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1 E 2016E 2017E COMPANY ANALYSIS 16 November 2015 Summary Cherry (Cherb.st) The Profit Rises as a Phoenix Cherry reported a Q3 which delivered well-above expectation of 154 million kronor (estimate 143 million kronor). Adjusted EBIT came in significantly stronger than expected at 10.4 (estimated 5.2) exclusive the extraordinary acquisition costs and deducting the minority interest. The online casino, achieved excellent performance amounting to million kronor (expected 96.9) in revenues and significantly improved profitability. Almor has several initiatives to further enhance the growth and profitability rate for Cherry in the future. Yggdrasil grew approximately 160 percent QoQ showcasing its quality games and associated popularity among operators. The staff has increased substantially by over 50 percent to 40 people which signifies the established traction and willingness to expand. It reported revenues of SEK 4.1 (expectation 4.0 MSEK) before internal revenues versus last quarter 1.6 million signifying the projected high-growth trajectory of this entity. The restaurant casino continued to act as a cashflow generator with revenues of 42.5 MSEK (estimated 42.4 MSEK). Our SOTP and DCF intrinsic value increased to SEK 140 per share (Previously: SEK 120) because of the de-risking both financially and operationally by Yggdrasil along with outperformance by the online casino. There are several significant short and long-term catalysts that are ready to progressively close the gap between the price and intrinsic value. The bear and bull case are unchanged being SEK 60 and 200 per share respectively. Operationally, the company is emerging to our bull case scenario. List: Aktietorget Market Cap: 1,397 MSEK Industry: Betting/Entertainment CEO: Fredrik Burvall Chairman: Rolf Åkerlind OMXS 30 Cherry Nov 15-Feb 16-May 14-Aug 12-Nov Redeye Rating (0 10 points) Management Ownership Profit outlook 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% 54% 45% 25% EBITDA EBITDA margin -9% -5% 6% 11% 18% EBIT EBIT margin -13% -10% 2% 8% 13% Pre-tax earnings Net earnings Net margin -13% -12% 0% 6% 10% Dividend/Share EPS adj P/E adj EV/S EV/EBITDA Share information Share price (SEK) 99.8 Number of shares (m) 14.0 Market Cap (MSEK) 1,397 Net debt (MSEK) -11 Free float (%) 30 % Daily turnover ( 000) 7 Analysts: Philip Skogby Philip.skogby@redeye.se 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: info@redeye.se

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 Profit 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. Profit Outlook Our Profit 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 Profit Outlook are: 1 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 Significant Outperformance Cherry s Q3 report significantly surpassed our expectations concerning turnover on an entity level at (expected 143) million kronor. This should also be seen in light of that deposits grew immensely due to Almor and holds significant potential to turn these into gamewin in the future. The growth rate became on an entity level 71 percent (expected 68 percent). Exclusive Almor and Finnish Affiliate sites, depending on their respective revenue composition the revenue would be in the range of SEK million which indeed means that the company reported organic growth of (5-10%) in a generally weak period in relation to the previous quarter. Indeed, in the case above Almor grew by approximately 10 percent by extrapolating the half year numbers. These are highly impressive numbers in any regards considering the competitions growth. Estimate vs actual MSEK Q2'15 Q3'15E Actual* Dif. Revenues % Restaurant Casino % Growth 13% Online casino % Growth 131% Yggdrasil % Growth n.a n.a 339% EBIT* Revenue growth rate 40% 59% 71% -20% EBIT-margin -4.9% 3.6% 6.7% -86% *Yggdrasil figures: Exclusion of Internal Revenues - Exclusion of M inority interest + extraordinaries *Source: Redeye Research, Cherry Marketing expenses declined quarter on quarter to 25.5 percent (expected 37 percent) with 32 percent for the previous quarter and still managed to grow immensely during the quarter. Indeed, this shows that the company is now in control of its marketing rather than letting it control the online casino. First turnaround in profit for years In conjunction with that personnel expenses were lower than expected it led to an EBIT-margin surprise of 6.7 (expected 3.6) percent before extraordinariness and exclusion of the minority interest contribution. COS was a bit higher than expected which we will come back to later which was primarily due to the VAT contribution of Almor. Overall, the company was affected by Almor s optimal cost structure which brought the margins up considerably and continued with strong growth in 3

