Description

Kindred Group plc (KIND-SDB)

Kindred – 40%+ IRR over 2 years – baby out with the bathwater

Kindred Group plc, one of the largest online gambling companies in Europe, is trading at a normalized 6x EBITDA and 12% FCF yield with long-term tailwinds driving double-digit FCF growth from 2022 onwards.

We believe the market is significantly mispricing Kindred due to several events that have occurred over the past three months. First, the Company had to temporarily exit the Netherlands as the Dutch government made a last-minute decision to bar unlicensed international operators. Second, the Company reported a disappointing trading update for October 2021, whereby abnormally low sports win margins (meaning sports bettors got unusually lucky for a month) resulted in lower profits despite underlying strength. Third, the entire industry has experienced a de-rating as DraftKings and Evolution Gaming have sold off for reasons unrelated to Kindred.

Kindred shares have declined over 40% in the last three months. We believe that the market has overreacted and is providing us a compelling opportunity to purchase a diversified, scaled online gambling operator that can use its unlevered balance sheet either to pursue M&A in this rapidly consolidating industry or to continue to return 75% of FCF to shareholders in the form of dividends and buybacks. Additionally, while Kindred does not have a meaningful US presence, the Company is likely to remain an acquisition target for US media companies and casino operators given its technology, significant online expertise, and controlling position over Kambi, the largest independent B2B sportsbook supplier.

In our base case scenario, Kindred will generate a 100%+ return over the next two years. We expect the multiple to re-rate as FCF growth resumes following the Netherlands regulatory impact.

Business Overview

Kindred is the third-largest public online gambling firm in Europe, behind Flutter and Entain. Unlike those companies, which originated in the UK and tend to be more familiar to investors, Kindred originated in Sweden and then expanded through the Nordics and into Western Europe primarily through its global Unibet brand, though it also operates localized brands in certain countries.

Over the next decade, Kindred will benefit from the same broad tailwinds as the rest of the major players in the industry, as the shift from retail to online gambling drives HSD to LDD growth. As online gambling continues to grow fast and become fully legalized, the regulatory burden will likely increase as governments request higher taxes and place restrictions on these businesses. Consequently, market share will continue to accumulate to the scale operators, who can absorb these impacts due to their geographic diversification and their ownership of proprietary technology, allowing for more efficient marketing spend.

Kindred operates its own proprietary platforms related to player account management and the front-end user interface, while outsourcing the betting engine to Kambi and casino game development to third-party suppliers. Given that Kambi has been a rumored acquisition target, it is worth noting that Kindred holds a poison pill in the form a convertible bond, which if exercised gives Kindred controlling voting rights over Kambi. This should assuage concerns of any key supplier disruption in the medium-term.

Markets

Kindred’s home market of the Nordics represents roughly 25% of revenue prior to the Netherlands impact. While disclosure on individual countries is limited, Sweden represents roughly half that exposure; the company operates as the #1 or #2 online operator there according to Swedish tax office records. The Nordics are a much more mature market relative to the rest of Europe (59% online gambling penetration) largely due to high internet speeds and mobile penetration, but should continue to demonstrate MSD market level growth, with Kindred growing faster than the smaller operators. In the near-term, there is some additional upside from Sweden, as the spend limits imposed by the government during COVID have been eliminated as of November 2021, implying a likely uptick in spend for the industry.

Most of the remainder of the business is in Western Europe (65% of revenue), primarily in France (est. ~20% of revenue), UK (est. ~10-15% of revenue), and Netherlands (est. ~15-20% of revenue).

In France, Kindred operates as the largest market share player (~25-30%) in competition with local incumbents Winamax and Betclic. Those three players total ~80% of the online market, a level of concentration largely resulting from the French tax regime which taxes online sports betting at 55% of revenue. Such a high tax rate makes it difficult for others to be profitable, which is why there are so few competitors and spend accrues to the scale operators. Additionally, online penetration in France remains very low at 19%, supporting market growth at a 20% CAGR over the last 5 years (excluding COVID, which delayed sporting events) and a likely mid-teens pace for the foreseeable future.

