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1 E 2016E 2017E COMPANY ANALYSIS 27 August 2015 Summary Cherry (Cherb.st) The Beginning of a New Era Cherry reported a Q2 which delivered above expectation of 107 million kronor (estimate 98 million kronor). EBIT resulted in a loss of -5.2 million kronor (estimate: loss of -4.5 million). The negative EBIT was burdened by other expenses primarily. List: Market Cap: Industry: CEO: Chairman: Aktietorget 629 MSEK Betting/Entertainment Fredrik Burvall Rolf Åkerlind The online casino, achieved excellent performance both by growth of 65.5 million kronor (expected 60.6) and improved profitability. Likewise did Yggdrasil continue to perform well on a business level with the fundamental components to improve revenues significantly going forward, indicating the potential intrinsic value of this segment. It reported revenues of SEK 1.6 (expectation 3.0 MSEK). The restaurant casino continued to act as a strong cash-flow generator which reported 39.6 MSEK (estimated 34.8 MSEK) OMXS 30 Cherry Changes in primarily the durable competitive standing as an entity, the short and long term underlying growth rate, and profitability causes us to change the intrinsic value. Consequently, the new intrinsic DCF and SOTP value is now increased substantially to SEK 120 per share (Previously: SEK 50). Our bear and bull case are changed to SEK 60 and 200 per share (Previously SEK 30 and 60 per share). The company continues to position itself for strong growth as a relatively small player in the Nordic pond along with solid prerequisites to achieve profitable growth throughout Europe in a highly competitive environment. The company trades at a significant margin of safety relative to our intrinsic value with several catalysts to close the gap Aug 25-Nov 23-Feb 24-May 22-Aug Redeye Rating (0 10 points) Management Ownership Growth prospect Profitability Financial strength 8.5 points 8.5 points 7.0 points 4.0 points 8.0 points Key Financials E 2016E 2017E Revenue, MSEK Growth 15% 28% 48% 42% 25% EBITDA EBITDA margin -9% -5% 3% 11% 15% EBIT EBIT margin -13% -10% 0% 8% 15% Pre-tax earnings Net earnings Net margin -13% -12% -2% 7% 13% Dividend/Share EPS adj P/E adj EV/S EV/EBITDA Share information Share price (SEK) 44.9 Number of shares (m) 14.0 Market Cap (MSEK) 629 Net debt (MSEK) -29 Free float (%) 30 % Daily turnover ( 000) 7 Analysts: Philip Skogby Important information: All information regarding limitation of liability and potential conflicts of interest can be found at the end of the report. Redeye, Mäster Samuelsgatan 42, 10tr, Box 7141, Stockholm. Tel E-post:

2 Redeye Rating: Background and definitions The aim of a Redeye Rating is to help investors identify high-quality companies with attractive valuation. Company Qualities The aim of Company Qualities is to provide a well-structured and clear profile of a company s qualities (or operating risk) its chances of surviving and its potential for achieving long-term stable profit growth. We categorize a company s qualities on a ten-point scale based on five valuation keys; 1 Management, 2 Ownership, 3 Growth Outlook, 4 Profitability and 5 Financial Strength. Each valuation key is assessed based a number of quantitative and qualitative key factors that are weighted differently according to how important they are deemed to be. Each key factor is allocated a number of points based on its rating. The assessment of each valuation key is based on the total number of points for these individual factors. The rating scale ranges from 0 to +10 points. The overall rating for each valuation key is indicated by the size of the bar shown in the chart. The relative size of the bars therefore reflects the rating distribution between the different valuation keys. Management Our Management rating represents an assessment of the ability of the board of directors and management to manage the company in the best interests of the shareholders. A good board and management can make a mediocre business concept profitable, while a poor board and management can even lead a strong company into crisis. The factors used to assess a company s management are: 1 Execution, 2 Capital allocation, 3 Communication, 4 Experience, 5 Leadership and 6 Integrity. Ownership Our Ownership rating represents an assessment of the ownership exercised for longer-term value creation. Owner commitment and expertise are key to a company s stability and the board s ability to take action. Companies with a dispersed ownership structure without a clear controlling shareholder have historically performed worse than the market index over time. The factors used to assess Ownership are: 1 Ownership structure, 2 Owner commitment, 3 Institutional ownership, 4 Abuse of power, 5 Reputation, and 6 Financial sustainability. Growth Outlook Our Growth Outlook rating represents an assessment of a company s potential to achieve long-term stable profit growth. Over the long-term, the share price roughly mirrors the company s earnings trend. A company that does not grow may be a good short-term investment, but is usually unwise in the long term. The factors used to assess Growth Outlook are: 1 Strategies and business model, 2 Sale potential, 3 Market growth, 4 Market position, and 5 Competitiveness. Profitability Our Profitability rating represents an assessment of how effective a company has historically utilised its capital to generate profit. Companies cannot survive if they are not profitable. The assessment of how profitable a company has been is based on a number of key ratios and criteria over a period of up to the past five years: 1 Return on total assets (ROA), 2 Return on equity (ROE), 3 Net profit margin, 4 Free cash flow, and 5 Operating profit margin or EBIT. Financial Strength Our Financial Strength rating represents an assessment of a company s ability to pay in the short and long term. The core of a company s financial strength is its balance sheet and cash flow. Even the greatest potential is of no benefit unless the balance sheet can cope with funding growth. The assessment of a company s financial strength is based on a number of key ratios and criteria: 1 Times-interest-coverage ratio, 2 Debt-to-equity ratio, 3 Quick ratio, 4 Current ratio, 5 Sales turnover, 6 Capital needs, 7 Cyclicality, and 8 Forthcoming binary events. 2

