Betting and gaming UCC Student Research Current Price: 29.55 Target Price: 31.27 Recommendation: HOLD Ticker: PAP.L/PALS.IR Contents: Highlights 1 Business Description 2 Industry Overview 2 Competitive Positioning 4 Investment Summary 4 Valuation 6 Financial Analysis 8 Other Headings 9 Investment Risks 10 Disclosures 11 Highlights Earnings per share P/E Ratio 2007 1.74 12.44 2008 1.52 8.95 2009 1.38 20.51 2010E 2.22 17.6 Source: own calculations The online business: Online currently makes up circa. 68.5% of group profits. It has seen substantial growth in the last number of years. H1 2010 has seen its operating profit increase by 66% to 36.1m and seen gross win increase by 117%. We recognise the 2010 Football World Cup as an outlier in this market and have adjusted future growth rates to reflect this occurrence. We foresee a growth rate of approximately 7% in the medium term. Australia Growth and acquisition: 2010 saw Paddy Power strengthen its position outside of Europe with the announcement to complete the acquisition of Australian bookmaker Sportsbet. The remaining 39% of Sportsbet will be purchased for 101m, pending shareholder approval. Paddy Power expects the deal to go through by February 2011. The Australian market is growing quickly with online gross win up 45% in H1 2010. UK Retail Expansion: H1 2010 has seen UK retail operating profit reach 3m with EBITDA per shop increasing by 27% to 71,000. 2010 has also seen the continuation of Paddy Power s expansion strategy with the opening of 22 new shops. By the end of 2011 Paddy Power aims to have 150 shops in the UK, a significant growth from 107 shops as of HI 2010. 34.00 29.00 24.00 19.00 14.00 9.00 Paddy Power's Historical Share Price Jan'08 Jan'09 Jan'10 Jan'11 Market Profile 52 Week Price Range 22.75-31.10 Average Volume (3m) 134,026 Beta 1 Dividend Yield* 2.36% Shares Outstanding* 47.1m Market Capitalisation* 1.37bn Price Earnings Ratio* 20.51 Price/Book Value* 9.17 Debt/Equity* 0.1285 *2009 Sources: Thomson Reuters, Yahoo finance, own calculations. Share Price Source: Yahoo finance 1
Business Description Paddy Power (also referred to as the group or the company ) is an Irish bookmaker founded in 1988 by the merger of three existing Irish main street bookmakers. Currently, the company operates across several of the world s premier regulated betting markets. The company splits its operations into 5 segments, online (excluding Australia), Irish retail, UK retail, Australia (online and telephone) and telephone. Paddy Power s B2B operation reports under the online segment and provides operating expertise to major players in recently regulated markets, such as PMU in France. The group s operations offline are conducted through a chain of licensed betting offices of which there are 107 operating in the UK and 203 in Ireland, as of H1 Results 2010. In the online segment of the business, the following services are provided: sports betting, poker, bingo, casino games and spread betting facilities. The company also provides telephone betting options across its markets to complement the retail segments. Paddy Power s current growth strategy is through both the increasing provision of B2B services as further markets regulate and through the acquisition augmented by aggressive marketing as shown by its recent actions. The future organic growth of Paddy Power is likely to come from its Australian and online business segments as well as from UK retail expansion. Industry Overview General and segmented Current Conditions The betting and gaming industry in which Paddy Power operates is unusual in its cyclicality. The industry, much like others, is significantly correlated with the general macroeconomic conditions due to the often discretionary spending nature of gambling for customers. The industry is therefore facing some economic pressures in spite of the growing popularity of sports betting and gaming. These pressures are emanating from worsening economic conditions and higher income taxes which curtail the discretionary expenditure available for punters. The closure of several retail shops of Paddy Power s competitors in Ireland over the recent downturn is a testament to this. UK & Ireland Online UK and Ireland online is the core element of Paddy Power s business, and the area from which the majority of its profits are currently derived (circa 75% as per 2010 H1 Interim report). The online segment is split into two areas, the online sportsbook and online gaming. The split in gross win between the segments is relatively even in non World Cup years (during which Sports book receives an additional revenue boost), and we would expect this split to remain reasonably consistent. To date, both areas have complemented each other in terms of customer attraction and retention. Competition within the online segment is strong and diverse. While Paddy Power competes with traditional operators like William Hill and Ladbrokes across the majority of product offerings, specialist players such as 888 or Partygaming compete only in certain niches. This makes direct performance comparisons difficult across the industry players. BetFair, fresh from its Oct 2010 Initial Public Offering is another significant competitor with a differentiated product offering and