“Owner-operator companies are those controlled by a significant, typically the largest, shareholder. This is a person with a great deal, perhaps most, of their personal capital at risk in that business…Businesses managed by their founders and/or largest shareholders tend to have much more liquid balance sheets, are more opportunistic, and exhibit remarkably higher long-term results.” – Murray Stahl, Chairman of FRMO Corp

Tessi (TES.PA) is a family-owned firm with a leading market position for high volume document processing in France.

Essentially, Tessi allows large companies to outsource the manual and often tedious task of handling and processing large volumes of physical documents. Through an acquisition, the company is also the leading wholesaler of gold and currency in France.

Operations are broken out into three business segments:

Document Processing – #1 market share leader in France for check processing and document digitization (converting physical checks or other documents to electronic form). While check processing is a declining business, the transition from physical-to-digital documents is a growth area. The company handles hundreds of millions of documents per year.

Core advantages: established customer relationships (why switch outsourcers in the middle of a 100 million document conversion?), available manpower, scale/efficiency

Marketing Services Operation – handles marketing functions such as redeeming rebates/coupons, processing customer gift fulfillments, executing mail campaign, and staffing call centers.

Core advantages: None really, lots of competition. Breakeven business but with a small “float” (see below)

CPoR Devises – acquired in 2005, CPoR is a broker of foreign currency and gold reserves, serving as the principal supplier in France. TES collects revenues from banks for holding reserves in its vaults, along with taking a fee for transactions between third parties.

Core advantages: sole supplier in France for these transactions, blessed by the French government, fixed investments in security/vaults, regulatory hurdles, reputation

Historical Track Record

Through a combination of acquisitions and organic growth, Tessi has turned in an enviable long-term track record under the current management team.

Since 2002, management has compounded revenues, operating income, and book value at 13%, 22% and 18% respectively.

Much of the growth associated with Tessi’s document/marketing businesses is due to acquisitions, as the company has taken out smaller competitors (scale is important in this business) and branched out into ancillary services.

These acquisitions are usually the ‘bolt-on’ variety, most often between €1-20 million in sales, a size capable of being easily integrated into Tessi’s infrastructure.

High Quality Business

Tessi’s businesses are attractive in two major ways:

1) The “float” from the marketing division – While Tessi has no competitive advantage in this space (as evidenced by the breakeven result), the marketing operation is setup so that customers prepay for campaigns, but consumer redemptions often occur weeks or months later.

Assuming TES signs on new customers, this cash advance reduces the need for external financing (effectively, Tessi can self-finance part of operations) – this marketing “float” has averaged roughly €20 million per year.

2) Asset-light business, especially in CPoR – Tessi supports €262 million in sales with just €22 million in net fixed assets.

Documents/marketing (the core business) is service-based. For CPoR, once the infrastructure/vaults/security is in place, there is little additional investment requirements as Tessi’s “product” in CPoR is essentially currency and/or gold – therefore, the cost of handling incremental transactions is negligible.

Combine these factors together and Tessi is generating ROIC north of 50%:

CPoR Acquisition = Game Changer

“Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold.” – Warren Buffett, Berkshire Hathaway

“The world seems more uncertain today than at any other time in my life.”– Howard Marks, Oaktree Capital

In 2005, TES paid €41 million for 80% of CPoR Billets (now CPoR Devises) in a break from its traditional document/marketing focus. The remaining 20% ownership is held by Crédit Agricole, which plans to eventually divest its stake.

CPoR supplies gold and foreign currency to all of France’s banking and financial institutions, with a market shares of 90% in forex and 95% in gold.

Dominant market share + little capital requirements = high margins/returns

In 2011, Tessi’s CPoR segment generated €27.4 million in operating profit at 43.6% margins from just €16.5 million in assets, for an ROA of 166%. As a broker, CPoR is leveraged to both price and volume of gold transactions, so in times of crises, results are boosted doubly.

With investor’s traditional view of gold as a safe haven, CPoR serves as a natural hedge during market crashes. As evidence, CPoR grew right through the recession, with margins increasing 1300bps in the last five years: 

Gold investment statistics also show the demand increase since 2008:

This increased demand has driven up gold prices:

Here is the revenue breakdown of the CPoR division through 2006 (TES does not break out profit-level details between gold and forex):

Margins have improved dramatically as gold has become a greater percentage of CPoR’s overall results.

