear as to in which markets the product may be marketed and that the requirements of the regulatory authority are met”. An 8-min company webcast is also available here (also accessible under “Presentations” that is under investor relations section of the company website). I have not been able to get access to the report itself but the accusations I have heard appear to just generate a lot of noise and basically have created the current opportunity to buy the stock at a significant discount to recent history. People in sanctioned countries or in countries where gambling is illegal have found ways to access games. VPNs and similar methods are typically employed to escape detection. Just because this is possible is neither new nor Evolution’s fault. Furthermore, this is not only the gambling industry’s problem. Netflix and similar have been accessed via VPN for years. Restricted pay-tv live football games are streamed illegally in high definition on the internet and can be watched even without VPN and without downloading anything. So, I have no doubt that Evolution is aware of this happening because it is something that is technically difficult to stop and detect. If Apple, Netflix, and Disney can’t stop it, how likely is Evolution? Knowing that it takes place does not make them guilty of any wrongdoing.

Conclusion

Evolution is the Coca-Cola of gaming. A consumer staple such as alcohol and tobacco. A sin stock that will make money regardless of how well the economy is doing. It has all the upside of a casino without the downside. As outlined, it an innovative market leader that is riding the wave of online adoption. Putting a precise value is difficult. If one assumes that growth trends to 5% in 10 years (posted expected 2022, 2023 of 32% and 23%) then the stock is possibly worth between SEK 1300-1700 (DCF). However, I am a lot more optimistic. While online gaming has doubled from 2015, Evolution’s revenues are up over 14x in that same period. Online gaming is expected to increase by 50% (per charts posted in this report) by 2025E, yet Evolution’s revenues are expected to increase by 63% by 2023E (which is below annual historical rates). Profit margins continue to rise due to economies of scale (one dealer/game host serves both 100 or 10,000) and it’s still early to estimate a tapering of growth and ignore optionality (eg. Lottery) or new paths (eg. Entry into sports?) that the company may take. The recent noise created an opportunity to get long at around 23x forward earnings as the stock dropped to around SEK 800 from a high this year of SEK 1709. (In full disclosure I am long with an average cost of SEK 1098). Paying under 30x earnings for a company that has grown 51-91% historically, is expected to grow by 63% in the next 2 years, has a visionary management selling a differentiated product with accounting net profits at 50%+ and until recently triple-digit returns on invested capital is an opportunity. (ROIC 2019: 147%, 2020 (ex-goodwill): 71%, LTM (ex-goodwill): 51%). I believe the stock is cheap and expect a rally back to the highs over the next 12-24 months. At worst the stock is fairly priced and as the Oracle of Omaha has said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

Recommended additional reading:

• Scuttlebutt in Europe: https://www.scuttlebutt.co/p/evolution-evo-the-netflix-of-the
• SVN Capital: https://www.valuewalk.com/evolution-gaming-leader-inlive-casino-svn-capital/
• Alta Fox Capital: https://static1.squarespace.com/static/5aaacb57506fbe4636414126/t/5f18432cb7db824f460a0f76/1595425581495/EVO+competitive+advantages+vF.pdf

Disclaimer: Any opinions expressed within are the authors’ and under no circumstances do they represent a recommendation to buy or sell a security. In no event shall the author be liable to any person for any damages of any kind arising out of the use of any content in this report.