is seen as a plausible threat in the medium term to the success of traditional bookmakers such as Paddy Power. BetFair, is the world s largest betting exchange, and by its nature eliminates the traditional bookmaker from the betting process. An advantage traditional bookmakers do retain over the betting exchange model used by BetFair is the ability to offer odds on occurrences with more than a two sided outcome, particularly relevant for horse racing and other popular betting sports. The incredible development across the general online business has been driven by three major factors in the past number of years, namely increased broadband penetration across the Irish & UK market, the growth of in running sports betting and the significant expansion of the gaming products offered online. These factors, in addition to the efficient running of Paddy Power s online segment through strong marketing and superior technology has meant EBIT margins of on average 37.5% for the last 6 years, a percentage that the company is confident can be maintained in the immediate future. These margins are in excess of William Hill (34%) and Ladbrokes (29%) as well as other operators. As a result it may be difficult to maintain for too long as competition online continues to intensify. On a positive note, the overall online market is likely to see considerable continued expansion for a number of reasons. Broadband penetration rates will inevitably continue to rise across the UK and Irish markets. Sports betting is set to become increasingly popular due to the additional avenues to view sport and the increased push for foreign sports to establish their products in the European market. Coupled to this is the continued emergence of in running sports betting which is proving increasingly popular with punters. To compliment the sportsbook further growth is expected on the gaming side from niche segments such as online bingo where unexpected volumes are emerging. Australia The Australian region (online and telephone only) has been a market for the company since 2009 with the partial acquisition (51%) of the number two player Sportsbet and Sportsbet s subsequent acquisition of the number five player IAS. Having increased their stake gradually over the following months Paddy Power announced the acquisition of the remaining 39.2% of Sportsbet in December 2010. This deal was the early exercising of a call option to acquire the remainder of the business by year 2013. The early exercise of the deal is primarily due to the success the Australian business has enjoyed to date. There are a number of key regulatory areas which could yield significant revenue growth for Paddy Power over the next decade. In a 2
government commissioned report by the Productivity Commission, various recommendations for the future of the betting and gaming market in Australia were outlined. The report recommended creating legislation to allow both online in running betting and online poker & casinos. These changes would be of benefit to Paddy Power. The report also recommended the retail exclusivity licences held by the Tabs (Tab Corp & Tatts Group) should not be renewed. This would again greatly benefit Paddy Power. The sitting Australian government has so far rejected the findings of the Commission, there are clear signs that the current system is not working and we believe that in the medium to longer term that liberalisation is likely. In addition to the possible regulatory advantages in the Australian market Paddy Power is also strongly placed in terms of expertise (particularly with regard to fixed odds betting). The group is also focusing on building strong customer relationships, based on customer enjoyment and satisfaction. This could pose a substantial threat to any potential entrants. Additionally the increasing diversification of the betting market, (currently 80% horse racing dominated) as corporate bookmakers promote other sports should offer a growth opportunity for the company. Other 54% Regulated Markets and B2B Source: Paddy Power 2009 Annual Reports One of the most important points to note regarding Paddy Power in comparison to its competitors and why it is often seen to trade at a premium to them is that the group operates only in regulated betting markets. This limits the company s downside in relation to regulatory risks. The basis of this can be seen from the recent occurrences in the French market place. Competitors such as BetFair, Ladbrokes and William Hill, were all players in the unregulated French market. Recent changes to the regulation have seen all three abandon their French operations because of the nature of the regulation imposed. With the advent of the PMU B2B deal Paddy has gone from a marketplace in which it had no earnings to one in which small returns are generated and perhaps more importantly a reputation for B2B expertise is established. Therefore, in addition to having less regulatory risk than competitors, the opportunity also exists for Paddy Power to exploit the future regulation of currently unregulated markets by leveraging its current operating expertise in the world s premier regulated markets. Irish Retail - Market Share Ladbro kes Paddy 17% Power Boyles 17% ports 12% Irish Retail The economic downturn