3 Cherry Delivers with Style Cherry s Q2 report surpassed our expectations concerning turnover on an entity level at 107 (expected 98) million kronor. To put in this perspective that s almost 12 percent on growth on an organic basis since the last quarter. This should also be seen in light of that deposits grew 26 percent showcasing the potential. The growth rate became on an entity level 40 percent (expected 29 percent). Continued high outgoing bonus payments (which can to some extent be considered as a recurring item) affected revenues negatively. Marketing expenses declined quarter on quarter to 38 percent with 45 percent for the previous quarter. This should be seen in light of strong gamewin development. Other expenses and higher depreciation than expected resulted in EBIT being slightly worse than expected -5.2 MSEK relative to expected -4.5 MSEK. This indicates efficiency in its marketing and increased brand awareness. The company is turning its business significantly within the next quarter due to more several value-accretive acquisitions on the affiliate and online casino side with an expected profitability momentum for current brands. Estimate vs actual MSEK Q1'15 Q2'15E Actual Dif. Revenues % Restaurant Casino % Growth 7% 0% 7% Online casino % Growth % 60% Yggdrasil % Growth n.a 275% n.a EBIT % Revenue growth rate 31% 29% 40% -38% EBIT-margin -9.3% -4.6% -4.9% -6% Yggdrasil figures: Exclusion of Internal Revenues Source: Redeye Research, Cherry Cherry s report surpassed expectations of the online casino The online casino division delivered a turnover of 65.5 million kronor during the first quarter (expected: 60.5 million kronor) surpassing the estimates heavily. This development should also be seen in light from that Q1 was also a strong quarter in revenue development. Moreover this was likely still affected by high outgoing bonus payments. The restaurant casino announced a turnover roughly in line with expectations of 39.6 million kronor (expected: 34.8) which was a combination of the seasonally strong quarter along with efficient use of cash registers. 3

4 Finally, Yggdrasil showed considerable progress with a reported turnover of 1.6 million kronor (before internal revenues) which were close to our expectations of 3 million SEK. This figure is estimated to be largely free of setup-fees which indicates that the majority of revenues originate from actual operations amongst the operators. Despite the not so enticing figures of Yggdrasil this quarter financially, the operational development is significant to say the least. For example game win is up 41 percent the first month of Q3 on a month-to-month basis, the number of people working is 25 and increasing on a step-by-step basis. Significant development can be adhered on its Jackpot slots across operators and the development process of its games. We are expecting more top-quality games releases that will now progressively take larger shares of promotional campaigns. In the beginning of 2016 the HTML5 framework is set to be implemented for all its old games producing another increment of revenues. The company is set to conquer UK operators with likely better initial royalty rates in On all accounts, the report in general and with developments in late has surprised positively with the underlying fundamentals improved. Even exclusive Almor the company showed strong growth and even EBIT contribution in July. Another note is that the company has historically had problems with the mobile platform, that seems now fixed with almost 30 percent of its customers playing through mobile in Q2. The balance sheet continues to be strong Solid Balance Sheet Cash and equivalents was 25 million kronor by the end of the second quarter, which will be affected in Q3 initially by approximately SEK 20 million. Another euro are expected to contribute to the cash and cash equivalents along with the cash flow during Q3. This would mean a cash position of somewhere in the range of 10 million in Q3. The company has an overdraft facility of 25 MSEK is expected to cover investment needs before reaching profitability. The New Cherry Emerging Cherry has a long track-record of successful acquisitions and Game Lounge and Almor is no exception according to us. The former will enable Cherry to continue to channel customers to its brands and generate revenue also through other brands. Almor will create a stronghold of profitable growth within the German markets. Almor itself will contribute to 55k active customers thus equivalent to twice Cherry s existing active customer base. Two of its sites still has no mobile/tablet support with a strong brand and a market poised for growth there exists large potential for future strong growth for this brand. Game Lounge also increased its presence for the Finnish market possibly preparing a strong launch for another Finnish casino to concentrate its affiliate efforts on. The Swedish equivalent startup casino is Sveacasino.com where we are excited and following closely and where we expect to see some results soon. The recognition of these efforts now and in the future along with its current brands reaching critical mass 4