4 its existing business where the personnel expenses stayed largely flat. In essence, the company has now turned its business around with several value-accretive acquisitions on the affiliate and online casino side along with a profitability momentum for its brands. Interesting to note is that the company had 20 percent of its revenues for mobile which is expected to converge over time and subsequently follow or increase beyond its competitors. 10 percentage points more is expected for a quality operator and with Almor releasing its mobile support the path is set to converge to the current 27 percent online casino figure. This is a significant growth catalyst going forward. Cherry s report surpassed expectations of the online casino The online casino division delivered a turnover of million kronor during the third quarter (expected: 96.9 million kronor) thus surpassing the estimates heavily. Moreover, this was likely still affected by high outgoing bonus payments. Unfortunately, we cannot go in detail about the revenue composition of the company between affiliates and direct channeling sales. Albeit, we think the company has a large amount of affiliate sales. The revenue from partner sites is likely significant as well but it s important that the company is highly active within this medium to catch the growth from this large customer segment within gambling. The restaurant casino announced a turnover roughly in line with expectations of 42.5 million kronor (expected: 42.4) which was a strong performance. Review our later section for more detailed analysis of this segment going forward. Yggdrasil showed considerable results with a reported turnover of 5.3 million kronor (post internal revenues) and 4.1 million SEK pre internal revenues. 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. The company also for the first time made the betting numbers (total wagers) public meaning that you could approximate the amount of winnings based on an approximation of the average RTP (Return to player) and amount of retention within each specific game. If the RTP is 95 percent, then payout to player is 5 percent on average (across the games portfolio) times the wagered amount of approximately 1 BN SEK during Q3 would be equivalent to a GGR of SEK 50 million. The attributable royalty amount is then approximately 10 percent judging by the SEK 5.3 million reported. Indeed, as the RTP decreases the royalty increases which means that the discount we were previously discussed about seems not to apply to the same extent. Furthermore, we believe the average RTP should be in the range of percent depicting which indicate some further higher royalty rate (9-14 percent) than the rate mentioned above. Indeed, for large operators it s likely that the game supplier must accept a lower initial rate. Another factor to consider in this argumentation is the theoretical RTP vs actual which can vary greatly in smaller samples which is what Yggdrasil 4

5 is somewhat more exposed to. Thus it might be more or less than the set RTP of the specific slot affecting the debate of the actual royalty rate. Indeed, the mobile amount will be important to follow as it will talk for the retention in the games evidenced by the amount of bets. In September it amounted to 37 percent of its game win. Nonetheless, with approximately 160 percent QoQ growth these results are nothing short of excellent the company has not even reached Unibet with all of its games. It just recently added Hero Gaming, albeit not a large casino it s one of the most innovative casinos at the market indicating once again the attractiveness of Yggdrasil games. In terms of EBIT it was positive in September but we wish that the company utilizes the full-freedom that Cherry gives in order to ensure that its strategy is not short-term optimized. We also want to add that the earnings potential Joker millions, albeit significant, was a bit overestimated due to the actual conversion by the wagering amount into winnings along with a somewhat compensating part of the higher than expected royalty rate. The more correct figure is likely in the range of million for its Q3 performance although highly dependent on the amount of royalty. The company has still three other contracts that is yet to go live, which poses another significant growth driver. In essence, the lower figure for Joker millions means that the operational performance of its slot releases as Chibeasties, Viking Go Wild and Holmes are performing excellent across operators. This indicates the growth trajectory aligned along with its other newly released top-tier slots. The number of people working is around 40 (up by over 50 percent from Q2!) people 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 also take larger shares of promotional campaigns that have been traditionally set for the larger suppliers. The company is set to conquer UK operators with likely better initial royalty rates in 2016 we expect a license in mid On all accounts, the report in general and with developments in late has yet again surprised positively with the underlying fundamentals improved and Yggdrasil being de-risked in the quarter and expect to follow suit in the future. The long-term fundamental case has strengthened significantly the last year for Yggdrasil. 5