In the UK, Kindred operates its 32Red brand for online casino, which is one of the larger individual casino brands, as well as a small sports betting brand. Kindred was a late entrant to the UK, entering the country through M&A in 2017, yet has managed to grow significantly faster than all its peers to the point that the UK is now one of Kindred’s core markets. While there is potential for regulatory impact in the UK through the Gambling Act Review, Kindred is less exposed relative to larger public players. Additionally, the mood around the operators as far as the outcome of this regulation seems to be getting rosier, although we are cognizant tail risks can always exist.

Kindred also has a very small US business, currently generating £28mn in revenue and -£25mn in EBITDA. Kindred has chosen to pursue an organic growth strategy, attempting to build its Unibet brand in the US without the help of any major casino or media partnerships. While we do not believe this strategy will succeed and we therefore capitalize these losses in our valuation, there is optionality both from a takeout perspective, as any casino or media company looking for technology, online expertise, or a global footprint should be looking to acquire a target like Kindred, as well as from management potentially exiting the US and boosting EBITDA by 10% overnight.

Recent sell-off provides a compelling opportunity

Netherlands

As mentioned, Kindred has had to temporarily exit the Netherlands market, which represented ~15-20% of revenues and ~35% of EBITDA. For background, the Netherlands fully legalized online gambling effective October 2021, but had previously decided that the international operators (Flutter, Entain, Kindred, 888/WMH, Betsson) would not receive a license on day one given they were still in a 33-month “cooling off” period as a penalty for marketing gambling services to Dutch customers in the past. However, the government agreed to allow those companies to continue operating their businesses until they exited the “cooling off period” in 2Q22 and received a license, as long as they were not actively targeting Dutch customers during this period. Roughly one week prior to legalization, the Dutch regulator reversed course and requested that all those international operators block all Dutch customers from accessing their platforms until they receive a license.

While this was a negative for Kindred in the short-term, we think the market was far too punitive in its reaction. First, not just Kindred but every major online operator (other than bet365) is under the same restrictions and the only licensed operators able to approach the market are land-based casinos and subscale online operators.  We believe that over the medium- and long-term, the “winners” are still going to be the major online operators, just as they are in every other market.

Second, as the public operators disclosed the impact of exiting the Dutch market, we learned that Kindred was the dominant market share player in the country. The Company projected a £12mn/month impact to EBITDA compared to £3mn for Flutter, £5mn for Entain, £2mn for Betsson and <£1mn for 888. We believe that once Kindred gets its license in 2Q22, the Company’s large customer base that has already signed up and deposited money very recently will reactivate.  To us, this is akin to if a US state barred FanDuel, DraftKings, MGM, and Caesars for 6 months, while Churchill Downs and TheScore got a head start – it is highly likely that over time, the first group would still be the winners in the market.

Additionally, now that marketing is legal in the Netherlands, we should see TAM expansion for the country. It is estimated online gambling penetration in the country is only 16%. This would imply to us that the market as a whole should grow at a 20-30% rate for many years, consistent with the stated belief of the Kindred CEO that the Netherlands could grow 3x over the next five years.

Sports Win Margin

The second issue that has recently impacted Kindred’s stock was its Q4 trading update provided alongside its 3Q21 results, citing a revenue decline through the first three weeks of October. While one driver of that decline was the Netherlands exit, the remainder was essentially temporary bad luck. Sports betting favorites won massively over that three-week period, resulting in win margins declining from 13% to <2%, implying the same amount wagered by customers generated 85% less revenue. We have seen this story play out with other gambling companies in the past. In the end, the house always wins, bettors who get lucky end up recycling most of their winnings back to the operators, and long-term win margins are very stable.

