Tuesday, 14 October 2014

RexLot and the Chinese Lottery Market

I always had a fascination with lottery. Not that I ever played it but this type of gaming sits at the intersection of gambling and the state/government i.e. essentially promoted gambling. Which brings me to China. The only way to gamble (legally) in China is via lottery that is sponsored by the state while any other method is forbidden (though that doesn’t seem to stop people, more on this later). Of course you have Macau but technically speaking that’s outside of the country. Furthermore, judging by the effectiveness of the clamp down on corruption and indications of going after some junkets this might be under pressure going forward.

In the below I’ll talk a bit about the Chinese lottery market and a HK listed company called RexLot that I think is pretty interesting in this space.

Chinese lottery market
There are two types of lotteries in the country: welfare and sport lottery, which have been operational since 1987 and 1994, respectively. It is an important fundraising method for the government as 20-25% of gross lottery sales are used to fund welfare and sport activities. Under the current set-up the Ministry of Finance operates as the regulatory authority.

Source: China LotSynergy

The Chinese lottery market has grown 20%+ p.a. over the last decade and current sales are RMB 309bn (c. $50bn). On a relative basis, lottery spending per capita in China is US$27 vs Hong Kong and Japan of $125 and $93 and USA of $185. Given that legal gaming (ex-casinos) is far below other Asian countries (either per capita or % of GDP: China is less than 0.5% vs c. 1% in the region on avg) the government has an incentive to support growth of lottery for welfare and sports development funding.

Source: China lottery sales since 2009 (RMB bn). Ministry of Finance

Various estimates point to the fact that the “not so legal” gaming market in China is worth around RMB 1tn (c. $160bn) i.e. the majority of gaming is kept off books currently. To illustrate the magnitude, assuming that 5% of this moves to the legal side of things that’s 16% growth yoy. The government is spearheading efforts by going after these operators, enhancing the choice of games and increasing official payout ratios to attract more players.

In terms of the big picture, 57% of the lottery sales is related to welfare and 43% to sports lottery. The most popular game is computer ticket game (CTG, or the traditional lottery tickets) both in welfare and sports. These make up 68% of the total sales. The remaining consists of video lottery, single match sports games (SMG) and scratch cards.

CTG is the bread and butter and sales grew 20% p.a., most notably due to the introduction of high frequency games (i.e. draws happening daily or intra-daily). Scratch card sales declined since 2012 partly due to capacity constrained card printers and lack of new games. Capacity is expected to be limited through 2014, however this segment, while the most flexible, is still facing challenges vs CTG and online based games. SMG grew 50% p.a. since 2009 mostly supported by the introduction of new games and sports gambling will be one of the key driving force going forward. VLT is perhaps the closest to casino gaming (i.e. similar to a slot machine, potential for addiction etc), thus has the highest potential for regulatory changes. Indeed between 2008-2009 the MoF ceased operations to strengthen regulation

Source: 2013 Chinese lottery sales breakdown. Ministry of Finance

Looking at the distribution of economics in the sector (depending of different games) 50-69% of the sales are paid out to the players, 18-35% paid to the domestic lottery funds, 3-5% to cover costs of operating the lottery centres. The remaining 6-10% is allocated to lottery game and other service providers. The majority of service agreements between the government and lottery operators are for a 5-year period on average and based on an element of revenue sharing.

Internet lottery
Perhaps, the most important catalyst of the Chinese lottery market is moving online and to mobile as internet penetration increases and e-shopping becomes more widely accepted. In 2013, online sales made up around 5% of total lottery sales in China.

There are many specialised sites that operate online lottery such as 500.com (listed on the NASDAQ, currently the target of Muddy Waters) or Okooo (60% owned by RexLot). Besides the specialised sites, portals such as Taobao and Baidu also started offering games due to the increasing popularity. The key benefit for the specialised site operators is that they already have existing relationships with the government authorities and customers whereas the platforms do not have the operations set up with the lottery stores/government (they currently use RexLot’s or other competitors' systems on which the companies charge commission – the beauty of being a toll road owner…).

Now, the online lottery market is currently in a nascent stage and as such regulation is key. Operators have to meet certain regulations (registered capital, risk management etc) before they can be granted approval. The MoF is currently developing the regulation for the market. There is pilot regulation in place for sports lottery and of the private operators only 500.com has one.

The ministry is expected to issue licenses going forward to move online sales from this grey area, however this will take time (most have expected this to occur before the World Cup). The MoF is expected to give licenses to 2-3 operators per province.

For now to circumvent the fact that there are no licenses operators are moving to mobile, where regulation is relatively more lax. Furthermore, while online lottery sales do exist the back-end is linked to traditional paper-based lottery in co-operation with the provincial lottery centres but the aim is to move fully online.

I’ll not hammer on about the increase in Chinese consumer spending and how the government is pushing for this rebalancing (it’s all over the news). Growth in disposable income has slowed recently and while certainly there will be bumps in the road, in the long-term there is a positive tailwind from the structural change in the economy. It is worth noting that lottery sales are highly correlated with disposable income. Historically, the minimum face value lottery bets were RMB 2, thus geared towards the blue-collar market. With the increase in the sophistications of the games and platforms (mobile and internet gaming) the addressable market will certainly be growing.

