Flutter Entertainment and the land that time forgot

Flutter’s first half results passed in a blur with eyes focused on the big prize of the US, the PokerStars-led hit on EBITDA and the grand scale of the business overall. But there was one, somewhat important segment, that didn’t really get much attention. Flutter’s European online business was mostly skipped over by analysts and this was a little surprising as it represents 34% of Q2 revenue and 39% of H1 2020 group EBITDA. This would imply that it’s a business everyone is well aware of the risks and growth potential of, but it’s arguable if anyone can be that sure of what lies ahead as we head into the latter part of the year. The lack of interest, or deeper interrogation is understandable, however. While the US is the promised land and Australia looks to be a near-term pot of gold as retail to online migration gets a huge kick up the arse due to lockdown, it’s harder to get excited about Europe with single-digit revenue growth in the major markets, downward adjustments due to regulatory tightening and an upside of bolt-on growth opportunities in a market more complex and more challenging than anywhere else in the world. And looking more closely at the Flutter business, the UK segment, while still retaining a big slice of group revenue, has a hugely challenging profile heading into 2021 with far more questions than answers at the current time. The business now comprises the combined UK-facing brands and within those there was a clear disparity between the recently acquired Sky Betting & Gaming (SBG) business and the legacy Paddy Power Betfair (PPB) business, with SBG revenue up 32% and PPB revenue down 8% in H1. The most striking thing was the sports betting margin with Sky Bet an eye watering 14.5% in Q2, up from 9.8%. The explanation given was as follows: “Sky Bet’s expected margin increased by approximately 100 basis points due to customers betting on less mainstream (higher margin) sports. This increase in margin was likely a temporary phenomenon, given the postponement of traditional sports.” But PPB’s margin, which underwent nearly exactly the same conditions with a large majority of revenue coming from UK and Ireland (more on that shortly) had nowhere near the same benefit at 10.4%, up from 10.0%. A tale of two brands Promotions were notably up at both Paddy Power (PP) and Betfair in the period, with PP throwing out free bets like confetti, but mostly it speaks to the truly recreational player base that SBG has built and the additional margin benefits it generates during outlier periods. It is likely a period of player-friendly results would see a more dramatic contraction in margin at SBG than Paddy Power. It also shows how different the two brands still are despite many happily lumping them into the same generic recreational category. Gaming growth at SBG also notably outstripped PPB in the period and again this is due to a number of factors, but mostly relates to a stronger product and brand proposition that speaks more directly to a recreational market. Growth in SBG gaming actives was +59% y/y in H1. All told just a very strong performance by SBG in the period that makes PPB look a little unfairly weak in comparison.

“This is not a zero-sum game, but it’s not far off it and to create winners you also need losing operators. The big question here for Flutter is will those losers be created within its own empire?”