Critically, the market is pricing in a decline in this business, as analysts are forecasting negative 5-7% annual growth in CPoR revenues from 2012-2014.

In order for revenues to fall by this amount, CPoR would have to see a decline in either gold volume or gold prices that was not counterbalanced by an increase in the other component.

Here’s how the company is doing on those two fronts:

Gold Prices

While prices have moderated in the last several months, average gold prices are still 17.5% above 2011 levels.

Gold Volumes

Tessi handled 15 million tonnes of gold in 2010. While volume was not disclosed in 2011, CPoR revenues grew by 36%.

In 2011, average gold prices were up 22%, which would imply an 11.7% increase in volume (this analysis is overly simplistic, but should be directionally correct):

Considering the YoY increase in gold prices for 2012, volumes would have to decreases markedly (by around 15%) for gold revenues to stay flat – and fall even further to justify analysts’ poor outlook.

Through the first six months of 2012, CPoR revenues were up 5.6% YoY, only to fall behind with the Q3 report. It is unclear whether this was due to gold or forex.

However, there are other factors that could mitigate this trend in Q4 and into 2013, lending credence to the possibility that analysts are being overly conservative:

The roll-out of more affordable gold ingots: CPoR released a series of very popular 50-500g ingots in 2011, which generated 2.4 million tonnes of new business in their first year. Last month, the company released a 5g, 10g and 20g version. With prices now starting as low as €225, these new ingots are within reach of many more people and volumes should improve (possibly dramatically) in Q4 and beyond.

The improving tax environment for gold: Historically, sales of physical gold in France were taxed at a flat-rate of 8% regardless of whether the sale generated a gain or loss, which limited demand. In September 2012, a law was passed which modified the tax treatment for gold, increasing the attractiveness for new investors by offering a:

• Choice of the most advantageous taxation system (either the 8% flat-tax or a 34.5% capital gain), depending on the gain obtained and the holding period
• Total tax exemption after a period of 12 years
• No tax due in the event of a capital loss, irrespective of the holding period

Since 2011 was such a record-breaking year for CPoR, similar growth is unlikely – at the same time, annual revenue declines of 5-7% and margin contraction of 500-700bps (what the Street is forecasting) seems too pessimistic as well.

Valuation

Here are relevant comps for the marketing/document (core) side of Tessi:

Assuming the core business grows at 3% with 10% margins, the fair market value of this segment alone would be €133 million versus Tessi’s market cap of €200 million:

Therefore, a buyer in Tessi gets a stake in CPoR – a business that enjoys 40%+ margins, 50%+ ROIC and a monopoly position in its niche market – for €67 million, or less than 4x earnings.

Here is how the valuation of CPoR might break down:

If current earnings continue, CPoR is worth €160-252 million (midpoint of €206), or 4-6x its implied price.

Even if I’m wrong and both gold demand and prices drop sharply – i.e. margins/NOPAT fall to pre-crisis levels – CPoR is still worth at least 150% more.

Here is a sum-of-the-parts valuation:

As a sanity check, Tessi has been able to convert an average of 131% of earnings into FCF over the past ten years.

With ’12 earnings estimated in the €30-31 million range, Tessi should generate close to €40 million in FCF, for a yield of 20.1%.

Add in inflation (2%) and organic growth (3-5%), and Tessi’s forward FCF yield is north of 25%.

Conclusion

“What I’m telling you is that the bulk of the return of the indices—and not just in the United States, but in all nations, the bulk of the return was earned by these owner-operators.” – Murray Stahl, Chairman of FRMO Corp.

Marc Rebouah is the Chairman and CEO of Tessi, controlling just over 50% of shares outstanding. Tessi is a classic owner-operator (Rebouah has been in charge since he purchased Tessi in 1979), and demonstrates how much value can be created by a smart management team combined with a long-term view.

Rebouah is now 68 years old, and according to company bylaws, he has to step down as Chairman in January 2014. A sale of the company is a possibility, but I’m hopeful that current management will remain involved in strategic decisions at some level.

If the next ten years are even half as good as the prior, an investment in TES should work out quite satisfactory…

Disclosure

Long Tessi (TES)

Company Overview

UMS United Medical (ETR:UMS) is a medical equipment service provider, focused on mobile service solutions – think “medical equipment on wheels”. Customers include hospitals, ambulatory service centers and physicians’ offices.