has adversely affected the number of shops in the Irish market. While this was probably a necessary correction given the perceived oversupply of betting shops in Ireland relative to the UK (almost double the amount of shops per capita) Paddy Power has managed to not suffer any closures in this time and even continues to expand both in number of shops and in market share. What is clear from the events of the past number of years is that retail opportunities do still exist in the Irish market provided you have the right advantages of scale, superior marketing and operational and technological efficiency. Paddy Power is therefore extremely well placed to continue to develop its standing in the Irish market in the immediate future. Number of shops per company Source: http://irishbookmakersassociation.com/ UK Retail The UK retail market differs from the Irish one in two key aspects. Firstly, the market is as previously mentioned far less concerned with over supply then the Irish market while general competition is not as intense in the UK with the market leaders (William Hill & Ladbrokes) operating at significantly better margins then they do in the Irish market. Overall this equates 3
to an attractive opportunity for Paddy Power to continue to expand its UK retail presence. An additional positive provided in the UK market is the permission for gaming machines to be present in UK shops unlike their Irish equivalents. Currently Paddy Power has a small retail presence in the UK (115 shops) relative to the market leaders Ladbrokes and William Hill, both of whom have over 2000 shops in the UK. The current plan for Paddy Power is to scale up their shops numbers to approximately 150 in 2011 and an accelerated roll out from there. General Competitive Positioning Paddy Power is well positioned relative to its industry peers across its various operating segments to take advantage of numerous and varying growth opportunities. Strong industry growth in online betting and gaming due to increased broadband penetration across Ireland and the UK, as well as the advent of additional highly popular products such as in-running betting and online bingo should allow the company to grow at least at the industry rate in the next few years. While the emergence of online betting exchanges such as BetFair could inhibit the growth prospects of Paddy Power we believe that they are the best placed of the traditional players due to the most complete product offerings of any online competitor, excellent technology and a growing reputation as the fairest bookmaker. While this final point may appear somewhat trivial, the group s growth in market share during this recessionary period highlights the importance of strong customer relationships to success in the industry. Paddy Power s reputation is earned from a string of distinctive advertising campaigns specifically aimed at growing brand awareness and through the advent of regular punter friendly offers which aim to enhance customer retention. Additionally due to the company s strong financial position we believe that they are the best placed of the traditional operators to continue to make additional punter friendly deals should competition intensify. The recent exercising of the option to acquire the remainder of Australian operation Sportsbet and the possibility of increasing regulation/liberalisation of the Australian market also provides significant growth opportunities for Paddy Power. Furthermore, as more governments seek to gain tax revenues from online gambling and the possibility of new markets becoming regulated increases, Paddy Power is well placed to compete for any new business. As a result, in comparison with peers such as Ladbrokes and William Hill, we believe Paddy Power is superiorly positioned because of its continued presence in solely regulated markets and its reputation for the provision of B2B services for recently regulated markets. Additionally we believe that the company s exposure to the potentially highly lucrative Australian Market and its ability in delivering customer value warrants a premium over its competitors. Until recently Paddy Power was also well positioned to exploit any sudden market opportunities because of the large cash balance it carried on its balance sheet. While this pool will be used up with the completion of the Australian acquisition, we are confident that Paddy Power as a strong cash generating business will look to hold cash again in the near future to exploit any further opportunities. BetFair, the emerging threat in the market place is similar to Paddy Power in being a zero debt, high cash business. In the Irish Retail market, toughening economic conditions and current austerity measures have put a lot of downward pressure on some of Paddy Power s less efficient competitors (such as Celtic Bookmakers) leading to shop closures and consequently additional market share for the company. In the UK retail market, on the other hand, Paddy Power has continued to open new retail facilities which are consistently proving successful (higher gross win per shop than William Hill and Ladbrokes) due to the company s strong brand recognition within the segment. Even though the gross win per shop is likely to reduce as the group expands