PPB was no doubt dragged down in the period by the exchange which had an absolute bath in the first half due to having far fewer hiding places in the event of top-tier sports cancellations. And you’d expect some rebound there in H2. Industry sources suggest Paddy Power is performing well at the moment and has recaptured some of its old mojo but exchange and B2B revenues were down 40% year-on-year in H1, while sportsbook revenue was down 9% for the half. Gaming looked strong in the period with PPB gaming actives up 37% in H1 and revenue up 18% with that notably accelerating in Q2 with revenue up 26% versus 9% in Q1. This was not as strong as SBG, but better than UK rival William Hill. However, this was a truly exceptional period and drawing too many conclusions from the first half of the year is probably a road to ruin with so many changes ahead. It’s not all bad news ahead either. The positives are there does seem to be a notable acceleration in the retail to online migration in the UK in all types of leisure spend, although it is also worth noting how relatively small the UK land-based gaming industry is in comparison to its European peers. Italy’s land-based gaming is more than 10 times the online sector in terms of annual revenue whereas the UK is closer to one-for-one so the runway here isn’t quite as long. But there is no doubting we’ve seen a big shift in consumer comfort with spending, playing and just existing online during lockdown and some of that is likely to carry over into H2 2020 and beyond – but that probably is the end of the good news. Bracing for the storm So, what’s coming in the headwinds column? Well, firstly the broad macroeconomic environment. We’re entering uncharted waters in Q4 2020 with nobody knowing how quickly or completely the economy will bounce back following the huge contraction in GDP caused by the Covid-19 pandemic. The impacts of this will go far beyond simple economic production too with the shift to more remote working acting as just one of the trends that could significantly shift the structure of the economy itself and the nature of leisure spend. Ostensibly this could even be good for online gambling with more time spent at home, online and less time spent socialising in city centres, but there is the small matter of rising unemployment, rising taxes and falling discretionary spending to contend with on the other side of this in the short-term. It’s difficult to make any predictions for how this will play out, but you do sense Flutter’s more recreational player base is possibly better placed than some with a relatively low per-player spend level, although this is perhaps less true across the recently acquired The Stars Group (TSG) business. Management noted it was upgrading TSG’s safer gambling/anti-money laundering (AML) procedures to bring them in line with its best practices and this would contribute to a £65m annualised decline in contribution to the business. The other major component of this was the shutdown of what it called a “small number of jurisdictions” TSG currently operates in, which appear to include China. The safer gambling measures do create an interesting pressure point on revenue in the year ahead, however, with more changes likely to be forced on the industry by the weight of regulatory and media pressure. The spectre of affordability limits looms large and some operators have already begun testing and experimenting with soft limits on new players. As the market leader in the UK, there is a question of whether Flutter should jump before it is pushed into this area, and if there is any sizeable and lengthy recession in the UK, it will be a tough question to avoid. Quantifying the impact of setting a soft limit of even £500 a month is much harder to do but you suspect it won’t be revenue neutral. Another headwind is the almost inevitable increase in online gambling tax rates that will come either in the autumn or the spring as the government looks to recoup some of the billions it has spent during the lockdown. Betting duty in particular looks very underweight at 15% of GGR, the lowest rate of all the major European regulated markets with only Belgium lower. Remote gaming duty also feels like it retains capacity for a further raise, perhaps on a more product specific basis with online slots perhaps being taxed at a higher rate than table games. Either way, if brought in it would drop directly to the bottom line and is yet another squeeze on costs at a time of fragile looking growth projections. Because the final headwind is to what extent the UK market is not at maturity with any gains materially harder to achieve in the future. Growing out of trouble? Growth rates in the double digits look like a relic of the past and operators are increasingly cheerleading for high single digit revenue growth. But it’s worth noting SBG revenue growth during H1 2020 of 32% YoY and continued positive commentary on the Paddy Power business. Even considering the very strong margins that flatters comparatives, this was a strong performance against a number of headwinds and management were at pains to show in the presentation it wasn’t simply a case of ramping up player spend levels. They would argue that even within the UK market there is still room for meaningful growth by focusing on the recreational market and improving the UX yet further. Part of this also will be continuing to take market share from retail and from both larger and smaller operators, with the latter a notable factor in both CY 2020 and CY 2021 as the cost of doing business grows and the opportunities for marketing decline. A slow drip of retail migration and customer switching can add up to a decent flow of new acquisitions in the short to medium term and there will be additional focus on increasing the share of leisure wallet from some of the more casual cohorts in addition to this. While at the macro level it’s hard to make a case for the wider market growing at double digits when overlaid with affordability limits, other regulatory changes, reduced marketing and a maturing market, at the operator level those arguments do become a little more persuasive.

“In a world of big mergers, perhaps a smaller break-up could lead to less heartache in the long run”

But there isn’t enough to go around. This is not a zero-sum game, but it’s not far off it and to create winners you also need losing operators. The big question here for Flutter is will those losers be created within its own empire? Sky Bet and Paddy Power look very much in direct competition with each other and it’s hard to see how you alter either brand positioning to counteract this. The old PPB approach was to try and put clear blue water between the Betfair and Paddy Power brands, while GVC went more for two slightly different brands targeting the same customer cohort with Coral and Ladbrokes. But here you sense the task is even more difficult and that’s before we even mention the Betfair Exchange problem. That’s one so nuanced it is, perhaps, for another article another day. But there are some more obvious conclusions to draw. Where next for Flutter UK? So how do you play Sky Bet, Paddy Power and Betfair off against each other? Total UK revenue for PPB for H1 2020 was £378.4m, which includes retail, compared to £439m at SBG where revenue is almost entirely from the UK. A reasonable assumption is SBG was around a third larger in the UK during the period than the combined Paddy Power and Betfair businesses, and that has some interesting implications for the future of the newly merged entity. It’s notable that the new UK and Ireland division is headed up by ex-SBG CEO Ian Proctor and ex-COO Conor Grant who take on the roles of executive chairman and CEO respectively. There is no indication this a quiet coup, however, and there will almost certainly be no desire for another brain drain as PPB experienced following the merger of Paddy Power and Betfair. That will mean not throwing out PPB’s wealth of knowledge and operational experience to replace it with the SBG model, but equally you sense there will be some shifts in how all three companies are run heading into 2021. Beyond brand positioning, strategy and leadership there is also the large technology piece to take into account. PPB went through a long integration process that severely hampered Paddy Power and nobody will be keen to repeat the mistakes of history, but you once more have brands on different platforms trying to work as one. There is no indication of shifting Sky Bet onto the in-house stack just yet, but it will doubtless be something coming down the line. But before then they need to find a way to complement each other if they’re going to be able to weather the storm that’s brewing in the UK, or perhaps, if they can’t do so, then find a way to create an amicable split. In a world of big mergers, perhaps a smaller break-up could lead to less heartache in the long run. You sense there will be enough battles to be fought externally to be dragged down by internal issues in 2021. And the industry will be watching closely. Whatever Flutter decides to do next will have a big impact not just on their own success but arguably on the entire market in the UK. The markets might be looking elsewhere for the next plot twist, but the UK story is far from over.