Changing the game: Why Paddy Power Betfair may be about to revolutionise the industry

Paddy Power Betfair (PPB) floated on the London Stock Exchange to widespread fanfare on 2 February 2016, immediately becoming the largest public egaming company and a fixture in the FTSE100. Shares traded at close to £105 and analysts appeared infatuated by the sheer scale and highly-regulated nature of the company. PPB wasn’t another grubby gambling company with opaque revenues and an opaque future. It was a modern, technology-powered ecommerce company and was valued as such. But a little more than a year on, the value of the firm has dropped 15%, or circa £1bn. So what changed?

On the surface, the first full year for the combined Paddy Power Betfair went as smoothly as possible. The group’s revenues grew by 18% to £1.55bn with double-digit growth across all four operating divisions, while underlying operating profit increased 44% to £330m. The integration of the two companies also progressed ahead of schedule, with the group set to benefit from £65m in annual cost synergies from 2017 onwards. The majority of the initial savings came from staff cuts, with around 650 of 7,200 workers made redundant. However, since those cuts, the firm has been growing so rapidly that new hands were needed on deck.

“People were very focused from the start in maintaining momentum and continuity and getting on with it,” said group chief executive Breon Corcoran during the recent FY16 earnings call. “It hasn’t been just about job cuts. Although there were redundancies last summer, we’ve been hiring consistently since then and we are on or about flat headcount from 14 months ago [when the merger completed].”

Paddy Power Betfair CEO Breon Corcoran says headcount has returned close to pre-merger levels

The technical integration has also progressed well, with Paddy Power’s proprietary games shared with Betfair, and the Irish firm’s risk management models now pricing more than 85% of bets on the Betfair Sportsbook.

Indeed, the Sportsbook has been one of the main beneficiaries of the merger, with the sharper pricing enabling a 70% jump in in-play betting events and a focus on attracting value-hunting customers thanks to a sportsbook-market-leading 102% overround on football books. And although PPB refused to detail which brands contributed to its 14% online sportsbook growth in 2016, it’s a safe bet to assume the Betfair brand performed the strongest.

Cornering the market
Elsewhere, the decision to pursue two distinct brands aimed at opposite ends of the market continued to pay dividends, with Betfair viewed as having a value proposition, while Paddy Power went after the more recreational punter. Paddys’ new 2 Up offer, which pays out customers as soon as their selection goes two goals up, is a great example of the firm’s expertise in gambling-as-entertainment. Not only does Paddy Power get to tweet about the offer every time it is activated, but a good portion of those early pay-outs are quickly reinvested in-play.

Scale also helped the group deliver major increases in its live streaming offering from January 2017, helping to close the gap on the only gaming company ahead of PPB on the EGR Power 50 list, bet365.

As Peel Hunt put it in a recent analyst note: “Bet365 has long been accepted as the dominant player in live streaming, something which was a key driver of its live betting revenues. Paddypower.com and Betfair now have the same amount of live content. Online bettors will not take too long to realise this in our view and this will give the group a competitive advantage against the majority of its online peers.”

Stick to your roots
The obvious investments being made in sportsbook has led to a common complaint floating around social media that PPB has de-prioritised the Betfair Exchange post-merger in favour of the higher margin platforms. But the firm dismisses the idea it is abandoning the product that first brought Betfair to prominence, pointing out it has rolled out a new desktop version of the Exchange in recent months.

“The Exchange sits on a separate technology stack so we can and will continue to develop products for that while we migrate the sportsbooks,” Johnny Hartnett, PPB’s MD of International, tells EGR Intel.

“We intend to continue to grow both. Exchange is bigger than Sportsbook currently and we’ll do everything we can to continue to grow it.”

That includes the launch of the product in New Jersey last May, and although the initial uptick has been relatively modest, Corcoran suggests it is bringing new customers to horseracing betting, with 70% of punters using it not already betting into New Jersey online pools. The firm also holds a provisional licence for exchange betting in California, and has several partnerships in place to expand West, should the New Jersey Exchange start delivering its benefits on a bigger scale.