5 volumes will make the market appreciate more of the underlying earnings power of the company. Thus, forming a new depiction of Cherry as a profitable and high-growth company. Nonetheless, the company has significant competition and can likely increase in the future but with Cherry s innovative DNA it is likely that the company can avoid being significantly hurt. Please review the section starting from P.11 carefully of how and why we asses that Cherry is undervalued. We believe that the company has acted wisely in betting on a balance of the two elements profitability and growth. High growth will help them preparing for a re-regulation on the fast growing online casino market via the mobile and organic segments, as well as with the transition away from the physical casino. When the new regulation comes into effect in the Nordic countries, the company will need to be in a position either as a consolidator, or as a potential acquisition object, which will require a sustained greater growth rate in Scandinavia and Europe. From the sole perspective of profitability, it will become essential to obtain a high growth rate to keep a strong profitable position in the market which is experiencing a climate of re-regulation, increased taxation as well as competition (which is partially compensated by the increased turnover). 5

6 Brand Awareness Reflected by Fundamental Improvement In the table below, it can be observed that the company is allocating significant resources on marketing as it has historically provided an acceptable yield. Now, the trend is clear the company is achieving better return on investment with scale and efficiency of its market budget the awareness of its brand increases. Marketing costs relative to revenues (%) / MAE-Ratio Continued substantial marketing expenses improvement in the MAEratio Source: Redeye research The company is showing strong signs of an improving MAE-Ratio trend (Marketing Efficiency Ratio Onlinecasino revenues divided by marketing expenses) which reflects the former deduction. The company has continued to invest in marketing endeavors for CherryCasino and Spilleautomater during the quarter. It should also be mentioned that the company invested considerably more than other gaming operators such as Betsson, Unibet with a total of 38 percent in marketing expenses in relation to revenue during the quarter, which explains the significant growth rate. We think the company should establish itself by investing some resources on the ranking of Casinomeister.com with the experience, platform and trustworthiness. We also believe that the company will reduce COGS in relation to revenue to the same levels of the competition about 20 percent as the online casino division progressively expands beyond that of the restaurant casino in sheer size (which is the primary driver of COGS). As of now the royalty rates are likely higher on some its brands due to its relatively low volumes with tier-1 gambling developers. CRM and VIP management continues to implemented Continued efforts in player management The company increased the number of active customers from to players during the quarter. It is highly likely that the increase in active customers as well as turnover is due to Cherry s continued efforts and use of CRM/VIP to manage its customers. Although new customers were registered during the period which represents a large chunk of the marketing expenses. It is essential for the company to make people return 6

7 and play more frequently to retain low customer acquisition costs, which we believe the company has potential in improving and to lower the frequency of bonus utilizing players. Amount of new and active customers Source: Redeye research Development of deposited amounts is positive, but a greater amount must be converted It is vital that the company continues to transform deposits to net gaming gains by gaining a higher degree of active customers for example, which they historically have succeeded with. As observed in the previous quarter the reason that the quarter s high deposit amount was not fully converted to net gaming gains to the same degree is due to the higher outgoing bonus payments. This indicates potential for an increase in turnover, if properly handled, and assuming existing deposited amounts continue for the coming quarters. Nevertheless, adjusting bonus amounts in general can be dangerous as it can detract the one s who actually enjoy playing. In turn a player whom enjoys playing will in the end unfortunately mean the loss of the invested capital if the session period is far stretched in time. As Cherry has affiliate owned business the company is making money on other sites as well however the distribution between direct and affiliate revenues is unknown although we believe the amount of affiliate is in par with other operators. 7