Lottery market summary
To summarise (i) lottery will continue to be an important driver of raising money for welfare/sports spending, (ii) with the deeper penetration of mobile/internet the distribution channels are increasing as well as the number of games, (iii) government is clamping down on casinos/junket operators. While Macau is certainly more exciting than buying a lottery ticket, we can expect some migration of gaming RMBs to the legalised market, especially in sports betting. While growth rates historically have been 20-25%+ p.a., I’m expecting it to slow to around 10% p.a. in the mid to long-term (simply law of large numbers and penetration).

The company is listed in Hong Kong and established a good track record in the Chinese lottery business mostly via M&A. RexLot has developed a vertically integrated lottery operation, with a very strong presence in the country and relations with the government. It is the clear market leader in a number of segments (e.g. welfare lottery) and well positioned to be a beneficiary of the currently nascent internet lottery market.

RexLot has the ability to distribute its games via their partners’ POS, lottery stores and increasingly mobile/internet. It is currently the largest lottery company in China. Barriers to entry are quite high, as operations require approval from the government (e.g. as noted above for internet operations), not to mention the existing customer base.

From 2009 sales grew from HK$1.2bn to HK$2.2bn in 2013 while net income grew from HK$0.4bn to HK$0.9bn. The company operates in two segments (i) System & Games Development and (ii) Distribution & Marketing. SGDB (essentially upstream) contributed 45% of revenue while DMB (downstream) makes up 65% in 2013.

Source: Key milestones. Company

Source: RexLot sales breakdown (2013). Company

Looking at the economics for the key segments: Welfare CTG, POS distribution, Internet and Mobile.

RexLot provides Welfare CTG systems (machines, system connections etc) to lottery centres in 17 provinces in China for a share of the revenue based on a 5-year contract on avg. This share has been as high as 1.8% back in 2010 but was lowered to 1% recently. The government is pushing down these rates and recently one of RexLot’s competitors agreed a rate at 0.65%. This is a huge drop in economics. In 2013, this market was worth c. HK$165bn, of which RexLot captured around 50%. Assuming a 1% rate on it gets you to HK$826m in sales, while lowering it to 0.65% results in a loss of c. HK$290m. This segment’s avg. EBITDA margin is between 70-75%.

RexLot’s POS distribution has an estimated market share of 30-35% with about 80k POS nationwide. On average the company has a 2.5% share of revenue with EBITDA margins of 70-75%. Retail channels include PetroChina, China Post etc as well as supermarkets and grocery stores.

RexLot owns 60% of Okooo.com, which it bought for c. HK$0.7bn (amongst other assets in a package deal) in 2011 and plans to buy the remaining portion as well (more on this below). This segment is about 20% of sales.

Lastly, mobile makes up 15% of revenues. Historically, SMS (text message) was the key driver, however as smartphones are becoming the norm this is migrating to the electronic lottery platform. EBITDA margin in this segment is between 60-70% and the company has c. 20m subscribers currently.

The company is controlled by Victor Chan (CEO of the company; finance and M&A background) who owns c. 14% and there are a few funds that own 5-10% positions.

Financials and valuation
The current share price is HK$0.8 market cap is HK$9.3bn while EV HK$8.7bn (company has been net cash since 2011). The company trades at 8x PE and 5x EBITDA, historically the multiples are 8.5x and 5.5x, respectively, which is quite modest for a company with leading market share.

As noted above the margins are high given the nature of the business. Net margin averaged 40% over the last five years. RexLot pays a dividend with a payout ratio of around 30% in 2013, which the company expects to raise to 50% in the mid-term.

The company runs a relatively conservative balance sheet, however to fund growth instead of raising debt they issue equity. In 2011/2012 the company diluted equity holders by about 25% by raising c. HK$1.4bn convertible bonds (maturing in 2016). Despite communication of more favourable shareholder treatment it issued another $1.9bn worth of convertibles in April 2014 (4.5% interest; maturing in 2019). Conversion price is HK$1.41 (vs current price of $HK0.8) resulting in an issuance of 1.3bn shares, assuming full conversion. In the company’s defence both capital raising rounds were for M&A, the most recent for the prospective acquisition of the remaining 40% of Okooo.com that they do not own. Mgmt communicates transaction close in late 2014.

I ran a DCF as I was curious how the market looks at the stock. Via some reverse engineering I think the market is valuing the stock excluding the internet business, which is fair to an extent. An internet business does exist (with the backend tied to the lottery centres), however no official licenses have been granted yet to move fully online. 

My key assumptions are 10% CAGR in Chinese lottery sales growth, reduction of the welfare CTG royalties from the current 1% to 0.5% over time and modest growth in internet and mobile platforms. Based on my assumptions (c. 7% p.a. EBIT/bottom line growth, which I think are pretty conservative) I get to a DCF value of HK$1.2-1.3 per share, excluding the internet business it’s HK$0.8-0.9 per share. There seems to be decent upside, subject to the official license, and even assuming no internet there is some protection on the downside.

  • Absolutely the key risk is changes in policy: e.g. change in the payout structure of contracts, revenue share percentages, regulation around introduction new games etc
  • The online licenses have not been granted, while RexLot operates its internet business as an extension of its SMG business (backend still based on traditional printed paper system). If the company doesn’t get a proper internet license and the government shuts this operation down this could have a substantial impact
  • In terms of macro, lottery spending is correlated with consumer spending and decline in a single year or years can impact revenues
  • Slower penetration of internet and mobile can slow down the rollout of the new games
  • On the company side, mgmt. has a good track record in M&A and growing the business but further potential dilution scares me