The company is broken out into three business segments, focused on different service areas: Urology (kidney stones), Gynecology (breast biopsy), and Other (namely Radiology services)

The most important division is Urology, which accounts for approx. 70% of revenues and 80% of operating profit:

Medical Technology Overview

The Urology segment primarily focuses on a technology called extracorporeal shock wave lithotripsy (ESWL), a non-invasive treatment of kidney stones using an acoustic pulse.

The technology has been around for almost 30 years and is considered a standard of care for treatable kidney stones.

However, ESWL isn’t a high-growth industry (at least in UMS’ niche), with the number of UMS patients growing each year roughly in line with inflation:

UMS targets medical services where the capital expense for the technology (which can range into the millions of dollars) cannot be justified by the volume of expected patients.

Corporate Structure

UMS International is a German-based company, but the majority of operations occur in the U.S via wholly and partially owned subsidiary companies.

A crucial part of the business model is the formation of partnerships with physicians, creating a shared ownership around the success of the mobile initiative and an economic incentive for both parties to maximize utilization of UMS’ machines.

UMS has over twenty of these partnerships spread across the country, with most rolling up into the U.S. subsidiary.

UMS usually takes a 10-25% ownership stake in these partnerships but retains management control, and therefore consolidates the subsidiaries on its own financial statements.

The portion of earnings attributable to the physicians (paid out as dividends) is included on the financials as non-controlling interests (NCI), which represents a significant portion of the overall balance sheet.

However, the parent company is the entity that purchases the machines, pays for gas to transport them to each location, accounts for the depreciation, etc.

This means that each partnership on its own right is extremely profitable relative to capital invested, since its costs are essentially just management/rental fees back to UMS.

Approximately 60-70% of UMS’ total earnings go towards paying out NCI.

Ownership

Board members and management hold 39% of shares, up quite a bit from the IPO due to share repurchases over the last several years.

In 2011,  less than €300k was spent on compensation for the management and supervisory boards, a number which is dwarfed by their ownership stake in the company (worth tens of millions).

Therefore, management should be incentivized to allocate capital in the most effective way for all shareholders. The presence of two investment funds, Union Investment and Capiton Value, should also ensure that management continues to grow shareholder value.

Investment Thesis

1. UMS is a ‘broken IPO,’ as losses from a failed international expansion led to frustrated selling, obscuring the value created over the past five years

UMS went public back in July 2000 for almost €25 per share, but fell to only €1/share by early 2003, a loss of 95%:

In the first four years as a public security, UMS reported net losses of €16.7M, €2.5M, €2.1M and €9.7M.

While most of the losses occurred below the operating line – consisting of restructuring charges, asset writedowns, and goodwill impairments – it was not exactly the best start to its public company life, likely scarring its original shareholder base.

During this time, UMS attempted to expand business operations across Europe, making heavy investments in new technologies (such as PET scans) and new offices in foreign countries.

Unfortunately, the company ran into challenges due to the “non-reform of “encrusted” state-run healthcare systems & lack of insurance coverage.”

By 2007, UMS had sold off its European operations and divested non-core business segments, and subsequently started focusing exclusively on the U.S.

While revenues were cut almost in half by the divestitures, profitability improved:

And the balance sheet was strengthened dramatically:

While the share price is up significantly over the past year, the market still seems to be ignoring the cash generation ability of the refocused business.

2. Economics of transportable medical procedures business model is attractive for patients, physicians, hospitals and UMS shareholders

These medical machines are expensive, and major hospitals often cannot justify the capital expenditure based on the projected patient volume – the usual alternative is to send the patient to another facility.

UMS transportable model allows hospitals to ‘rent’ the medical device for a daily rate (say on every 3rd Thursday), providing the needed services to patients in a cost-effective way.

UMS receives management and equipment fees from the hospital and its physician partnerships. Since UMS’ mobile units are able to serve multiple sites, the company is able to drive up the overall asset utilization of the machines.