outside of the main London hotspots, there are still significant growth opportunities in this market. Paddy Power s low leverage ratio and large cash balance combine to yield negative net debt. This gives Paddy Power excess borrowing capacity relative to its peers and may yield a competitive advantage. This extra financing ability could assist in the UK, Online and Australian expansion strategies. Investment Summary Our valuation process yields a target price for Paddy Power of 31.27. Based on the current price of 29.55, this represents an upside potential of 6.8%. This does not meet the required 15% for a BUY rating, so we recommend a HOLD rating. Our optimistic price of 34.71 represents an 18.5% upside and our pessimistic valuation yields 25.17, a 13.8% downside. Our target price and recommendations are based on the following factors: 1. Online UK and Ireland & Australian markets. The prospects for the online and Australia markets look positive. Both markets have experienced rapid and strong growth in recent years. Paddy Power is well placed to excel in both these markets. The online market is growing due to the rise in popularity of sports betting, the continued growth of broadband penetration in the UK and Ireland and the growth in usage of the iphone and other smart phones. The Australian market offers Paddy Power a good opportunity for growth. If in-running betting online were to be allowed in Australia Paddy Power would see a significant increase in its revenues. Regardless if this happens we foresee substantial growth opportunities for Paddy Power in the future. 2. Management profile. Paddy Power s management has been the stand-out management team of the betting and gambling industry in the UK and Ireland, in recent years. They have shown themselves adept at making the right decisions at the right 4
time. Through their guidance Paddy Power has become a force in the UK and Australian markets while also cementing their dominance in Ireland. Acquisitions in the Australia have shown the team to be committed to adding value to the company by continuing to explore unique opportunities. The management have also proven themselves to be risk averse in their behaviour resisting the temptation to operate in the numerous unregulated markets within the gambling industry. Paddy Power s management has successfully steered it away from operating in then which has allowed the business to grow safely only in regulated markets. 3. Marketing. Paddy Power s brand has been growing from strength to strength in recent years and is a core asset of the company. In a consumer driven market where product differentiation is key, Paddy Power is leading the way. The company has created ways for sports fans to engage with their brand in a positive and fun way. Paddy Power has developed the image of the fun and fair bookmaker in the UK and Ireland by having such promotions as paying out on Chelsea for the Barclays Premier League 09/10 season and paying out on Tiger Woods at the halfway point of the 2009 PGA Championship. Paddy Power has also continued to develop their brand awareness in the UK and Ireland by using innovating marketing techniques such as a 270ft Hollywood-style sign erected outside Celtic Manor Golf Course in Newport, Wales during the Ryder Cup. 4. Regulatory Risk. One of Paddy Power s main strengths is it s limited exsposure to regulatory risk. Paddy Power unlike many industry peers has chosen to operate in only regulated markets. This decision while limiting initial growth opportunities has allowed the company to operate without fear of having their business impacted negatively by unexpected regulation in these markets. Paddy Power s competitors are engaged in many of these unregulated markets and have recently had to end operations in France for example because of the negative affects the country s new regulatory system has had on operations. For this reason we believe that Paddy Power is regarded as a low risk stock with regard to its peers in relation to regulatory risk. 5. B2B. Following on from the advantages of this regulatory approach, Paddy Power is currently well placed to earn the new business emanating from these recently regulated markets. Many of the domestic operators in these countries lack expertise of operating in highly regulated environments and so the company has sought the provision of B2B services as a method to compliment the operations of dominant domestic operators. Paddy Power s technological and operational expertise from operating in regulated markets, coupled with a growing reputation for the provision of B2B services (following the successful PMU partnership) has the company well placed to compete for future B2B deals. 34.00 Paddy Power's Historical Share Price 23/12/2010 Purchase of the remaining 39.2% minority shareholding in Sportsbet 8000 29.00 24.00 12/11/2009 Entry into French betting market, B2B Partnership with PMU 7000 6000 5000 4000 19.00 14.00 9.00 27/05/2008 Entry into Northern Ireland 14/05/2009 Entry into the Australian market, acquiring 51% of Sportsbet Jan'08 Jan'09 Jan'10 Jan'11 3000 2000 1000 0 Share Price ISEQ Source: www.ise.ie 5