6 The balance sheet continues to be strong Solid Balance Sheet Cash and equivalents was 10 million kronor by the end of the second quarter. Strong cash flow generation ahead supports the growth trajectory along with its unused overdraft facility of SEK 25 million. There is an conditional additional purchase price of maximum 18.6 million for Game Lounge which can be paid the earliest of by the end of February. We expect if it would be paid in full it would be paid by shares in Cherry to further align the stakeholders at Game Lounge. It should be noted that the company utilizes funds in order to maintain compliance for its Malta Gaming license. Cash Flow Effects During The Quarter Last few quarters we have seen an improvement in underlying cash flow especially between the Q1 and Q2 report for The Q3-report by Cherry also continued to indicate decent development relative to Q2. There were many one-offs positive and negative along with acquisition related items that affected the current quarters cash flow and as such we feel obliged to try to give a depiction of the underlying cash flow for the quarter. First, the company took net acquisition costs relating to Almor cashtransaction of approximately SEK 21 million during the quarter. Furthermore, net investments increased due to likely the payout to the Finnish affiliate network acquisition of SEK 11.5 million (equivalent to approximately the price of 1.2 million euro). The remaining increase of approximately 6.5 million we deem could be split between capitalizations which we would consider normal considering its growth orientated state and other related acquisition costs or miscellaneous costs during the quarter. We assume capitalizations was between 3-4 million split between the segments and other related acquisitions costs of approximately 3 million totaling the approximately the 18 million increase in net investments for the quarter. The adjusted underlying profitability for Q3 was the following according to our calculations: 11 million (EBIT) million (Depreciation-non cash flow items) million extraordinary acquisition costs Capitalizations of approximately 4 million 3 million minority interest = Around 13 million in underlying cash flow. However, all capitalization costs are likely not maintenance related, albeit as a security measure we assume it as we can t pinpoint it. Furthermore, the profit from Almor for May/June affected the company s consolidated net cash of SEK 6.5 million (700 thousand euro) but according to the company this did not affect the income statement. We would welcome more detail in regards to the general effect on cash flow between quarters in the future as possible capitalizations, working capital differences and investments as we can only assume the composition above. It would certainly help in deciphering and thus increasing the accuracy of the underlying earnings power estimation when there is many acquisitions and one-offs involved for this quarter. Nonetheless, the cash-flow trend will 6

7 be being easier to read out when the company normalizes its operations the coming quarters assuming no further acquisitions. Proposing The Rejection of The 2015 Dividend We have previously been against a dividend for Cherry and this time is no different of our decision and importance. Considering that the company is going forward profitable but that the company is still a small player it is imperative that the company aggressively takes on new markets and continue to take market share in its markets. There are several other points of interest that is important to notice improvement of its mobile solution and user experience. The elevated competitive landscape makes this is a natural ground to invest in. Instating a large dividend can harm these opportunistic features of Cherry and thus its long-term prospects. Yggdrasil should receive the freedom it rightfully entails and should not be driven on ill-focused short-term objectives in the sake of profitability. Furthermore, historically the company has been able to put its money to decent use considering the development of its businesses. M&A Opportunities In The Horizon? Acquiring more companies at a more justified value of Cherry is a tangible opportunity for the company to grow faster than the market and further evolve its brand and product offering. This can be seen as doing multiple arbitrage and can substantially increase shareholder value further. Although, we cannot determine the time point of this the likelihood of it has significantly increased as the share has appreciated in conjunction with the fundamental development. 7

