A Greek Drama

How Much Would You Pay for This Company?

Over the past ten years, it has generated roughly €500m annually for its shareholders.  This amount is matched by free cash flow (defined as net income plus depreciation less changes in working capital and less capex) and on average 95% of it has been paid out in cash dividends.  Top line growth averaged close to 20% from 2000 to 2008.  Return on equity was around 100%, with almost no debt employed.

So, what’s your number?

€10 billion?

€15 billion?

Are you feeling generous?  Because Mr. Market was feeling generous last year.  He offered to sell you his interest for as little as €1.1 billion.  A bit over 2 times 10-year average earnings.

Of course, having seen the title, you aren’t falling for this one.

The Company

The Company has the sole concession to operate and manage nine existing numerical lottery and sports betting games as well as two new numerical lottery games, which it has yet to introduce. … The Company also holds the sole concession to operate and manage any new sports betting games in Greece as well as a right of first refusal to operate and manage any new lottery games permitted by the Hellenic Republic.

This monopoly is one of the most profitable companies in Greece.

The Risks

OPAP has been discussed on The Corner of Berkshire and Fairfax, Seeking Alpha, and Jacob Wolinsky at ValueWalk has just posted an exhaustive update on the latest developments around the company.  I recommend you read all three posts.  You may also find these helpful:

• the annual reports,
• this presentation,
• this court decision, and
• the latest press release

I first looked at the company in mid-2012.  I saw a situation of great extremes.  On the one hand, you don’t get a better business from an investor’s point of view than this – a national gambling monopoly selling at 2 times earnings.  Gambling is a controversial industry.  It preys on people’s psychological flaws which makes it persistently profitable.  Having a monopoly doesn’t hurt either.  On the other hand, you don’t get many countries shakier, politically and economically, than Greece.  Nationalization and extreme currency devaluation are always on the table in such situations.  Then, there is the question of government regulation – whether the license will be renewed and how much money the cash-strapped government may decide to extract from the company, and how.  Gambling, being a controversial industry and a monopoly in this case, is a very vulnerable target.  Last but not least, it is not perfectly clear whether the EU is OK with OPAP’s monopoly.  They would rather have the market liberalized, but there is enough leeway for Greece to uphold OPAP’s monopoly as long as it regulates it heavily and doesn’t allow it to grow too much.

I thought about all this.  The price was low, but I couldn’t get greedy enough.  All the uncertainty left me scared.  So, I put OPAP aside.

Until, I read that Seth Klarman’s Baupost has taken a 5.2% stake in the company.  I follow Baupost’s 13-Fs and I can’t wrap my head around most of Seth Klarman’s investments.  Nevertheless, it stuck me that one of the brightest and most risk-averse investors out there would take a position in this very risky, in my opinion, situation.  I guess, the old saying that everything is a good value at some price holds.  At current prices Baupost’s stake is worth €116m.  This places it as the 8th largest position on the 13-F, behind News Corp.  Even if it was established it at half today’s price, it is still around the top 10.  Also, Dan Loeb of Third Point expressed interest to participate in the auctioning off of the government’s one-third stake in the company.

So, I thought I’d take another look at OPAP.

New Developments

The numbers have expectedly worsened somewhat.  But, the critical information is contained the latest press release, dated November 20, 2012.

1. Starting 2013, all player winnings will be taxed at 10% (up from zero for winnings below €100) irrespective of the amount, leveling the playing field for offline, online, and Video Lottery Terminals (VLT) betting.
2. Between 2013-2020, OPAP will pay 30% (and up to 35% for VLTs) of the gross win from its legacy (offline) games as a royalty to the government.
3. For the period of the extended concession (2020-2030), the royalty will be 5% on legacy games.

I doubt the 10% tax on winnings will have a major effect on people.  I believe they will keep buying their lottery tickets anyway.  They have more to worry about their probability of winning than the new 10% tax on that.  Judging by how much they care about probabilities, I honestly doubt they will care about the tax.  The issue is more about the so-called recycling of profits.  Winners won’t be able to “reinvest” as much as without the tax.  This will affect negatively OPAP’s top line.  The good news is that the tax-free threshold for betting wins under €100 may be reestablished.

