Gaming Nation Inc fka FAN

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Gaming Nation: Significantly Better Odds Than A 50/50 Raffle

http://seekingalpha.com/article/3783926-gaming-nation-significantly-better-odds-than-a-50-50-raffle

Dec. 31, 2015 7:00 AM ET|8 comments | About: Gaming Nation Inc (GMNZF), Includes: HCHC
Disclosure: I am/we are long GMNZF. (More...)
Summary

With CAD$0.48/share in cash, 90%+ gross margins in its largest segment, and minimal capex, Gaming Nation offers 91%-184% upside.

The crown jewel of the company, from which over 50% of revenues is derived, is the 50/50 raffle business, a cash flow monster.

A deal or series of deals with media companies could drastically improve Fantasy Feud’s economics.

Gaming Nation

Editors' note: Gaming Nation trades on the Canadian Stock Exchange under ticker symbol FAN.V.

Financial Profile

Share Price:

CAD $0.63

Fully Diluted Market Cap:

CAD $27.6M

Enterprise Value:

CAD $6.7M

2016E EBITDA

CAD$3.8M

2017E EBITDA

CAD$4.8M

2016E EV/EBITDA

1.8x

2017E EV/EBITDA

1.4x

Cash per Share

CAD$0.48

Thesis

Gaming Nation (OTC:GMNZF) is a misunderstood Canadian gaming and media company that is surprisingly well insulated from regulatory risks related to daily fantasy sports (DFS), deriving only 13% of its revenues directly from its DFS web property, Fantasy Feud. Due to the newness of the company (it started trading in June of 2015 and is down 75% from an initial price of CAD$2.50 per share), an overreaction of the stock price to regulatory actions against daily fantasy sports, technical pressure from selling shareholders, and a general lack of understanding of the business mix as well as its growth prospects, the stock is highly undervalued.

I have modeled what information is available in the financial filings, held conversations with management, and made conservative valuation assumptions. Based on a DCF calculation, Gaming Nation has a midpoint intrinsic value of $1.44 per share, which represents upside of 129% to a recent price of CAD$0.63 per share. The market is currently implying an EV/EBITDA for 2016 of 1.8x, which is extremely cheap on an absolute basis and far too low for a company with Gaming Nation's high growth (I model 125% revenue growth in FY2016) and minimal capex requirements (less than 2% of sales).

How can the enterprise multiple be so low? The company has CAD$20.9M of cash and cash equivalents, which translates to CAD$0.48 per share. Backing out the cash from the share price leaves CAD$0.15 versus fully diluted net income of CAD2.6 cents per share in Q3 alone. Applying that CAD$0.15 to the more bearish of the two sell-side analysts covering the stock, with his adjusted EPS of $0.03 in 2016 and $0.07 in 2017, yields a 2016E and 2017E P/E of 5x and 2x, respectively. The stock trades at an EV/sales multiple of 0.4x 2016E. A very conservative approach is to add back projected cash burn to the enterprise value, but the enterprise multiples are still extremely low following that exercise, around 4x, and that assumes no improvement in cash burn. Management is committed to improving the cash flow profile of the consolidated company over time through scale and strategic deals at the cash-burning fantasy sports segment (CAD$1.1M negative adjusted EBITDA in Q3), which I discuss further in the write-up. The market valuation metrics are irrational, and the stock is unlikely to remain at the current price over the coming quarters as management executes its growth strategy.

Gaming Nation's insulation from DFS regulatory risk is most notably due to its ownership of a highly unique and compelling asset. The crown jewel of the company, from which over 50% of revenues is derived, is the 50/50 raffle business, a cash flow monster that is expanding rapidly into North American professional stadiums; imminently into European soccer and rugby stadiums due to an exclusive partnership with a U.K. based company, BD Sport Group, that provides in-stadium betting services to over 35 sports stadiums throughout the U.K. and other European countries; and eventually NCAA stadiums, a market of 700 target schools based on current 50/50 raffle regulations. With gross margins of 90% to 95%, potential EBITDA margins of 35% to 40% by 2018 (according to management) relative to a 3Q15 level of 33%, a long growth runway, minimal competition, and a product that helps charitable foundations raise money while simultaneously providing entertainment to participants through a progressive slot-like pot dynamic, the 50/50 raffle business is a treasure of an asset.