Everyone benefits:

• Hospitals avoid major capital expenditures
• Patients receive required treatment at lower cost/procedure and without traveling to another location
• Physicians create a new revenue stream by offering additional services
• Shareholders participate in the earnings stability afforded by long-term contracts and steady patient volume

According to the company’s research, the economics of the mobile units are attractive, providing services at a fraction of the cost over a five year period:

In the last five years, UMS has shifted its capital allocation policy from ill-fated growth initiatives to a strategy of returning cash flow to shareholders via aggressive stock buybacks and dividends

From 2002-2006, the company spent an average of €5.9M per year on acquisitions in attempt to expand around the world. After years of losses, UMS curtailed the acquisition-fueled growth strategy to focus instead on returning cash to shareholders, with small tuck-in acquisitions along the way.

This shift is represented in management’s new capital allocation record – the company spent €0.9M/yr on acquisitions in the past five years, with the bulk of the remaining FCF being returned to shareholders.

This represents a marked shift from ‘empire building’ to a focus on shareholder returns.

The change in policy coincides with Union Investment Funds (a large European asset management firm with €180B+ in AUM) taking a 5% stake in the stock in 2007/2008.

Since that time, UMS has aggressively bought back shares via open market repurchases and tender offers. Total shares outstanding have fallen from 6M to 4.8M, or more than 20%.

UMS paid its first dividend to shareholders in 2010, offering an average dividend yield of over 6% – if share repurchases are included, total cash returned to shareholders yields greater than 10%.

Valuation

Looking at the company’s ten year financial track record, there is a clear delineation pre and post-2006, representing the shift in business strategy.

Even after adjusting for the payments due to NCI, the core business is solid, with sustainable ROIC in the mid-teens.

Looking at the past five years, the business becomes even more attractive on a cash ROIC basis, as D&A is higher than maintenance capex:

And over that time, the company has provided a double-digit FCF yield, with a significant (and increasing) portion of that cash returned to shareholders:

So why is the company trading at an EV/EBITDA < 3x? (Added: See comments below)

Lack of growth. (Added: And due to the fact that the majority of the EBITDA goes towards NCI)

The company has struggled to grow its business organically (or at least grow faster than the rate of inflation). 2011 sales of €38.3M were up only 11% from the 2004 number – that’s just 1.3% per year.

Due to a recent acquisition and stronger organic growth, 2012 sales should reach the €42-43M range, but this is definitely not a fast-growing business, so let’s value it as a ‘no-growth’ stock:

Despite a share price that is up 33% in the past year, UMS is still trading at a 28% discount to its EPV valuation.

Not only does this provide a margin of safety, but any growth (if it ever materializes) is free.

Conclusion

UMS has carved out a niche for itself within this mobile medical services space.

If the recent run-up in share price is any indication, maybe some investors are starting to take notice of the new shareholder-friendly strategy, as the stock continues to offer a steady double-digit yield (not bad in today’s rate environment).

The company is not exciting, and many investors seem to pass over such steady cash flow generating stocks in a pursuit of growth. However, as evidenced by UMS’ past, growth – if done for growth’s sake – can destroy value.

Finally, I think it’s important to point out the mission of Capiton Value, which continues to hold a sizable stake in the business:

“[Capiton Value’s] objective is to purchase significant shares in noticeably undervalued medium-sized enterprises as well as offering when suitable the respective management support for the implementation of value-creating measures…CVM combines capital market know how of many years with sound private equity expertise”

“CVM can offer support ranging from e.g. enhancement of capital market communication up to divestments (sometimes combined with a cash out) or Buy & Build strategies as far as assistance during a Going Private”

It remains to be seen whether CVM’s involvement could be an eventual route towards closing this value gap for minority equity holders…

Disclosure

Long UMS

Spin-off Details

Lotto24 AG (LO24) began trading on July 3, 2012, as a spin-off of Tipp24.

According to Tipp24’s CEO,

“we believe that a complete legal separation is the best option to provide Lotto24 AG with a starting position in the German market which is not burdened by legal disputes.”

Two board members from Tipp24, Petra von Strombeck and Magnus von Zitzewitz would join the new executive board of Lotto24 AG, with von Strombeck as CEO.

Priced at €2.50 per share, the spin-off jumped to the mid to high 3’s on the first day of trading before falling to a low of €2.78 only a month later.

Specific details of the spin-off included:

• Treated as a dividend in kind from Tipp24’s capital reserves
• Offered an additional 5,988,816 ordinary shares via a rights offering
• Total proceeds of approx. €13.87 million after-fees

Lotto24’s goal is to re-establish lottery brokerage services within Germany as soon as possible, essentially resuming Tipp24’s domestic business which was halted by the 2008 German State Treaty on Games of Chance (“GlüStV 2008”).