Analysts agree Betfair would do well to continue pushing the Exchange, with Cenkos’ Simon French explaining: “The Exchange, while suffering some intermittent downtime, is still a differentiated product. They’re the only ones that have managed to do that at scale and it gives them a relatively risk-free edge on the competition.”

Behind the game
But of course, resources are only finite, even at a firm the size of PPB, and the focus on its sportsbooks and the Exchange has led to something of a blip in gaming, which Corcoran admitted had seen an “underwhelming” start to 2017 after a weak fourth quarter.

The firm said the downturn was attributable to lower direct gaming activations on the Paddy Power brand, a reduction in Betfair sports customers cross-sold to gaming and reduced year-on-year VIP activity across both brands.

In response, the firm increased TV advertising from mid-December, but Corcoran admitted that other “operational levers” would need to be used to kickstart the vertical. “We aren’t satisfied with gaming,” he said. “We should have put more focus into it last year. We’ve started that but it isn’t fixed yet,” the exec added.

In Corcoran’s own words, gaming “continues to be a fragmented competitive market”, where scale is perhaps less effective than a multi-brand approach, and “some of the pure-play gaming businesses” have had a jump on the likes of PPB in recent months.

“We should have put more focus into gaming” – Breon Corcoran

The solutions aren’t necessarily rocket science for a management team widely regarded as one of the best in the industry. The VIP business is notoriously volatile and Hartnett suggests that dropping TV advertising in the first place was partly to blame for the drop off. Paddy Power gaming ads have already been returned to screens, although it is too early to see returns.

“There’s no silver bullet there,” adds Cenkos analyst French. “It sounds boring, but as the industry matures it’s about product and executing. Maybe some more advertising, some more cross-sell and just doing the basics well.”

Paul Leyland from Regulus Partners puts the gaming ‘weakness’ in a more positive light, pointing out the vertical still grew 14% year-on-year to £245m.

“We’re in danger of painting too black a picture,” Leyland says. “They’ve not got much to turn around, they’ve got stuff to build on. Gaming is 40% of online revenues and a lot of betting companies with higher gaming mixes have that because they’re bad at sports betting.

“Are we looking at this from the wrong side? Are we actually looking at a highly successful betting business? Does bet365 make more money from betting or gaming? Benchmarking this to Ladbrokes Coral or William Hill massively misses the point. Those firms should be asking what’s wrong with their betting brands that they make more money on casino.”

The next step
But a consensus seems to be growing that the marginal gains and quick wins for PPB have now been accomplished, and things are about to get trickier for the giant. “This merger is a two phase process,” says Leyland. “Phase one is melding together two businesses operationally and culturally. And that’s the easy part. We have two similar businesses, a chief exec who knows both businesses extremely well and quite a lot of staff crossover.

“Phase two is melding them together technically and using that to deliver transformational change, and that’s the hard part. That’s what’s coming this year and we need to see strategic operational synergies, and genuine game-changers. Well done so far but those were the baby steps,” he adds.

The big steps will be made in the next 12 months, where PPB will be focusing on migrating the Paddy Power legacy business onto the group’s new tech stack. Management warned investors there could be a slight slowdown in growth as the tech teams focus on that project to the detriment of new product releases on Paddy Power. The migration is expected to be completed sometime in Q4 and analysts voiced fears about the potential impact on Paddy Power’s market share in a rapidly-moving sector.

“[We are concerned by] the apparent deemphasising of market share gains as an operational target,” said Ed Young from Morgan Stanley. “On one level, this reflects an admirable discipline towards returns and efficiency. On another, we consider this potentially greater emphasis on cost and profitability as a longer-term concern if restraint on marketing allows competitors to build stronger market positions.”

Waiting game
PPB is aware of the dangers but says the integration is being done as quickly as possible as the primary focus of the largest tech team in the industry and can’t be rushed. There are plenty of other firms that would testify to the difficulties of such an integration.