While Gaming Nation's exposure to DFS is higher (~24%) if you include revenues from its sports intelligence website FantasyGuru.com, the 11% additional exposure from the sports information sites is exclusively growth potential-related. In other words, since Fantasy Guru is season-long focused, which is consistent with the fact that the site hasn't seen any sort of explosion in growth related to DFS (the site's revenue had been stagnant for many year prior to its recent acquisition by Gaming Nation), the existing revenue base does not appear to be at risk, regardless of DFS regulatory developments. However, future opportunities for the sports intelligence sites related to cross marketing between Fantasy Feud and Fantasy Guru could be impacted. Fantasy Guru has been in existence for 20 years and boasts one of the most prominent fantasy sports experts in the business on staff, John Hansen. Regardless of what transpires with DFS regulation, the site's strong reputation in the fantasy sports world and focus on season-long fantasy sports will insulate it from DFS regulation. Meanwhile, Pick Nation, the other web property in the Sports Intelligence segment, is focused on handicapping sporting events and geared towards sports betting, which is less correlated to the DFS explosion. While the Fantasy Sports segment loses money (CAD$1.1M in 3Q15) due to marketing expenses that still overwhelm revenues, the Sports Intelligence segment, in which Fantasy Guru and Pick Nation reside, sport exceptionally high profitability (36% EBITDA margins in 3Q15) and point to a duo of valuable web properties that should soon transition from flat performance to growth under their new management.

Looking forward, despite regulatory risks facing the Fantasy Sports segment, media companies are showing interest in accessing DFS consumers. Gaming Nation is exploring business development opportunities with these companies, such as partnering with them to incorporate fantasy sports into their programming/content in order to improve the media companies' viewer/reader engagement. Such deals would expose Gaming Nation to large audiences with zero associated marketing spend, which is the cause of their loss in that segment. The most recent development here, discussed on the Q3 earnings call, is that the media companies do not want to "private label" the technology due to regulatory concerns form their legal teams, and would rather Fantasy Feud represent itself, but on their sites/networks. A deal or series of deals with media companies could drastically improve Fantasy Feud's economics. Such deals are part of management's strategy to pursue a low cost customer acquisition strategy, seeking to avoid the marketing excesses occurring at industry share leaders DraftKings and FanDuel.

Company History & Capital Structure

Gaming Nation Inc., formerly Oceanside Capital Corp, is a holding company with a complex capital structure (convertible debenture, warrants, common equity) focused on the acquisition and operation of companies in the online and mobile sports gaming space. It was formed through a reverse takeover between Oceanside Capital Corp and Gaming Nation Acquisition Corp that closed on June 9th, 2015. The company now trades on the TSX-Venture Exchange under ticker "FAN".

The Gaming Nation CEO, Scott Secord, and CFO, Blair McGibbon, were running a Canadian sports technology company called Pointstreak when they were approached in fall of 2014 by a small group of investors, who wanted to buy the 50/50 raffle business from Pointstreak and combine with others sports media businesses such as daily fantasy sports and sports intelligence. Pointstreak had purchased the 50/50 business when it had less than $1M in revenue in 2011 and grew the business to nearly CAD$6M in 2014 (most recently, that business did CAD$1.7M in sales in 3Q15 for an annualized pace of nearly CAD$7M). During the sale process of 50/50, the investor group suggested that Scott and Blair run the new company. Between November 2014 and June of 2015, management spoke with investors and raised CAD$65 million, which included a CAD$20M debenture from HC2 (discussed further below), CAD$34M in various private placement tranches in 2015, and CAD$11M from private placements in November of 2014.