8 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. 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 (Suomicasino) 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 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). 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. The MAE-Ratio is on all time high basis (+ 3.5 times the money invested) showcasing the brand recognition, smart marketing and increasing volume advantage. Now, as we will have depicted later in this text is that revenues relative to deposits is more of a challenge for the company to increase its retention of players. 8

9 Marketing costs relative to revenues (%) / MAE-Ratio Source: Redeye research Continued substantial marketing expenses improvement in the MAEratio 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 now invests in par with operators such as Betsson, Unibet with a total of 28 percent in marketing expenses and still manages to outgrow them significantly. We think the company should establish itself by investing some resources on the ranking of Casinomeister.com with the experience, platform and trustworthiness. This is not only good for as a marketing strategy but also getting even closer to its customers. We also believe that the company will reduce COS 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 COS). 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 Number of Players Increased Substantially The company increased the number of active customers substantially from to players during the quarter led primarily by Almor. It is also highly likely that the turnover increased is also driven by 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 where turning these into active players is important. In turn this depends on factors such as the gaming experience itself, responsiveness and support these are highly intertwined. It is essential for the company to make people return and play more frequently to retain low customer acquisition costs, as the prerequisites 9

10 previously mentioned enables. We believe overall the company has potential in improving and to lower the frequency of bonus utilizing players. What we d want to see for the next reports is the development of active customer s post acquisition of Almor for full year in where we can do a more concrete judgement. Amount of new and active customers Source: Redeye research Development of deposited amounts is positive, but a greater amount must be converted As also 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 probably due to the higher outgoing bonus payments. The difference being that Almor is included which indicates the upside potential in turning these into revenue. This is most likely among other reasons being the lack of mobile gaming support which likely will reverse this trend going further. Nevertheless, adjusting bonus amounts in general can be dangerous as it can detract the ones who actually enjoy playing. 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. We think affiliate revenues are in the range of approximately 30 percent of revenues, with an increasing amount in the future as the company accelerates this venture. The affiliate costs being the RSA (Revenue Share Agreement) are reported in marketing costs for its partnership affiliates - the payout for its affiliates depends on a variety of factors like what the operator wants to charge on the affiliate in turn on its customers, usually performed by setting a progressive payout dependent on Net Revenue per client. It s better to have a broad affiliate low netting affiliates rather than to have a few very high net revenue affiliates as that would increase the margins for Cherry. 10

11 Deposited amount (MSEK) Source: Redeye research Fundamentals pointing towards exceptionally strong growth the coming years Yggdrasil Zenith Launch of Nirvana Approaching 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. The upcoming game Nirvana paves a new way of dynamic graphics, interaction and game mechanics. This represents well what the company wants to perform, doing things differently to the competition, constantly looking to improve the user experience. Organizationally, the company has the prerequisites to become a fresh twist in this industry with an underlying genuine passion for developing games. The organization has grown immensely the latest quarters and is now around 40 people split between Malta and Krakow (over 50 percent growth in relation to Q2). By 2016 the company is expected to grow even more with new games and the strive for developing unique games ensues. We believe that the company must fully utilize its cash flow into these kind of projects to ensure long-term shareholder value. Therefore, Cherry should preferably spend its cash flow and revoke its dividend to ensure that Yggdrasil is longterm aligned and does not have constraint on short-term profit optimization. Of the reported gamewin we expect that GGR is about SEK million goes to the operators (RTP). Then a royalty fee is taken for the game supplied by the RTP level. Thus the company s royalty rate assuming a payout between 3-6 percent it should lie between 9-14 percent. Increased gamewin likely means somewhat steeper downwards revision initially considering that it had limited bargaining power initially. At a certain point in time increased gamewin means a downward trajectory for the royalty levels upon the operator. 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. 11