Q2 Financial Report

Lotto24 just released its first quarterly report as a public company, and it provided some detail about the company’s current state and future plans. Another quick history lesson on the German legal situation:

• Jan 1 2009: The GlüStV 2008 is passed, banning online gambling including lottery advertising and ticket brokerage over the internet

• Sept 2010: European Court of Justice (ECJ) declares that key elements of the GlüStV 2008 contravene EU law

• Dec 2011: Based on the ECJ’s opinion, the German States draft a new treaty

• Jan 2012: Schleswig-Holstein, one of the 16 German States, moves forward with its own law making online gaming legal and allowing LO24 to restart operations for SH residents

• March 2012: A revised treaty, the First State Treaty to Revise the State Treaty on Games of Chance (“GlüÄndStV”), is given to the ECJ for positive approval, but the ECJ does not approve or comment on it, casting doubt on whether it complies with EU law either

• July 1 2012: The GlüÄndStV treaty is ratified by the German States anyway

• July 2012: Schleswig-Holstein reverses its original course and now plans to join the other states in ratifying the GlüÄndStV this fall

So what does this all mean for online lottery brokerage in Germany? The short answer is that it’s still unclear.

The longer answer is that

“although the approval process [for nationwide rollout of online lottery brokerage] has been initiated, the permit criteria, Internet requirements, and advertising guidelines have not been finally decided yet.”

In addition, Lotto24 still believes that the new treaty’s validity as it relates to the ECJ ruling is still questionable:

“All in all, it is uncertain under such circumstances whether or not the GlüÄndStV can be legally applied.”

What the company does know is that the internet and TV advertising permits are handled by the German State of North-Rhine Westphalia, and will not be finalized until after their state elections – sometime in November 2012.

Although the GlüÄndStV might need to be revised even further to pass the ECJ (ultimately ending up in an even better situation for LO24 in all likelihood), the state of online gambling seems to be moving forward (albeit slowly and with a ton of uncertainty), and the company expects to be operating its lottery brokerage nationwide within the next twelve months.

On the financial side, LO24 has total equity of €32.6million, with the vast majority made up of cash (€14.7mil) and goodwill (€18.9mil). The goodwill is a result of the contribution in kind from Tipp24 for the “business opportunity for the resumption of online lottery brokerage in Germany.”

Unlike other start-ups, Lotto24 does not have to re-invest much back into operations or R&D – the software is developed already and can sit on the shelf without incurring holding costs, and the majority of expenses (like marketing) are discretionary and can be ramped up when the internet ban is lifted.

Operating expenses through the first six months of the year were €1.6 million. However, €960 thousand of that expense was due to one-time IPO costs.

After removing these non-recurring items and annualizing this figure for the entire year, LO24’s has a steady-state cash burn rate of €1.25 million per year.

With almost €15 million in cash, that’s a long runway…

Lotto24 Positives

Brand recognition:

With more than 2.5 million customers prior to the internet ban, German lottery players are familiar with the Lotto24 brand – it seems reasonable to assume that they will return to a familiar and trustworthy service. Lotto24 should benefit from a sharp initial jump in customers when the online lottery market resumes.

Negative working capital:

Lotto24 benefits from advanced customer payments and a slight lag in payouts, leading to “steadily increasing negative working capital” balance. With limited reinvestment requirements, FCF will be higher than net income[1. For reference, from 2003-2007, Tipp24 had cumulative FCF that was 2x of total earnings.]. This is very similar to insurance float, and allows LO24 to grow basically for free.

Stable investor base:

Gunther Holdings, a large shareholder in Tipp24, increased its stake even further (to 33%) via the rights offering, signaling confidence in the stock’s prospects. Gunther has been involved in the Germany gambling industry for decades, and will likely be a stabilizing shareholder through any delays in starting up operations.

Broadband penetration:

More internet users = a greater number of people who can gamble online. Over the past five years, Germany’s broadband penetration rate grew by 76.8% to 32 users per 100 inhabitants. This is faster than any Western European country save Ireland, and Germany now ranks 5th overall in broadband penetration out of the entire European Union. Basically, the pool of potential customers has almost doubled since 2007.

Growing lottery market:

See below.