In addition to the 2015 financings composed of:

USD $0.4M private placement at USD $1.50 per share (297,883 shares)
issuance of 29,788 broker warrants exercisable for two years at $1.50 per share
CAD$32.9M brokered offering of subscription receipts priced at CAD$2.50 each (13,150,000 shares)
issuance of 767,525 broker warrants exercisable for 18 months with a strike price of CAD$2.50,
Gaming Nation Acquisition Corp received the CAD$20 million convertible debenture investment from Philip Falcone's HC2 (NYSEMKT:HCHC) on April 6th, 2015, prior to the closing of the reverse takeover. The two-year debenture earns 6% interest in-kind with a conversion price of CAD$2.25 (8,888,889 shares). If not converted into stock at maturity, the debenture is settled with share issuance (incorporating principal plus accrued interest from the PIK feature), not cash, a favorable feature for Gaming Nation from a credit/liquidity perspective. HC2 also received a warrant to acquire 28,126,068 shares at various prices-- CAD$5.00 per share for the first two years, then resetting on April 6th, 2017, for the following two years to the greater of (i) CAD$0.30; and (ii) a 150% premium to the April 6th, 2017 market price. After April 6th, 2019 until expiration, the exercise price is 150% of the market price on April 6th, 2019.

The merger was concurrent with the acquisition by Gaming Nation Acquisition Corp of two electronic fifty-fifty raffle companies (5050 Central Ltd. and 5050 Central Delaware Inc), a daily fantasy sports site (Fantasy Feud Inc.), and two subscription-based fantasy sports intelligence website (Guru Fantasy Reports and Stevo Design / Pick Nation).

The stock began trading on June 15th at CAD$2.50 per share, and has since declined 75%, significantly de-risking the investment opportunity.

Business Overview

Consistent with the recent acquisitions, Gaming Nation reports across three segments: 1) the fantasy sports platform, through Fantasy Feud; 2) electronic 50/50 draws platform through 5050 Central Ltd and 5050 Central Delaware; and 3) sports intelligence information through Fantasy Guru (fantasy sports focused) and Pick Nation (sports betting focused).