12 Reception and Prerequisites of Its Games 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. The progress the last two quarters has been immense in both dynamics and in-gameplay dynamics pushing the boundaries of its previous games - Chibeasties, Vikings-Go-Wild and Holmes. Indeed, 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. Finally, the quality factor relates to dynamics often working in pararell as variance, modes, mechanics, sound, graphics and general user experience. These neat characteristics we believe the company can utilize to its full extent. We will follow closely the development of when Yggdrasil deploys its new games across tier-1 operators. Yggdrasil is delivering its games solely through the HTML5 (isense 2.0) format and platform going forward. Historically, the company has not had complete support for its mobile games, but it is now expected that turnover will increase rapidly 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 relationship building and associated turnover growth, if it occurs earlier than we expect. 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 norm of games developing industry in the future. 12

13 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 that the company can continue to capitalize on quicker payments from the customers. There were a total of 10 new agreements entered with gaming locations and 9 agreements were amended. The company currently enjoys a significant market share of 65 percent compared to 65 percent one quarter before. A negative development is the payroll taxes (increasing from 16 to 25.5 percent effective by July 1 st ) which we will see the full effect from Q4 which is expected to be shared the restaurant itself mitigating the earnings effect along with further consolidation. It can be quite a hassle 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. 13

14 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 has now and will likely 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 begun 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 14

15 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 deem 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 Q4 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. This will lead to easier access to capital. 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 15

16 one of these. Operationally the company has surpassed our expectations as of yet. 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. Acting in non re-regulated markets is a risk and can spiral into lawsuits which a reaction of this sort can be a substantial opportunity for the investor. 16

17 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 as a relatively small innovative player. Despite the growth, competition is highly intense in the Nordics and competing at a high level is likely a certification of success in expanding to Europe where markets can be a bit less intense. 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 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 17

18 regulations will lead to lower margins regardless, but it is likely that it will be compensated by a higher turnover level. EU has accelerated its process for licensing in Sweden by having the Swedish regulations examined at the EU-Commission. With the government expressing the need for re-regulation a license will likely be granted in as legal changes tends to generally to take longer than consensus expectations. 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. 18

19 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 segment the growth rate will accelerate to 573 million by 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 as markets mature 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 rapidly, but the yearly growth again is still quite conservative at around 30 percent for An acquisition can add anything from SEK million per year if and only if they find something value-adding which will most likely take time. 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. Thus, we have likely underestimated the traction for Yggdrasil 2016 but we d think these estimates provides a decent cushion if the company cannot accelerate its games portfolio as fast as hoped and problems with life time value of its games and/or retention. Nonetheless, the British megalodon gambling operator s revenue contribution by Q3-Q 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 Q3'15 Q4'15E 2015E 2016E Restaurant casinno Growth 3% 5% 1% 4% 3.1% 6% 13% 13% 5% 9% -3% Online Casino Growth 43% 38% 33% 60% 44% 49% 61% 131% 109% 91% 64% Yggdrasil Growth n/a n/a n/a n/a n/a >100% >100% >100% >100% >100% 147% Källa: Redeye Research, Cherry 19

20 Detailed estimates, SEKm Q1'15 Q2'15E Q3'15 Q4'15E Revenue EBIT Net profit EPS Revenue growth rate 31% 40% 71% 68% 52% 51% EBIT-Margin -9.3% -4.9% 7.1% 6.8% -0.1% 7.6% Källa: Redeye Research For Q4 we expect an EBIT of SEK 11.5 driven by the fundamental optimization its current online casinos and its recent acquisition. These are figures including minority interest of Almor, thus these figures are somewhat overrepresented but we expect that Almor will be retained by Cherry in the longer term and that its key owner will be retained and rewarded by Cherry shares. 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 (Pre Almor contribution 25 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 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 (personnel 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. It will likely move increase its presence through a variety of strategies during 2016 e.g. M&A, Affiliate or direct brand establishment. 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 COS will shrink in relation to income over time Explanations on Important Valuation Parameters Albeit, the approximately 26 percent marketing rate at the moment is lower than the competitors we expect this figure to ramp up when the company sees opportunities in its existing and prospective markets. When the company continuously reaches scale it should converge to 20 percent. Competitors such as Unibet and Betsson have marketing expenses relative to turnover of percent. This goes through all channels affiliate and 20