Lottery Market

The gaming gambling, at least when looking at global numbers, is largely immune from economic downturns, growing at 4.9% per year from 1999-2011 without a single down year (2009 was flat):

As the second largest market (only slightly behind North America), Europe is expected to grow from $122.9 billion in 2010 to $171.5 billion by 2015, or 5.7% CAGR, slightly faster than the global rate:

The largest gambling product worldwide?

Lotteries, with 29.1% market share.

German Lottery

While it has been four years since the GlüStV 2008 was passed, a relaxation of the law seemed inevitable.

First, as shown by the above charts, people love to gamble and have done so via lotteries for hundreds of years – moving that business online seems logical.

Second, the ECJ was strongly critical of the original treaty and will likely continue to apply pressure to the German states until a compliant law is passed.

Finally and most importantly, money from the state lotteries goes towards the sports, environment, youth projects, and state budgets.

To put this in perspective, the German lottery had total receipts of €6.66 billion in 2011. Due in part to the treaty, this number is down more than €3 billion from the average levels from 2004-2007 – a pretty staggering drop – and no doubt forcing some unpopular budget cuts.

With a restart of online lottery brokerage, Lotto24 is planning for an immediate jump in lottery receipts to €8 billion, with the overall lottery market in Germany growing to €12 billion by 2020.

The company is also projecting a rapid increase in online ticket sales, growing to €6 billion by 2020, or 50% of total lottery sales.

While this growth rate seems optimistic, it is not crazy outlandish. Two thoughts:

1. Already, some countries (such as the UK) have more than 20% of gambling done via online/mobile channels – 50% in the next eight years seems within the realm of possibility:

2. While lotteries are still the most popular form of gambling, they lag other products in online sales, so there is even a larger runway for internet growth:

In summary, there is a ton of potential for LO24 once the company’s marketing machine can crank up again.

Historical Business Model

Lotto24’s plan is to sell tickets online for the State Lottery and take a small percentage commission. This is the same model that Tipp24 employed from 2003-2007, before the German gambling ban forced the management team to focus on secondary lotteries abroad.

Tipp24 was the dominant player in German lottery brokerage, reaching 60% market share of online ticket sales by 2007.

Check out this growth rate:

Roughly 25-30% customers were ‘active’ (completing at least one transaction per month), but Tipp24 earned almost €600 in billings per active customer[2. Active customers play a lot, and show almost no churn after the first year].

In the brokerage model, Tipp24 generated revenue from three sources:

• 10% distribution fee on traditional lottery ticket sales
• 20-30% markup fees for premium lottery products like scratch cards
• 15-20% margins on ‘white label’ business services (Tipp24’s technology powered the back-end on other lottery broker websites)

Therefore, blended gross margins – revenues / gross lottery receipts – were historically around 13%.

Here are the biggest operating expenses as a percentage of revenue:

Both marketing and other expenses were skewed higher in 2006-2007, as the company spent money on legal/consulting fees while also dealing with slowing customer growth due to the uncertainty surrounding the impending internet ban – Tipp24’s management was targeting marketing expenses at 30% of revenue.

As shown by the cost breakdown, the key part of the brokerage business model is marketing, as money spent to attract new customers is the largest expense by a wide margin. Customer acquisition costs averaged roughly €20 per new registered customer.

As the business matures however, these costs should fall as the rate of sign-ups slows and the company moves towards maintenance marketing.

This is a highly scalable business model, in that ‘other’ expenses (such as personnel, rent, etc.) will fall dramatically as a percentage of revenues as the number of customers grows.

Once the infrastructure is in place, the marginal cost of selling another lottery ticket is basically zero.

This should lead to future margin expansion, with a steady-state ceiling well above the 20% EBIT margins shown by Tipp24 historically, assuming the growth materializes and management executes successfully.

Lotto24 Forecasts / Valuation

So what is LO24 worth?

LO24 is essentially a start-up right now – with only a few thousand existing customers and negligible revenue – facing a still uncertain legal situation.

There are a ton of variables to consider:

• what year (and if) the ban is reversed
• legal restrictions in the new permitting process
• growth rate of the lottery market overall
• % of lottery market share taken by online tickets
• growth trajectory of LO24’s market share
• new customer acquisition cost curve
• and the list goes on…

However, with five years of Tipp24 financial history, there are some historical benchmarks to guide the exercise.