The fantasy sports platform (13% of revenues) operates daily and longer fantasy contests through five different contest types across eight professional sports leagues. Revenues come from entry fees, of which Fantasy Feud takes a cut. If the site guarantees a certain-sized prize pool for any given contest, as they most frequently do for NFL and MLB contests, and they don't sell enough "seats", then they can lose money on the contest.
In Q3, Fantasy Feud revenues were up 392% y/y
The breakeven for Fantasy Feud to make money on a contest is about 92% of seats. As of 3Q15, Fantasy Feud had a % unfilled seats rate of 21%, which is the lowest of three competitors ranging between rates of 29% and 33% listed in the MD&A who have offered between $100K and $1M in guaranteed prizes (DraftKings and FanDuel have much higher guaranteed prize pools), and the segment lost CAD$1.1M in 3Q15, which is equivalent to 65% of Gaming Nation's total sales and marketing expense during the quarter. More precisely, about CAD$0.8M was actually due to losses from guaranteed prize pools. Management says GPP losses will come down in Q1, after the NFL season is over (NFL has the highest value GPPs).
So far, only DraftKings and FanDuel have actually received cease and desist orders in New York, where regulatory scrutiny appears highest; smaller sites like Fantasy Feud have avoided regulatory wrath (perhaps in part due to their lack of excessive commercials with shaken bottles of champagne being dumped over contest winners' heads).
Management's strategy is to acquire customers without spending nearly the kind of money that its larger competitors DraftKings and FanDuel have been. They intend to achieve this through partnerships with media companies that wish to incorporate elements of fantasy sports into their content/programming, as I describe in the thesis section.
Management believes that because the prize pools at Fantasy Feud are lower, the site is better for casual players, since professionals are more likely to be attracted to higher prize pools. Due to the problem of pros making the game "less fun" for casual players since they are less likely to win, Fantasy Feud is going to implement "home games", where you can pick only your friends as opponents. My thoughts on this are that since the dynamic where 1% of the players win most of the prize money (91% in one study on MLB DFS contests) is also somewhat of a problem for DraftKings and FanDuel, if those two behemoths decide to emphasize home games, they have much more marketing dollars for customer acquisition. Second of all, if pros believe that Fantasy Feud contests are "soft", they will likely compete there just as vigorously, since even though the prize pools are lower, their probability of winning will be higher. Overall, since Fantasy Feud is not particularly well positioned in the absence of large media deals, I think it's important that management focuses on running the segment profitably, rather than hoping for a large future return on loss-making marketing expenses.
The 50/50 raffle platform (51% of revenue) sells and distributes hardware and software solutions that facilitate electronic 50/50 raffles at events and venues globally. Gaming Nation gets revenue from equipment sales as well as taking a cut of gross proceeds from the raffle, which is a risk-free proposition for them.
The rationale for venues buying the electronic system is compelling and mostly boils down to larger pot sizes at the events, which means more proceeds for the non-profit organization. The pot is visible in real time, which helps build hype around the contest; the venue can collect entries for longer because they no longer need to manually count tickets; they can sell more tickets because they don't need to collect manual contact info; there is less "leakage", or stolen cash; and there is a better audit trail.
Teams experience large growth in 50/50 raffles after implementing Gaming Nation's electronic system. NFL pot sizes are up 40% y/y in 2015, while MLB pot sizes are up 20% y/y in 2015, versus a gain for MLB teams of 20% in 2014.
Management believes that Gaming Nation has a 96% market share of 50/50 raffles in North America
Regulatory tailwinds have worked in favor of this segment, with the recent approval by Texas and California of 50/50 raffles expanding the market by 25 professional teams.
Gaming Nation recently hired two former college athletic directors to help them penetrate the 700 target colleges and universities. Running 50/50 raffles and maximizing the pot sizes through an electronic system are particularly compelling to NCAA teams since, as not-for-profit organizations, they can keep the money for their core mission, sports programs. This differs from professional sports venues, where the money must go to the team's non-profit foundations rather than the sports teams directly.
Similar to a razorblade model, the company makes a small percentage and dollar margin on the initial hardware, the price of which has fallen 40% to 50% over the past three years. The bulk of profits in the segment are made by clipping a percentage of gross proceeds in perpetuity, with an overall gross margin in the segment of 90%. The more frequent and larger the raffle, the lower of a cut Gaming Nation charges. While major league professional sports teams (MLB, NBA, NFL, NHL) are charged 5% per raffle, less frequent raffles (NASCAR, golf, concerts) command fees of 15% to 20%.
Barriers to entry are high; contracts average 3.5 years in length, and there is little competition. Four provinces in Canada and eight states require the machines to be licensed by their provincial/state regulator. The more regulation that is required on the equipment, the better it is for Gaming Nation, because barriers to competition rise, providing protection from both new entrants and stadiums attempting to conduct the raffles themselves. Once installed, pot sizes increase, Gaming Nation works with the teams to optimize their sales process, and the incentive to replace it with a different system becomes non-existent.
Payback period to teams is just 1-2 games/events, which is exceptionally fast, and makes the sales pitch highly compelling
The sports intelligence sites (36% of revenue) are subscription-based and provide online fantasy sports information and analytics, as well as fee-based sports betting handicap information. Revenue is recognized across the subscription period.
Pick Nation is responsible for 70% of revenue within the segment, while Fantasy Guru makes up the other 30%.
Fantasy Guru is season-long fantasy league focused, rather than DFS, which is reflected in its stagnant growth
Pick Nation focuses on handicapping sporting events and is thus geared towards sports betting
Like the other segments (but especially similar to Fantasy Feud) capex requirements are minimal