8 Deposited amount (MSEK) Source: Redeye research Fundamentals pointing towards exceptionally strong growth the coming years Yggdrasil The Rise of a Titan The games have continued to receive good reception at Mr. Green, Vera&John, LeoVegas as well as Unibet where amongst others, free-spins marketing has been executed with the operators during the quarter. This is also shown by continued traction that the revenues indicated. Of the reported gamewin we expect that GGR is about SEK million for the operators. Increased volume (gamewin) likely means increased royalty rates initially until a certain point in time where the volumes progressively declines. In July alone the game win increased by 41 percent if comparing month-on-month (July being a weak quarter) reflecting successful performance of its slots. The jackpot slot alone will in Q3 probably contribute in the range of SEK million with a 7.5 percent payout ratio of game win assuming an accumulated jackpot of million estimated during Q3. The analogy here that is important to remember is that one single high-quality game can be worth many times more than a dozen of half-decent games. Furthermore, if the reputation is lost it could be devastating. With increased quality of its games we are determined that Yggdrasil with high-quality approach will take part of the marketing budget for games which are important to gain recognition of its games. The quality factor relates to dynamics of the games itself in terms of variance, modes, mechanics, graphics and depiction of experience. These neat characteristics we believe that the company has and can leverage over time. We will follow closely the development of these slots across tier-1 operators. We interpret the critique and ratings the games have received as evidence of further momentum and Yggdrasil competence within this sector. With an increasing amount of highly innovative slots the company is set to find the jackpot of slots in due course. Currently, Yggdrasil employs 25 people with more to come to be able to scale up development further in the future. We have seen so far that the company will only scale up development under the prerequisite of not reducing quality. Quoting the CEO of Yggdrasil himself illustrates the strategy going forward: We re not aiming to be the biggest supplier by the end of the year, but we re certainly planning to be the best. Another interesting point from its press release statement is that the company will make an application for UK license by Q4, thus reaching all 8

9 major UK operators at some point With Yggdrasil games being in demand increased initial royalty rates cannot be neglected in the future. As revenues increase incrementally from its slots it s likely that the royalty rate will incrementally increase. 5 percent of increased royalty compensation can suggest that Yggdrasil will double to quadruple its turnover, dependent on negotiation parameters which are often determined by the size/reputation of the operators. The balance between quality and quantity will become increasingly important in the future. The advantage of the low number of competitors in the game development industry is reflected in the barriers to entry in the form of experience and game design. It should be mentioned that the company is still experiencing a considerable challenge in its efforts to increase the quantity and at the same time being the most imperative factor: to constantly improve the quality of games. This will be a constant struggle for Yggdrasil and we expect that Yggdrasil will act as a challenger to the games developing industry in the future. We believe that the game interface is being improved, depth in the slot and the sample of low-variance and highvariance to manage the differing gaming types will improve continuously. Yggdrasil is not dragging its feet with the multi-platform as they achieved this with its latest game and is expected to be delivered solely though the HTML5 (isense 2.0) platform going forward. Historically, the company has not had complete support for its mobile games, but it is now expected that turnover will increase even in this segment, which we see as an imperative factor for Yggdrasil s growth going forward. The old games platform is also expected to be gradually activated for mobile phones by Q This of course increase the overall revenue as the isense effect means both that the user experience and downloading is significantly better than porting a solution for each platform. From a game perspective alone, we believe that the next step for the company within a year or two, after the company has established a stable customer base, is to customize the games specifically for the gaming operators. This is a trend which will and is emerging for the gambling operators in the industry, one which they would do well to partake in. We believe that this can provide a significant turnover growth, if it occurs earlier than we expect. Cherry currently owns 89 percent of Yggdrasil; however, if Yggdrasil s management members choose to utilize their options, the ownership level will decrease to 86 percent. High turnover due to seasonal effects The Restaurant Casino Continues to Deliver The restaurant casino experienced another strong quarter due to continued use of the new cash register terminals. With Cherry s new cash registers which provide the customers with more payment options we see a tendency 9

10 that the company can continue to capitalize on quicker payments from the customers. There were a total of 3 new agreements entered with gaming locations and six agreements were amended. The company currently enjoys a significant market share of 65 percent compared to 64 percent one quarter before. A negative development is the payroll taxes (increasing from 16 to 22 percent effective by July 1 st ) which is expected to be shared the restaurant itself mitigating the earnings effect along with further consolidation. It can be quite a hazzle for a restaurant to change operator efficiently with fewer organizations involved in the industry. This is necessary for the industry to work efficiently. The division can likely grow by 2-3 percent per year with the help of acquisitions on the market. According to the company the contraction in the restaurant casino industry is lower than previously and has stabilized at about 2 percent per year. At the same time, it is possible that a positive outcome of the incoming regulations of the gaming industry will contribute to a doubling of the turnover as well as profits. The cause is that the maximum bet would increase from 70 to 200 kronor in 2016 or later, which may now occur earlier depending on EU s impact upon the Swedish gaming regulations. Another opportunity is that customers on physical location can register its accounts on Cherry s online platforms which if executed well can act as an additional revenue pillar. 10