The real buzzkill is the 30% take of the government.  This comes on top of the existing 20% income tax.  As a matter of fact, quite on top of it as it appears immediately below the top line.  Gross win is what the house keeps after it nets payouts from gross receipts.

OPAP pays out 70% on average on its existing games.  On €4-5b turnover, the 30% tax on gross win will be between €360-450m.  Pre-tax profit has come at ~€700m in the past 10 years and ~€850m in the past 3 years.  However, the decline that started after the peak in 2008 has not abated yet.  Both the top and the bottom lines have lost ~30% in the last 4 years.  Estimating from the first nine months of 2012, pre-tax profit for the year will be ~€630m.

Assuming normal pre-tax profit is €600-700m, the effect of the new 30% tax on gross win will bring it down to €150-250m.  This is €120-200m net income annually for the next 8 years.

For the period of the extended concession, 2020-2030, the royalty is only 5%.  So, net income can be expected to be around €420-500m.

This gives some idea about the cash flows from the legacy business until 2030, which everyone can value using their favorite method.  The tough part is figuring out how much of it will be cannibalized by VLTs and online betting.

Growth Strategy

OPAP’s growth strategy relies on the introduction of VLTs and entering online gambling locally and then internationally.

Judging from Italy’s experience, where VLTs were introduced in 2010, they are a very fast-growth, high-turnover business.  Despite the 90%+ payout, a VLT in Italy makes some €180 gross win every day (from the presentation) or €65,700 annually.

Gambling is quite popular in Greece.  The country ranks #9 on the 2010 list of gambling losses per adult.  The average Greek lost a little over $400 betting.  This level is comparable to Italians’ (#6) $500+ loss.  In Europe, Greece is the 6th largest gambling market, according to the same H2 Gambling Capital study.  Assuming VLTs in Greece make 4/5 of those in Italy, that’s €52,560 per machine.

In late 2011, OPAP signed a contract with the Greek government according to which was licensed for 35,000 VLTs.  The license cost €560m (€16,000 per machine).  The company intends to operate 16,500 VLTs and sub-contract 18,500.  The company operated VLTs were planned to be deployed by the end 2012, the sub-contracted – by the end 2013.

Once fully operational, the 16,500 machines should bring in ~€400m net income annually.

For the 18,500 sub-contracted machines OPAP will receive “an upfront payment as well as royalties.”  However, I couldn’t find any guide as to what this will amount to.  In the presentation, it is also stated that “In case of unsuccessful subcontracting process for part or all the 18,500 VLTs, OPAP will have the right to operate the remaining VLTs.”  So, there is a chance that company operated machines will increase.

Counting the flow from the 18,500 machines for nothing, I think, more than offsets the cannibalization of legacy games.

Then, there is the prospect of growth online.  This space is still pending regulation in Greece.  I expect UK online bookies to have an advantage as the UK is the only country in Europe with an open online market.  However, OPAP management believes that it will be granted online monopoly as well.  This remains to be seen once the licensing regime becomes clear and OPAP shares its plan for online gambling.

Sum of Parts

This is what the net income from the legacy and VLT segments looks like, based on my assumptions above:

What is this stream worth?  For convenience, you can assume that past 2030 the license will not be renewed and OPAP will not be worth anything.

Conclusion

OPAP is trading for €2.15b today.  As I see it, the income stream is worth anywhere between €3-5b.

The big question is how reliable my estimates are.  There are still too many moving parts – micro and macro – for me to feel confident about OPAP’s future.

Just because a great investor has a position in a company is a silly reason to invest (especially, based on a 13-F that paints only part of the picture).  Even the best are oftentimes wrong as seemed to be the case with Klarman’s HP position.  Nevertheless, it was Klarman’s involvement that compelled me to take another look at the company.

I have a small position and I may add to it if the price goes down and as new information becomes available.

Expect to see my thoughts on several more Greek companies soon.

My other Greek posts:

• A Greek Company That Was Cheap (METKA)
• OPAP 2012-2013 (An update on OPAP, based on management’s road map)
• Jumbo 2002-2012 (Where does the macro fit in?)