“It’s tempting to spend more money on technology to try and speed this up but some things just take a certain amount of time,” Corcoran said on the earnings call, musing: “Nine women can’t make a baby in one month.”

He adds: “This can’t be done before the end of the year. It’s frustrating we’re not getting the credit from our customers for the work we are doing at the minute, but we will do once this is done.”

Hartnett explains that once completed, the group platform will be able to house three or four brands, with products available across the entire portfolio. Paddy Power’s Kicker, or Betfair’s Each Way Edge, for example, could be shared between the two once the process is complete.

Whether they will be is yet to be decided and will be based on the “distinct brand propositions,” ie value for Betfair punters and entertainment for Paddy Power customers.

“Once this is completed, everything we do will be available across both brands which is a significant strategic advantage,” says Hartnett. “We’re prepared to accept there will be a small slowdown of product development but we’re satisfied the prize is worth going after.”

The platform will also enable things like KYC, payment processing and geo-location to be done centrally rather than across various brands in various jurisdictions. The scale of the platform also means the firm’s Australian brand Sportsbet could be added to it in the next couple of years, with space for another brand should M&A become a priority again.

The idea of 2017 as a consolidation year was buttressed by the firm’s tone on its marketing budget which management suggested would flatline in 2017. CFO Alex Gersh said the firm spent £300m on marketing last year, adding it was “difficult to visualise how or where we could spend more in the UK”.

Again the focus was on efficiency and profitability rather than growth, with Gersh lauding the benefits of pooling the two companies’ analytics data and optimising digital marketing spend. “For example, we can better test the effectiveness of different approaches to promotions on a particular event and up weight activity that is driving the most effective returns,” he said.

The Google effect
At some point though, investors will expect the investment and consolidation to deliver growth; the stock after all trades at a 2017 EV/EBITDA of more than 15x, compared to a gaming sector average of 9x. Part of that is thanks to the highly-regulated nature of the business, but there’s also still the lingering expectation that the company has such an unprecedented position in the gaming industry that it can deliver something truly transformational.

“If PPB can sustain double-digit growth during transition, it will be in a very strong position to begin rewriting the rules of the game,” says Regulus Partners’ Leyland. “In theory PPB has the scale and the wherewithal to do something we haven’t even thought about yet. Think Google’s driverless cars or Uber disrupting taxis.

“They are in a unique position. Listed gaming companies to date have been mainly midcap. When they’ve been large, they’ve been traditional. What we’ve got now is a large, white-collar, regulated online-facing business that has the scale and brains to do transformational things.

“They can change the game and leave everyone behind,” Leyland adds. “The Google effect. But if they focus on marginal improvements to the product, they’ll win some and lose some and their scale probably means they will lose market share.

“So we could either see something strategically profound which would change the rules of the game for everybody and make it very difficult for anyone to compete with them. Or we’ll see a relatively successful giant lumbering on and trying to keep 15-20% of growth, which will be a huge challenge.”

Shades of grey
But there are those who are less willing to bet on the firm’s ability to transform the industry, and for them, the EV/EBITDA multiple represents a premium that isn’t justified given PPB’s recent results, specifically a 4% decline in Q4 revenues from regulated markets.

“They’re maxed out in the regulated European markets,” says one analyst who requested anonymity. “They are mature, if not maturing, and have already got strong market share in all those key markets.”

While sporting results went the punters’ way in Q4, gaming revenues were also down, leaving the analyst questioning where the double-digit growth the market expects is going to come from.

“Our policy is to invest across a range of markets and there’s no specific plans to change that direction” – Johnny Hartnett

“As far as I can see, new revenues can only really be unregulated. And that’s fine – unregulated market revenues were up 9% in Q4. But then my issue is they can’t have the stock trading on such a big premium to everyone else because they have 95% regulated revenues.

“If 95% of your business is dropping at 4% then you’ve got a bit of a problem. This is the difficult position they find themselves in. To get topline growth they need a more accepting view of unregulated markets and if the growth is coming from these markets then ultimately the stock price will go down because the multiple that investors are willing to pay will shrink towards the other listed gaming companies.”