11 The Emerging Fundamental Components of The Investment Case Cherry: Before this analysis goes any further we would like to evaluate some critical factors going forward the upcoming years for the readers to quickly grasp. In the following paragraphs we want to list some of the most important value-driving characteristics that the market will progressively appreciate for Cherry in the future. Maturity phase and Critical Volumes Margin Expansion Cherry will be able to cut costs as royalty decrease caused by that volumes are incrementally lifted. Furthermore, as brand awareness increase the marketing budget will become more efficient thus expanding margins. Scale of marketing will also help the company to expand its margins. The personnel expenses base is set to handle higher volumes, thus personnel expenses relative to revenues will become incrementally more distant. Cutting middlemen such as affiliates are another way to improve revenues in the future. All of these factors Cherry is poised to nurture carefully including that of letting the player to enjoy the playing time to its maximum, thus increasing the retention rate. The online casino industry is growing but there is also rapid expansion of newcomers that are quickly taking market share. Standing out of the crowd will become gradually more important whether it s the best and/or exclusive games, customer service or any convenient or fun feature that makes customers more inclined to play on a certain platform will become more and more imperative to withhold a competitive edge. With the earnings perception of the company changing due to reaching maturity for its brands because of the previous factors a subsequent value appreciation will likely follow. Essentially, the bottom-line is that we can expect EBIT margins of around 20 percent with a market growth of around 15 percent in a maturity phase. The Name of The Game is Evolution The company has recently began to expand to the sportsbook arena which can create a significant revenue and profitability boost in the future. Furthermore, its strategy of waiting for the right acquisition works well, this could be a further catalyst in the future. But more importantly, the company s internal willingness to search and try out new things is in its DNA. It is no surprise that Cherry has produced both Betsson and Netent. At the same time it has failed many times as well but if you are willing to learn by your mistakes then success is a natural consequence. With its own games developer Yggdrasil it is set to expand in a large market. In essence, the online casino industry is growing but there is also rapid expansion of newcomers that are quickly taking market share. Innovation and excellence is therefore imperative to success. Nevertheless, many markets are its infant stage for regulatory reasons. In the future standing out of the crowd will become gradually more important whether it s the best and/or exclusive games, customer service or any convenient or fun feature 11

12 that makes customers more inclined to play on a certain platform like faster payouts will become more and more imperative to withhold a competitive edge. Cherry has the proper operational prerequisites to satisfy these needs. Continued Strategic Internal Investments and Acquistions Historically, the company has performed several value-accretive acquisitions such as Web resorts and Automatgruppen. Net Entertainment and Betsson is two other well-known internally created brands which has been spun off. Now, Yggdrasil is such an internally created potential for future value growth. Almor is what we deems is a value accretive acquisition over the long-term helping to support further growth in Europe. We can expect more of these acquisitions only if the potential far exceeds the cost even in a negative scenario. This strategy has helped the company to survive over the years and we do not see these fundamentals to transition to the negative for the shareholders in the future. New Frontier Arenas Sports Betting and B2B The SBTech s betting platform has now launched Q2 bringing Cherry upon the door step for the sportsbetting arena. First, the loyalty amongst existing casino customers may improve as it would provide a choice for betting, but may also improve customer acquisitions of casino customers as new betting players commence playing online. Cherry with a strong brand in the background may likely take advantage of this to create a solid brand for its new betting operations. Now, by Q3 many of its other brands will also go live with this product. This is of course a long-term investment that needs time to yield significant results and resources must be spent on this to achieve results. Another area of interest is its platform systems which it could sell as a B2B model as both an operator and affiliate systems that in the longer term can be supplied for startups or established operators. Small Cap Listing Historically, the management of Cherry has been shareholder friendly. A natural step to realize values of this company is to list itself on small cap, thus attracting institutions. Institutions will naturally appreciate the risk diversification of Cherry s three current primary segments, history, impressive growth rate and the strong ownership. Yggdrasil Surpasses Expectations Yggdrasil consists of people with passion of developing fun games. With the increased number of operators and the gradual increase of employees the likelihood of an AAA-slot does not seem implausible. An AAA-slot can stand overwhelm the revenues during a significant period of time due to continued high-ratings. We deem that the company will eventually produce one of these. Operationally the company has surpassed our expectations as of yet. 12

