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.
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).
RexLot
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 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.
Risks
- 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