Indeed, PPB appears to be shifting towards grey markets, as the 9% uptick suggests. It’s rumoured to run the largest online casino in Brazil and has historically done very well from the Indian market where the Exchange is very popular.

Hartnett is non-committal when asked whether the uptick in grey markets is the result of a deliberate internal change. “Our policy is to invest across a range of markets and there’s no specific plans to change that direction,” the exec says.

Diversification
Of course one upside of more grey market presence is diversification. PPB is perhaps more exposed to some regulatory pressures than big international rivals thanks to its highly regulated nature. Top of the list in the UK is the incoming Horseracing Levy expected in April, and the PoC tax on free bets, which will kick into action in August. PPB estimates a hit of £10m and £6m a year respectively.

Over in Australia, the risk comes from the introduction of a PoC tax in South Australia next July, which other states could potentially follow should it prove to be successful. While bookmakers in the region have been vocal in their opposition to the introduction of the 15% tax, Morgan Stanley predicts the impact on PPB’s Sportsbet brand will be “relatively limited” in the short-term, with potential even for medium term upside.

“Any increased pressure on profitability from regulation is likely to lead to market exits by marginal players, cementing PPB’s dominance,” the analysts said.

It’s a similar story from the UK government’s review of sportsbook advertising which could lead to restraints on TV advertising in the daytime, again favouring established incumbents over lesser-known firms. It is yet another of the benefits of scale; “the most important determinant of long-term success,” according to Corcoran.

Big deal
And if scale is so important, why not add some more, with PPB expected to be back on the M&A trail in the not too distant future. Goldman Sachs estimates the firm will have around £400m cash to spend next year and sees bolt-on M&A as “increasingly likely”.

Morgan Stanley echoed that sentiment, pointing out the technology platform’s ability to absorb and run multiple brands, and the company’s strong balance sheet all look like “key drivers towards more potential M&A activity in the coming years”.

It’s an option Corcoran refused to rule out in the recent earnings call, confirming the company is back to a “steady state” and willing to look at potential options as and when they arise.

“We are a balanced portfolio with international diversification with a great platform to generate growth – that doesn’t require M&A but if the right thing came at the right price we would look at them,” the CEO said.

Target engaged
But what kind of acquisition would the firm be looking for? Management was understandably tight-lipped about a specific target, but as one analyst speaking on the condition of anonymity suggested, there were two routes forward for PPB.

“They over-indexed in betting and over-indexed in the UK, so they can either try and reinforce those positions – operational M&A – or diversify – strategic M&A,” the analyst said.

The diversification options are more immediately obvious with pure gaming brands – the type Corcoran admitted were outperforming sportsbooks on gaming – presumably at the top of the list. Peel Hunt’s Ivor Jones mooted 888 among the possible targets, and the casino-led brand could potentially be a willing partner, with its CEO Itai Freiberger telling EGR Intel last month: “888 will be a major player in future industry consolidation.”

Abroad, there are plenty of rumours swirling about Las Vegas that PPB has agreed a deal to buy a sportsbook operator, which would mark the firm’s first pure sportsbook play in the market, to go alongside its New Jersey casino, New Jersey Exchange and horseracing network TVG. Hartnett said he had “nothing to say” about such an acquisition.

The strategic M&A options could also be interesting, with a potential focus on content – think Sky Bet and Oddschecker for example – or technology, as the firm looks to bring even more of its pricing feeds in-house.

The options are essentially limitless for a firm which possesses more routes to growth than just about any competitor. M&A aside, it has a unique product in the Exchange that will grant it differentiation in any market. It has high-performing sportbook brands that will soon be even more technologically efficient and can cater to the full spectrum of customers. It has a one of the best marketing teams in the sector under the Paddy Power brand, with such a large budget it literally can’t find anywhere else to spend. And it’s all guided by one of the most respected management teams in gambling.

At worst, the company will remain a market leader by growing steadily. At best, it has the potential to revolutionise the sector. Sounds like a fair bet.