13 Regulatory Positioning If the company succeeds in avoiding margin contractions due to competition, it will result in a strong position in the case of a re-regulated market. It is possible that the company can achieve a multiple expansion as the company then succeeds in sustaining a large market share in Scandinavia, which would then even be perceived as lower risk generally than a company with smaller market share. 13

14 Aligned For Strong Growth This chapter will present the market dynamics of the three segments that Cherry have operations in. Cherry has still only a fraction of the market share of the total online casino market in Scandinavia and Europe The Online Casino Industry Large Potential For Growth Cherry can utilize some promising opportunities to obtain a part of the projected growth in the online casino market, which is expected to grow with a CAGR of 5.4 percent in net gaming profits until The company has a small share of the European market which accounts for 23 billion kronor in net gaming profits, which should make it possible for Cherry to take part of the projected growth due to a greater investment rate than the average market rate. In addition, it is also expected that the mobile market will become a decent catalyst for Cherry s future growth which is on average growing by 32% per year in Europe. This would make it possible for a higher growth rate for the company, which we now expect for We should also mention that it is not certain that the growth in this mobile segment will cannibalize the growth in the PC segment, nor how large this segment will become; we expect that cannibalization will not be an issue for Cherry. There is however a possibility of an increase in the Swedish turnover growth rate in relation to the competition, without international establishment, strengthened by the ongoing transition from physical to online casino (at present only 9 percent of games are conducted online). We also expect that the company can and should achieve growth in Scandinavia to be able to act aggressively in the market when (less if) the regulations are altered. The company may be able to acquire an additional market share of percent in Scandinavia, which according to our calculations represents approximately million kronor, which enables the company to position itself for further growth in existing markets. It will also be strategically important to achieve a greater turnover relative to both minimize the staff expense levels and marketing level without significantly impacting the operating margins. An important question concerning the effects of the impending regulation changes, is in regards to eventuality of decreased sales and lower margins in its wake, where larger competitors gradually enter the market and acquire market share. Most of the gaming operators appear to agree that it is not the case. Rather the the key factor is taxation. A low taxation provides for greater penetration of the online casino market and sustains a highly competitive industry. The regulations will lead to lower margins regardless, but it is likely that it will be compensated by a higher turnover level. 14

15 The EU has hastened the process for licensing in Sweden by having the Swedish regulations examined at the EU-Commission. We expect that still a license will be granted in 2018/2019 as legal changes tends to take longer than expectations. Svenska spel originally applied for an online casino license, which, in hindsight suggests that Swedish games are subject to a regulatory change. It is important for Cherry that if it is to achieve sustained high growth rates through organic growth, partnership or acquisition it needs to expand its operations to other European markets. The regulatory change trends have continued in a few markets during the quarter, such as the Netherlands, Spain, Great Britain as well as North America. Cherry s restaurant casino can still grow through acquisitions as well as through easier payment solutions. Cherry s Yggdrasil aligned for growth The Restaurant Casino - Industry Challenges Ahead The Swedish restaurant casino industry is regulated and Cherry acts under the jurisdiction of the Swedish Gambling Authority. The restaurant casino market represents approximately 1 percent of the total gaming industry, which is a contraction of almost five percent points compared with the millennium shift (before the online casino and Casino Cosmopol s entry). The potential for Cherry lies in the opportunity to continue consolidating the market and expand the opportunity for customers to play. A catalyst for turnover growth and multiple expansion for the restaurant casino will likely occur at the time of regulatory change in 2018/2019 which may lead to an increase of the max bet from 70 to 200 kronor. As the question concerning the increase of the maximum bet may not be of the same priority as that surrounding the change of online casino regulations, we expect that it may take additional time before that motion is passed. The employer contribution raise is also a factor which can come to increase staff expenses, which in turn would reduce operating margins somewhat. The Game Development Market - Promising Outlook Yggdrasil, which is connected to the game operator Cherry, is similar to many other game developers, which have historically been linked to game operators to only be sold off later. Example of game developers (suppliers) are Net Entertainment, Playtech, Scientific Games, IGT, Bally Games, and Betsoft. The market for game developers is expected to grow alongside the online casino market. The game developer market is not as competitive as the game operator market, which can be explained by higher barriers to entry. It is important that Yggdrasil continues to remain competitive in the future in regards to both quantity and quality of games, as the gaming operators may otherwise lose confidence in the distributor. Yggdrasil is subject to positive circumstances and opportunities which will allow it to become a significant games developer, considering its experience in the game developer market. 15