Valuation In order to obtain a target price for Paddy Power, we used two valuation metrics, a Discounted Cash Flow and a Relative Valuation. Discounted Cash Flow We have calculated the expected share price in three scenarios, a base case, a bearish case and a bullish case. The completed calculations are attached as appendices. We recognise that the DCF relies heavily on a number of assumptions. We have included reasonable assumptions we have made for each case of the scenario analysis. We discounted the cash flows using the company WACC. We have adjusted the WACC calculation due to the net debt position of the firm because of the acquisition of the remaining percentage of the Sportsbet throughout the valuation. Base Case We assume that Paddy Power s business in the UK and Ireland will continue to be profitable as the macroeconomic environment recovers and market share is increased. We also assume that the Australian business continues to grow as the economy remains strong and the market matures. We assume that Paddy Power s online businesses face diminishing growth rates and EBIT margins due to increased competition in the online markets from BetFair, Ladbrokes, William Hill and others, as well as reduced acceleratory factors for previous growth levels such as broadband penetration and the advent of in sports betting. In our base case we assume that Paddy Power s sports book maintains a steady gross win rate over our forecasted years in line with previous years gross win averages. We forecast forward for the effects of the recent introduction of the betting tax in Ireland. However, we currently see no substantial evidence of any other tax being introduced in any of the other markets Paddy Power operates. We assume that Paddy Power grows capital expenditure to 30m by 2014 and grows it at a rate 5% per annum thereafter. This is reflective of the growth in number of retail shops in the UK market. Terminal Value, the present value of the future cash flows beyond the forecast period, is calculated using a terminal growth rate of 2% and discounted using WACC. Our WACC is calculated by giving our cost of debt (7.29%) 0 weighting and our cost of capital 100% weighting. The large cash balance causes net debt to be negative for the year ended 2009. This WACC will temporarily change in 2011 as Paddy Power acquires the remainder of the Australian business (a debt weighting of 5% is applied for 2011). Our cost of equity was calculated using a risk free rate of 3.62% which we feel reflects the current market sentiment. We used a risk premium of 4.5% which we believe reflects the current investor climate. We also used a beta of 1, which is reflective Paddy Power s risk relative to the market. Further detail is included as an appendix. Taking these assumptions, we calculated a target price of 31.27 using the Discounted Cash Flow method. Bear Case In our Bear case we have looked at a number of events that could negatively affect the share price. These factors do not merit inclusion in the base case due to their reduced probability of occurring. We assume the worst case scenario for taxes in the UK and Ireland. We have adjusted for an increase from 1% to 2% in Ireland and the introduction of a 1% tax on online Turnover in the UK. Also included in the bear case, is the possibility of a further contraction in both the UK and Irish economies. This would cause the UK business to have a growth rate of only 9%, rising slowly thereafter. We also assume that in this case the Irish retail business would shrink in 2011 and have neutral or low growth rates thereafter as both economies suffer from doubledip recessions. In the online sector, we assume that Paddy Power s strong brand and excellent customer relations are not enough to stave off competition from other online competitors with them taking market share. We assume this will negatively affect Paddy Power s turnover in that segment. With these assumptions in place we calculated a pessimistic valuation of 25.17. Bull Case In our Bull Case we take several positive events and assume they occur. Australia legalises in-running betting online. This would increase the growth rate and revenues of the business substantially. Paddy Power s fortunes in Ireland and the UK improve as the economies of both markets turn around. This leads to a recovery in Irish margins close to pre crash levels and better margins in the UK as the estate continues to mature. Paddy Power secures a similar deal to the one it secured in France with PMU which would give them a similar EBIT margin to the French deal. Taking these assumptions we receive an optimistic valuation of 34.71. 6