Here are key metrics for Tipp24 from 2007, the last year before its business was disrupted by the GlüStV 2008:

These metrics can be used as a baseline to forecast possible growth scenarios, in order to value Lotto24 based on its expected future cash flows through 2020, discounted back to the present.

First, some core assumptions which apply across each scenario:

• Activity rate starts out at 30% but falls as the market matures
• Billings per active customer gets an initial boost when the ban is lifted (i.e. the most die-hard lottery players sign up first) but stabilizes around €580 per active customer
• Gross margins start out at 8% and rise to 12% as premium lottery products and business services are phased in
• The company burns cash until the ban is lifted, but once legalized, operating margins rise steadily due to the scalability in the business model (i.e. falling marketing expenditures & other operating costs as a percentage of revenue)
• Capex and depreciation cancel each other out (reinvestment is negligible)
• Business model benefits from negative working capital, and FCF outpaces net income (consistent with Tipp24’s track record of cash flow generation)

Finding a precise value is not the goal[3. Whew!], but the exercise can demonstrate a range of scenarios.

Here is how Lotto24 might look in 2020:

Bull Case

This assumes that the online market is fully legalized by 2013, and grows – both overall and online – to meet management’s forecasts of €12 billion and €6 billion respectively. It also models sustainable EBIT margins of 30%[4. Analysts were predicting 5-year margins closer to 40% for Tipp24 back in 2005-2006, so 30% seems achievable].

Even with a peak market share well below the company’s past history, if this plays out, LO24 would be an absolute home-run investment.

Base Case

This projects a more realistic growth trajectory for lottery sales (5% CAGR), with online transactions making up 15% of the total (still a €1.5 billion market).

It also assumes that the internet ban isn’t lifted until 2014, even though LO24’s management is predicting full resumption of activities within 12 months.

Even so, this scenario still results in over 100% upside.

Bear Case

In the bear case, Lotto24 burns money for three years before finally winning the legal argument and starting up in 2015.

The total lottery market does get an ‘internet spike’ in 2015 (20% growth, back to pre-internet levels), but barely grows above the rate of inflation overall, with online sales reaching only 10% of the total.

Active customers fall to 20%, as LO24’s customers get bored and move to new forms of gambling , and economies of scale never kick in to boost EBIT margins north of 20%.

The market thinks the bear case is likely (i.e. Lotto24 is fairly valued).

Ultra-Bear Case

The stock goes to zero, a possibility for any start-up.

In this world view, the German government never allows internet brokering of lottery tickets and/or centralizes that function within the state lottery itself.

LO24 burns through its cash fighting legal battles and eventually goes bankrupt.

While this seems unlikely, there are still lots of uncertainties, and management will have to prove that they can navigate the legal and regulatory situation while executing on the company’s growth potential once the opportunity arises.

Growth Comparison

Here is a simple chart that shows the growth in registered customers under the various scenarios:

Conclusion

Putting it all together, LO24 is more of a special situations investment, where investors are weighing the probabilities of several scenarios and not necessarily coming up with a specific intrinsic value.

Using this range of outcomes, here is the expected value of making the investment:

This assumes a reasonable chance that Lotto24 is a success, while giving some weight to the extreme outliers on both the positive and negative side. With these probabilities, investing in the stock seems to be a very +EV decision.

Inverting the argument, here is what the market is currently forecasting:

In order for the stock to be fairly valued, the market is assigning zero probability for the bull case, and a 30% chance of the stock going bankrupt (even though a full bankruptcy is unlikely, given that LO24’s cash pile is almost 12x the current cash burn rate).

In fact, because the bullish outcome has such a high reward, the chances of the bull case playing out only needs to be 7.6% for an +EV outcome, even if the rest of the probability (92.4%) is assigned to a the stock going bankrupt.

In poker, maximizing positive expected value decisions is one of the keys to making money over the long term. Unlike poker – where hands can be analyzed – the exact probability weightings are unknown in Lotto24’s circumstances, but it appears that the odds are heavily in favor of some sort of positive outcome.

With a poker background, passing up +EV situations is against my nature – with the odds on Lotto24, I’ll stay in the hand and see how the river plays out…

Disclosure

Long LO24, TIM

P.S. – If anyone has updated lottery statistics from LaFluer’s 2012 World Lottery Almanac, please contact me.