16 Financial Estimates High growth is sustained over time by the mobile venture, the Nordic market potential as well as the establishment in overseas markets. We estimate that for the online casino division the growth rate will increase to approximately 30 percent during 2016 (extrapolating Q3 s revenues in to FY figures) which we expect then to incrementally decrease. The growth is sustained on a high level due to the entrance into new European markets in a more mature stage in the Nordic markets, the mobile growth and less bonus payments. Thereafter, the growth rate will decrease progressively to 20 percent in To ensure that this growth is possible, a high investment rate and conquest of market share of the online casino market is required; we believe that the conquest of market share should be possible given the size of Cherry, market growth, experience and innovation along with the capability of the management team. As the table below indicate is that revenues for the online casino is expected to grow quite rapidly, but the yearly growth again is still quite conservative at around 30 percent extrapolating Q3 s into full year figures for As mentioned earlier, the accounted revenues are somewhat underestimated as Cherry has high bonus payouts, which in a mature stage should lead to a greater positive revenue change which will have a direct impact on EBIT in the longer term. Making players play longer at the site increases the amount of gamewin, we believe the company is able to stay innovative in this arena, personalizing the experience to retain players over time. We still think the company has room to surprise considering that we think that the company can further accelerate its marketing. Especially because the growth of Yggdrasil could gain significant momentum during next year with several games for this year in the pipeline. The British megalodon gambling operator s revenue contribution by Q4 should not be underestimated. It should be noted that these figures are fully consolidated figures with Almor minority interest included. Estimates MSEK Q1'14 Q2'14 Q3'14 Q4' Q1'15 Q2'15 Q3'15E Q4'15E 2015E 2016E Restaurant casinno Growth 1.6% 4.9% 0.6% 4.3% 2.8% 2.8% 9.0% 8.7% 7.4% 9% 9.1% Online Casino Growth n/a n/a n/a 31% 32% 43% 38% 33% 60% 79% 58% Yggdrasil Growth n/a n/a n/a n/a n/a >100% >100% >100% >100% >100% 376% Källa: Redeye Research, Cherry 16

17 Detailed estimates, SEKm Q1'15 Q2'15E Q3'15E Q4'15E Revenue EBIT Net profit EPS Revenue growth rate 31% 40% 68% 56% 49% 46% EBIT-Margin -9.3% -4.9% 3.6% 4.6% -1.5% 8.0% Källa: Redeye Research For Q3 and Q4 respectively we expect an EBIT of SEK 3.9 and 5.8 million respectively driven by the fundamental optimization its current online casinos and its recent acquisition. These are figures post minority interest of Almor. From a margin perspective, we expect improvements in the coming years. Of the reported EBIT above we expect around 70 percent or approximately SEK 40 million representing the online casino contribution for This is equivalent to an EBIT margin of 8 percent (Post Almor contribution 71 percent = 6 percent EBIT) under 30 percent growth which seems fair considering the effect of reaching critical mass for several of its brands. This does not seem either unreasonable in relation to other high-growth operators growing even faster at that stage with even better margins like Mr Green, V&J and Guts casino. Thus, it seems like we have a natural margin of safety in this estimate as the brands incrementally become more profitable and efficient. It is possible that in the near future that the margins will increase due to the fact that the fixed expenses are retained at current levels (personel expenses) which will decrease progressively in relation over time. Although, the near-term is important, the long term case, to significantly outgrow the market is likely considering its still low market share in its respective markets with little expansion into European markets. One ought when valuing Cherry to consider the maturity across its top contributing brands across several geographical regions to understand the value of this segment. The relative part of the marketing and COGS will shrink in relation to income over time Explanations on important valuation parameters We also expect that the marketing expenses relative to turnover will shrink from present levels of around 45% when the company reaches scale in its markets. Competitors such as Unibet and Betsson have marketing expenses relative to turnover of percent. This goes through all channels affiliate and direct marketing. To be able to acquire further market share in Sweden, the company will need to intensify its marketing efforts to later be in a position to utilize the opportunities of the changed regulatory environment, in other words to be able to consolidate or to be an attractive consolidation target. This we believe is necessary due to the fact of taxation 17

18 and thereby turnover growth will become more difficult in the changed regulatory climate. COGS are also expected to shrink in relation to the revenue when the net online casino revenues gradually increase over time. Royalty rates of its games is usually tied to amount of revenue. With higher amount of revenue each customer become more profitable all other assumptions being equal. It should however be added that if outgoing bonus payments decrease, turnover will not need to have a perfect positive relationship since one would lose prospective customers due to revoking bonuses. It is therefore about fine-tuning to customers whom enjoy playing and frequently at the platform without doing excessive risk arbitrage on the bonuses. Customized and personal playing experience is important. Competitors such as Mr. Green for example incur staff costs of 20 percent against Cherry s 30 percent. Continued development of the mobile venture is likely to impact the net cash, but it is supported by higher margins in the long term given favorable position in the regulatory changes. We chose to focus on EBIT as we believe that depreciation will not compensate for CAPEX investments, which are estimated to be higher, which means that we can have overestimated the long-term revenue generation capability if we had focused on EBITDA. All in all, we do not see any reason as to why the company cannot sustain an EBIT margin of 20 percent, similarly to that of the competition or even higher at the maturity stage. Although it is expected to concentrate on profitable revenue growth the coming three years. We have not executed any estimate changes to revenues and EBIT the coming years and quarters. 18