Relative Valuation The purpose of our relative valuation is to establish whether or not Paddy Power is over or undervalued relative to the other major players in the gambling market. It is recognised that relative valuation is not the optimum current valuation method due to the rapid changes that have taken place in Paddy Power's business segments over recent years. We also recognise that Paddy Power is not directly comparable to any of its competitors. In particular its participation in Australia and its B2B relationship in France are not comparable with peers. The following table displays our findings: Ratios Paddy Power William Hill Ladbrokes Bwin 888 Party gaming Sporting bet Unibet BetFair Mean Current Market Value P/E (e) 2011 16.93 9.14 9.56 13.5 16 11.33 8.48 12.36 21.79 13.18 EV/EBITDA (e) 2011 10.87 6.31 7.77 7.18 6.6 7.36 4.52 8.17 9.99 7.64 EV/Sales (e) 2011 2.99 1.73 1.91 1.54 0.8 2.02 1.03 2.37 2.13 1.83 Profitability ROE 42.4 11.18-38.32 23.1 21-9.87 4.19 23.96 8.72 9.637 Operating Margin 22.53 19.97 21.21 13.5 12 20.03 2.5 22.87 4.51 15.48 EBITDA Margin (e) 2011 27.48 27.32 24.52 21.4 11 27.45 22.77 29.02 21.31 23.62 Leverage: Net debt/ebitda -0.69 2.27 2.37-2.09-2.3-1.25-2.9-0.45-3.63-0.96 Liquidity: Current Ratio 1.04 0.32 0.57 1.52 1.4 1.28 1.22 0.69 1.51 1.06 Dividend Yield (e) 2011 2.72 4.49 5.34 3.02 2.5 0 3.05 6.19 1.03 3.15 Source:Thomson Reuters Current Market Value: Paddy Power has one of the highest PE ratios at 16.93, which ranks second only to BetFair. This suggests that investors expect Paddy Power to perform well and for management to create more value with its given assets in relation to its peer group. The high EV/EBITDA and EV/Sales would convey that the company is trading at a slight premium in comparison to its competitors. Profitability: Within this area Paddy Power compares quite favourably to its competitors. The company s ROE 42.4% and Operating margin 22.53% measure up extremely well against its peers. Paddy Power s core profitability also compares well in terms of an EBITDA margin of 27.48%. Leverage: Paddy Power is comfortably positioned in relation to competitors with a Net debt/ebitda ratio of -0.69 which is in keeping with the industry average. This is largely attributable to a large cash balance and allows Paddy Power a high degree of flexibility in terms of acquisition strategy such as with the recent activity in the Australian market. Liquidity: Paddy Power ranks slightly above the industry average with a current ratio of 1.04. In the current economic climate this is essential to ensure financial stability. Dividend: Paddy Power compares less favourably to its peers with a dividend yield of 2.72%. This could in part be a result of its PE ratio and its investments in growth such as in Australia and the ongoing expansion in the UK. This is also reflective of Paddy Power s intention to keep significant cash balances on hand. In summary, our relative valuation indicates that Paddy Power is correctly valued in relation to its competitors. It performs strongly in almost all of the areas examined and the current share price reflects that performance. P/E Price Valuation Expected earnings in 2011 121,661.00 The data in the table shown demonstrates an intrinsic target share price on the basis Avg. Shares Outstanding 48,481 of the P/E ratio. We first calculated an historical average P/E ratio off the average P/E ratio of 03-present. This ratio was then utilised in the calculation of our Diluted EPS 2.51 Earnings per Share. It has set us a target share price of 32.25 which we feel Historical Average P/E ratio '03-'10 12.85 complements well the price from our DCF base case calculations. Share Price 32.25 Sources: Paddy Power s Annual Reports and own calculations 7
Financial Analysis Despite the difficult economic climate, Paddy Power has maintained a very strong financial position in recent years evidence of which is detailed below. We have calculated 2007-2009 figures based on Paddy Power s Annual Reports and 2010 based on the interim results for H1 2010 of the company. 35% 30% 25% 20% 15% 10% 5% 0% Margin Analysis 2007 2008 2009 2010E Operating Margin Net Margin Pre-tax margin Trends Year/year growth 2007 2008 2009 2010E Sales (Amounts staked by customers) 11.47% 3.48% 23.65% 37.52% Gross profit 24.26% 5.46% 0.60% 39.78% Pre-tax profit 34.46% 7.22% -21.63% 29.78% Net income (in m) 34.30% 8.78% -20.85% 35.56% Sales have grown strongly throughout the period due to Paddy Power s expansion strategy in the UK retail, online and Australian sectors. The latter two being relatively young and immature markets, which gives Paddy Power an opportunity to capture growth at an early stage of the cycle. The dramatic decrease in profit before tax and net income in 2009 was directly related to unfavourable sport results and the deterioration in the macroeconomic environment. However, these have recovered in 2010 by 29.78% and 35.56% respectively. Margin Analysis 2007 2008 2009 2010E Gross Margin 86.9% 90.40% 87.17% 85.84% Operating Margin 25.85% 27.65% 22.54% 24.08% Net Margin 22.50% 24.26% 19.76% 22.17% Pre-tax margin 27.18% 28.81% 22.71% 24.03% Profitability Return on Equity 64.61% 64.23% 42.40% 59.98% Return on Capital Employed 59.48% 56.38% 34.83% 47.41% Return on Assets 42.77% 41.23% 22.81% 37.39% Margin analysis indicates that Paddy Power continues to tightly control their cost and expenditure at all stages of the business highlighting Paddy Power s ability to navigate the difficult economic climate astutely. We will look for an improvement in the group s margins in the near future as both economic conditions recover and Paddy Power s investments in UK retail, online and Australia continue to increase. Figures for 2010 year end have shown progress in Paddy Power s margins, except for a slight decline in the gross margin. The group s profitability deteriorated in the most recently reported period. However, it still remains strong, with ROE at 42.40% in 2009 (down from 64.23%) and