In addition, a closer look shows underlying demand metrics were very positive. The total amount wagered on sports was down 17% and online casino down 21%, which we view as largely indicative of the Netherlands exit, implying the rest of the business was flat against what was already known to be a tough COVID-influenced comp.

DraftKings and Evolution

DraftKings has been in freefall over the past month as investors have begun to question its competitive position (as Fanduel and BetMGM take share) and its high levels of marketing spend. As a result, every US land-based casino and international online operator has sold off in sympathy. While there might be a read-through for certain companies, there is none for Kindred, which unlike others has never received valuation credit for operating a subscale US business, and generates more than £200mn in FCF every year in its growing European business.

Furthermore, Evolution Gaming (EVO), a B2B supplier of live casino to the online gambling industry, has been under pressure recently given accusations that its games are operational in restricted countries like Syria, China and Iran. EVO was the largest online gambling company in the world by market cap and one of the ten largest companies listed in Sweden. As the Swedish investor base got skittish around EVO, the entire Swedish online gambling sector appeared to be sold indiscriminately.

Importantly, there are major differences between operating B2B and B2C businesses in online gambling, in that many countries do not have formalized licensing procedures around B2B suppliers. EVO has always operated in more “grey/black” markets relative to B2C operators like Kindred. There would be severe penalties for any public B2C companies operating in definitively restricted markets like China, and we are confident Kindred is not doing so.

Capital Allocation

In early 2021, Kindred implemented a new capital allocation policy and committed to return 75% of FCF (post-acquisitions) to investors in the form of dividends and buybacks. So far this year, the company has returned roughly £75mn in dividends and will complete a buyback program in mid-December to return another £65mn, implying a total return of ~8% of the current enterprise value in 2021.

In addition to buybacks and dividends, we expect the Company will continue to pursue M&A to acquire companies that have established podium positions in immature, high-growth, regulated markets, and/or to enter new markets organically, as management believes in the value of global scale in the online gambling sector.

Valuation

Kindred currently trades at a 12% unlevered FCF yield on 2022 numbers, which we believe will conservatively grow at a double-digit rate over the following two years, driven by re-entering the Netherlands, sector level growth from the secular shift to online, and market share gains.

It is worth noting that profitability does not return to 2021 levels in the forecast period largely because of a 31% revenue tax rate in the Netherlands in addition to elevated marketing spend given low online penetration in that country, making the Netherlands low profitability in 2022.  We also conservatively assume that Kindred will only recover 60% of its pre-exit Netherlands revenue by 2024, while the remainder of the business continues to grow at a MSD to HSD pace.

We value Kindred at approx. 130% above today’s price. A 12% FCF yield growing to nearly 17% in 2024 is far too cheap for an unlevered asset with long-term growth tailwinds, capital return, and takeout optionality. We apply an 11x EBITDA multiple, representing a 7.0-7.5% FCF yield, not dissimilar to the pre-COVID/pre-US multiple seen on Flutter and Entain nor to takeout multiples for Gamesys and William Hill in the past year.

Risks

Regulation

The key risk for an online gambling company is regulatory risk. As we have discussed, taxes can rise, products can be restricted, and so forth. We believe that geographic diversity, strong underlying growth, and share gains accruing to scaled players mitigate a lot of those impacts and will keep Kindred in growth mode after 2022.

Additionally, comments by Entain’s and Flutter’s CEOs at recent conferences seem to imply that other than the UK, there are not any major countries with negative upcoming potential regulation.

Netherlands License

While we think it is highly unlikely given the licensing process is already underway, there is a possibility Kindred does not get a license in the Netherlands. Moreover, even on an ex-Netherlands basis, Kindred is trading at close to 6x EBITDA and a double digit unlevered FCF yield with growth tailwinds ahead. 

Catalyst

Company gets a license in the Netherlands in 2Q22 and returns to historical growth rates

Takeout by a US casino chain or media company

Takeout by a larger online operator (e.g., Flutter or Entain) looking to establish larger global footprint given Kindred does not overlap with them in many core markets