Risks & Mitigating Factors

Changes in regulation around 50/50 raffles is the primary concern for Gaming Nation, only given their high exposure to this segment, not due to any high probability of change in current laws. There has been no noise around regulation in the 50/50 area, but large increases in pot sizes and greater visibility could draw scrutiny. At current valuations, investors are being very well compensated for any remote risk that exists. In my judgment, new onerous regulation is unlikely given that half of the net proceeds in a 50/50 raffle go to charitable foundations.
Competition in the fantasy sports and sports information segments from large and smaller sites alike could entice management to alter their strategy and spend heavily on marketing. This would be a strategic shift that would cause us to re-evaluate the thesis and projections. More likely, the company will strike one or more media deals that positively change the economics of the fantasy sports business. At the very least, management is unlikely to lose a lot of money in the space if they exclusively pursue a low cost customer acquisition strategy and avoid the DraftKings and FanDuel models.
An expensively valued acquisition (for example, paying a high price-to-sales multiple for another loss-making daily fantasy sports business) with the company's large stockpile of cash would be a big negative, although a smart acquisition that was directly complementary to the 50/50 segment could accelerate growth beyond the current trajectory. I do not expect any sort of special dividend given the company's early stage of growth. Much more likely is some sort of strategic acquisition that enables higher growth in North America or Europe, and management will hopefully act prudently.
Depending on the investor's size, liquidity is limited on an absolute dollar basis, which is largely a function of the small market cap of the company. Average volume is 168K shares, which equates to a daily dollar volume of CAD$106K. If an investor limited himself to 15% of daily volume, it would require 40 trading days, or two calendar months, to build a CAD$1M position (USD$740K). Of course volume will be higher around news events (one recent day of volume after Q3 earnings was 830K shares). The market cap is likely to grow substantially over time as the stock price appreciates in order to more closely reflect Gaming Nation's intrinsic value, which will also increase the daily dollar transaction value.
The stock price is denominated in Canadian dollars. For U.S investors that do not hedge the currency, movement in the USDCAD spot price will affect the value of the position. Most of the revenues are in U.S. dollars, but with high gross margins and low capex, the FX rate has little bearing on financial results.
Valuation

Based on a DCF analysis (see graphic below) that sensitizes the equity risk premium to levels between 10% and 14% and levered beta between 0.8 and 1.2, the company is worth between CAD$1.20 and CAD$1.79 per share, which, relative to the current market price of CAD$0.63 represents an upside range of 91% to 184%. Our midpoint valuation estimate is CAD$1.44, which represents 129% upside from the current price of CAD$0.63 per share. Note that currently levered and unlevered beta for the company are the same because the company has no debt; the debenture is essentially a forward sale of stock, with no cash actually owed to HC2 upon maturity. The DDM terminal value that corresponds to the valuation midpoint implies a 6.75x terminal value multiple in year six (2021), which is most heavily impacted by the DCF's high equity risk premium range. At a 6.7% ERP, the DDM would correspond to a terminal value multiple of 10x. I employ this high ERP range to account for the small capitalization, which incorporates factors unique to small- and micro-cap stocks such as liquidity discount and limited financial history.

The applied operating assumptions are highly conservative relative to the way management talks about growth potential, with the 50/50 business revenues capable of growing at least 50% y/y in each of '16, '17', and '18. In order to neutralize some of the execution risk in the valuation, I assume 125% revenue growth in 2016, 17% in 2017, and 12% in 2018, which basically means that for 2017 and 2018, where visibility is realistically lower than 2016, half the business grows at materially less than 50%, and the other half is flat or even down. A 2% terminal growth rate is assumed. The high rate of revenue growth in 2016 is based on annualizing 3Q15 Gaming Nation revenue and applying an additional growth factor of 20% to account for Q4 being the strongest seasonal quarter, as well as some acceleration in growth due to favorable 50/50 regulatory tailwinds in Texas and California, and potential for NCAA traction given the recent hire of two former athletic directors from Boston College and UNLV.

The DCF model assumes a 24% overall company EBITDA margin in 2016 that ramps up to 31% by 2019 and then stays at that level through the terminal year. Estimated tax rate is 25%, and D&A and capex are both 2% of sales. I assume the company would have to pay a 12% coupon to issue an unsecured note, based on high growth but limited financial history, and that the target debt-to-capital ratio is 35%.

Like any DCF, there are a lot of assumptions made, but I have attempted to err on the side of conservatism, for example, by assuming maturity of the model by year six (2021). Ultimately, given the early growth stage of the company, the model will need to be updated and tweaked each quarter to reflect management execution, any forward-looking comments, and new information related to capital structure and cost of capital.