improving to 59.98% in 2010. This drop off is directly attributable to unfavourable results and should not be of concern for investors going forward. Earnings Paddy Power s earnings margins have deteriorated in 2009 to 22.54% for EBIT, 19.59% for after tax EBIT and 28.66% for EBITDA. This is again attributable to economic factors, cyclicality factors and additionally the appreciation of the reporting currency the Euro versus operating currencies in the UK and Australian segments. There has been an improvement in 2010, which gives us confidence that EBIT margins will continue to grow in Australia, online and in UK retail with slight weaknesses in Irish retail given the economic climate and the telephone sector given its diminishing popularity. Paddy Power s financial position in the main sectors of the business remains strong and optimistic looking forward. Earnings Margins 2007 2008 2009 2010E EBIT margin 25.85% 26.69% 22.54% 31.02% EBIT (1-t) margin 22.51% 24.25% 19.59% 29.25% EBITDA Margin 33.32% 32.65% 28.66% 26.47% 8
Balance Sheet & Financing Paddy Power s large historical cash balance and low debt positively impact their leverage, liquidity and solvency ratios. The Cash Ratio has decreased between 2008 and 2009 due to a large increase in current liabilities. In spite of the recent burning of Paddy Power s cash reserves in the Sportsbet acquisition, Paddy Power s financing position remains positive and strong especially compared to the company s more leveraged industry competitors. Leverage 2007 2008 2009 2010E Debt/Equity Ratio 0.03 0.09 0.13 0.15 Net Debt/EBITDA Ratio -0.90-0.70-0.69-0.70 EBITDA Interest Cover 0.005 0.005 Interest cover 165.92 165.92 Liquidity and Solvency Current Ratio 1.64 1.39 1.04 1.07 Cash Ratio 1.56 1.35 0.78 0.80 Cash Flow Cash balance increased from 2008 to 2009 from 76m to 80m in order to be in a position to take advantage of the Australian opportunity. This balance is likely to be almost fully used up as the acquisition of the remainder of Sportsbet is finalised in early 2011. We feel it is probable that short term borrowings will remain constant as cash re-generates quickly. Paddy Power have also stressed to us they wish to keep significant cash balances on hand in order to take advantage of any future unforeseen opportunities. 2007 2008 2009 2010E Net cash from operating activities 97,549 95,287 85,420 89,596 Net cash used in investing activities -16,930-37,371-48,073-49,879 Net cash used in financing activities -79,795-65,535-31,204-33,848 Net increase / (decrease) in cash and cash equivalents 824-7,619 6,143 5,869 Cash and cash equivalents at start of year 87,061 87,885 76,661 80,576 Foreign currency exchange loss in cash and cash equivalents -3,605-2,228-2,538 Cash and cash equivalents at end of year 87,885 76,661 80,576 83,907 Other Headings Relevant to Company Results of sporting events The results of sporting events drive the company s gross win percentage which along with betting volume determines the company s gross win. The somewhat random nature of these events has a significant impact on the financial performance of Paddy Power. In 2009 gross win percentage decreased by 2.5% due to a series of Punter friendly results. The favourites won the majority of races at Cheltenham followed by a Six Nations where the favourite lost only once. The English Premiership was also unfavourable for the group. This resulted in a 26 m loss year on year. In 08 gross win percentage also diminished by 0.5% on the previous year. If results were to normalise it would bode well for Paddy Power s performance. Events Sporting events have a significant impact on the amounts staked, one of the key drivers of turnover. While there are many annual events such as Cheltenham and the English Premiership, it is often the one off events that make the difference in a particular year. For example, the 2006 Football World Cup and 2010 Football World Cup directly resulted in a 4m and 18m gross win respectively. There is a distinct absence of revenue driving one off major sporting events until the next 2014 Football World Cup. 9
Investment Risks As companies utilise risk management strategies more aggressively Paddy Power may change their hedging policies in the future. However, the following are Paddy s most significant current exposures. We deem the risks excluded below as being sufficiently hedged against, or being of immaterial significance. Economic Environment Like any discretionary income based industry, Paddy Power is significantly exposed to the current downturn. Although Paddy Power has dealt with the recession well thus far, significant changes in the economic environment are still possible, for example the IMF bailout in Ireland. In response, Paddy Power continues to offer value for money to punters with numerous recession friendly offers ultimately allowing the company to compensate for the downturn by increase their market shares. Currency and FX exposure Paddy Power operates in markets denominated in Euro (EUR), Sterling (GBP), Australian Dollar (AUD) and US Dollar (USD). The company is traded on the ISEQ and LSE. The nature of the business is cash generative in each location and a natural hedge is achieved. However, the reporting currency is denominated in Euro (EUR). Therefore, the group faces a significant translational exposure. Movements in the exchange rates may change the valuation of the company as a result. These exchange rate movements may cause pricing and valuation mismatches resulting in volatility beyond that of the current environment. To quantify, the profit of the group was reduced by 3.3m in 2009 as a result of FX movements, this figure is slightly lower than the 5.0m in 2008. In response Paddy Power does explore a matching strategy in respect of receivables, payables etc. This is particularly important in the context of the financial crisis due to the emergence of quantitative easing as a recovery option and the ensuing Currency Wars. The company have facilities in place to use forwards, derivatives and intentional foreign currency cash balances in order to hedge the currency risk. The company did not deem necessary the use of any forward contracts in the years ended 31 December 2008 and 2009. Taxation, Regulation and Fiscal Measures It is worth highlighting both increased taxation in Ireland and the introduction of taxation in other territories as material risks. That said, there are no current commitments to increase taxes across Paddy Power s operating geographies. Although Paddy Power faces tougher regulation and potential tax changes in some markets, the potential regulation of markets may have an upside effect. Opportunities in further geographies will emerge, as Governments try to raise new tax revenues; begin to regulate their online sports betting and gaming industries. The regulatory and taxation policy in Australia presents another significant problem. The policies are subject to large variation by territory, state and jurisdiction. Changes in the regulatory environment in Australia could have numerous effects on the group and its profitability. This point is particularly important following the recent acquisition of the remainder of Sportsbet. In-experience in Australian Market Although Paddy Power has been operating in Australian bookmaking under the Sportsbet brand for circa.18 months there are some additional risks to the firms continuing growth and profitability. Paddy Power s traditional stronghold in Football in UK and Irish markets may not transfer in a similar manner to the Australian market. Paddy Power s brand name and recognition is a large source of competitive advantage in the traditional markets. It was achieved and is maintained through aggressive and fun marketing campaigns. Paddy Power s intention to keep on the Sportsbet brand could significantly impair their ability to adopt a similar marketing strategy and generate profits. Increased competition Some of the markets Paddy Power operates in have seen large changes to the competitive environment. Examples include the emergence of BetFair as a worldwide online player and the collapse of Celtic Bookmakers. As companies such as BetFair, 888 and Bwin have shown, there is a place for new entrants to the bookmaking and gaming market. The threat of new entrants in the Australian market is also worth noting, however, Paddy Power have entered this market in good time and so already have an advantage over potential entrants. As described in earlier sections, Paddy Power only operates in regulated markets. This may surface as a disadvantage to Paddy Power as other companies may look to expand their operations into non regulated markets and gain a larger world market share. 10
Disclosures: Ownership and material conflicts of interest: The authors, of this report do not hold a financial interest in the securities of this company. The authors of this report do not know of the existence of any conflicts of interest that might bias the content or publication of this report. Receipt of compensation: Compensation of the authors of this report is not based on investment banking revenue. Position as an officer or director: The authors do not serve as officers, directors or advisory board members of the subject company. Market making: The authors do not act as a market maker in the subject company s securities. Ratings guide: Banks rate companies as either a BUY, HOLD or SELL. A BUY rating is given when the security is expected to deliver absolute returns of 15% or greater over the next twelve month period, and recommends that investors take a position above the security s weight in the S&P 500, or any other relevant index. A SELL rating is given when the security is expected to deliver negative returns over the next twelve months, while a HOLD rating implies flat returns over the next twelve months. Investment Research Challenge and Global Investment Research Challenge Acknowledgement: University College Cork Investment Research Challenge as part of the CFA Institute Global Investment Research Challenge is based on the Investment Research Challenge originally developed by the New York Society of Security Analysts. Disclaimer: The information set forth herein has been obtained or derived from sources generally available to the public and believed by the authors to be reliable, but the authors do not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with University College Cork, CFA Institute or the Global Investment Research Challenge with regard to this company s stock. 11