19 Valuation A discounted cash flow analysis and a sum of the parts (SOTP) valuation are used to determine the value of the company. The essential circumstances necessary to achieve our estimate are in force Discounted cash flow analysis The turnover growth rate as well as EBIT margin will in large be changed between the periods , from approximately 8 and 14 percent to 15 and 16 percent respectively. Longer term EBIT margins have been increased to reflect the conviction of Cherry entering the maturity phase. The reasoning behind the changes is the fact that Cherry has experience, strategy and the market circumstances necessary to achieve our estimates. The company will also be in a decent position to consolidate or be consolidated for the upcoming regulations in Europe. We estimate that the turnover growth rate will decline progressively from the current percent (previously 20-40) the next coming years to 20 percent (previously 10 percent) from The high growth rate is supported by the higher growth rate experienced by the online casino. The growth rate is also motivated by the fact that the company is absorbing parts of the strong growth experienced by the mobile segment. It is also likely that the company will need to be prepared for further establishments in overseas markets, to be able to reach a maturity stage by the end of EBIT margins are progressively nearing 20 percent (entity level) in the long term The EBIT margin will converge to 20 percent on an entity level when the company begins to reach higher maturity of its marketing expenses when it reaches scale. Simultaneously, the restaurant casino s impact upon the EBIT margin will decrease over time as the online casino s growth rate increases, which will see COGS as well as staff expenses decrease relative to turnover. This will enable it to be possible to achieve an EBIT margin of 20 percent. Even Yggdrasil is thought to provide a positive effect, but we do not asses that it will be major in a relative short-term horizon. We believe that the company tax will be around 5 percent after 2018 when the company reaches maturity, since the relative part, after profits, from the online casino in relation to the restaurant casino (where they cannot take part in tax advantages) will become substantially larger in the future. Consequently, the tax is expected to progressively decrease to 5 percent. The deferred tax assets will to its majority mean that the tax will be low during assuming profitability. Unrecognized deferred tax assets amount to around 10 MSEK. So what did we underestimate in relation to our previous intrinsic value? And why now? The Redeye intrinsic value have been at approximately SEK 50 per share for over a year. 19

20 Well, the first factor being an underestimation of the aggressive growth, reaching critical volumes and fast adoption of a profitable durable strategy for the online casino (both through acquisitions and new brands). Furthermore, the innovation through affiliate, continuously releasing new brand and strategies to retain customers are also factors to consider. Secondly, the Yggdrasil trajectory was barely accounted for previously, although we covered it on a detailed level it was still an early startup but has reached far since a year. As previously explained the prerequisites, operational development and future trajectory resembles an emerging high growth games developer. It is seldom you get to observe a company that seems to have the right prerequisites. Our initial margin of safety, was indeed, too conservative upon reflecting on the actions performed and the expected operational leverage in the longerterm for both the online casino and Yggdrasil. Also, intrinsic value should be seen in the light of a dynamic environment, we are putting emphasis on strong growth under profitability to some extent for both the online casino and Yggdrasil as they are fulfilling the prerequisites for this trajectory. It s important to note that this valuation is based on a long-term view of the fundamental trajectory of the company. Individual quarters can be worse than expected but as long the operational fundamentals does not change significantly an investor s perception of the company should not change, given that the right long-term framework of fundamental development has been figured out. Our rating is set to 10 percent after a revaluation of the growth rating from 6 to 7 points, reflecting Yggdrasil s increased presence of Cherry. When the online casino and Yggdrasil continuously delivers we will review the Profitability and Growth rating further. The DCF value thus now indicates 120 kronor in the base case where the scenarios can be observed as below: Scenario summary For more information regarding the scenario analysis, see page 25. Bear case scenario: Our estimated value is 60 kronor per share with an estimated probability of 25 percent. Base case scenario: Our estimated value is 120 kronor per share with an estimated probability of 50 percent. Bull case scenario: Our estimated value is 200 kronor per share with an estimated probability of 25 percent. 20

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