The Yin of CryptoLogic

I come to you today to praise Motley Fool Hidden Gems recommendation CryptoLogic (Nasdaq: CRYP  ) ; for the cynical among you, don't worry, we'll get to the negatives in the next article.

What is there to praise? How about strong quarterly results, reasoned capital deployment, a management team focused on the business, and stellar financials? Couple that with a still-below-market valuation, and you've got (I believe) a worthy addition to your portfolio.

The numbers
CryptoLogic did a great job of spoonfeeding a worried Wall Street exactly what it needed to hear. Revenue and earnings grew strongly (35% and 80% year over year, respectively), exceeding analysts' expectations. Casino growth bounced back from a couple of flat quarters to register 12% year over year in what is traditionally its weakest quarter, while poker grew 89% year over year and accounted for more than 30% of total revenue. International markets continued to provide the bulk of CryptoLogic's revenues (greater than 65%), continuing the international focus the company adopted several years ago in response to the uncertainty of U.S. legislative prohibition efforts.

Focus on the business
Between earnings release dates, CryptoLogic's stock managed to lose half its value -- yet the company remained focused. It announced a new CFO in August and appointed a new British executive to its board. It continued to upgrade its infrastructure, introduced new games, and rolled out new video slots featuring Marvel Entertainment (NYSE: MVL  ) superheroes. The company is in various levels of discussions with six potential new licensees who, to be accepted, must have brand-name recognition, an existing player base, and a marketing commitment and resources.

Going forward, management is preparing for industry change. Big guns Party Gaming and Empire Online are doing the merger dance. Industry consolidation is ongoing as valuations in the online poker and casino space have cooled, and CEO Lewis Rose outlined CryptoLogic's desired acquisition characteristics in the third-quarter conference call. Sounding positively Buffett-esque, Rose stressed that the company would not overpay, and was prepared to wait for the right pitch before swinging; no acquisitions simply for the sake of acquisitions. So what is it seeking? Candidates must either strengthen the core business or accelerate growth in new technology, channels, game areas, or geography. A prospective target must complement CryptoLogic's strategy, must be accretive, and must create long-term value for the company and shareholders.

Meanwhile, full regulation in the United Kingdom is drawing nigh, and CryptoLogic is planning its 2006 compliance spending with that in mind.

How can I miss you if you won't go away?
Betfair
, a U.K.-based online sports-betting firm that has licensed CryptoLogic's poker software for the past two years, has been on the minds of shareholders since last summer. Arguably the only CryptoLogic licensee that has the resources to develop its own in-house poker solution, Betfair has been the subject of much speculation. Betfair is leaving. Betfair might stay. Betfair has extended its contract. There's no shortage of Betfair news. So what do we know for sure?

CryptoLogic took the unusual step (for it) of releasing Betfair's contribution to total revenue: between 5% and 10%. Even assuming the high end of those numbers, a 50% haircut gave calm investors an opportunity for a bargain price. Next, it appears that Betfair's attempt to bring its poker operations in-house have hit a snag. As evidence, I offer two points. First, CryptoLogic was able to agree to a six-month contract extension to continue driving Betfair's poker product, and agreed on an option for a second six-month term that would see CryptoLogic get paid through the end of 2006 even if Betfair leaves mid-year! Second, Betfair is in the process of acquiring another poker client (PokerChamps) as well as a software client; a not-so-promising sign regarding Betfair's timely in-house development.

In short, while I'd prefer to see the Betfair poker contribution remain in CryptoLogic's pocket, given the circumstances, it appears that management arranged a more-than-fair divorce settlement.

So much cash, so little time
CryptoLogic has long been a tremendous cash generator -- a nice problem to have. At the end of 2004, the balance sheet housed $86 million in cash and equivalents. After spending $2.1 million in dividends, $3.3 million on the special investment program, $7.6 million on regular capital spending, and $8.9 million on bargain-priced shares, there remains ... $88.5 million in cash and equivalents year to date. Perhaps it should come as no surprise that management raised the dividend again to $0.28 a share, or 1.3% annually. Those who took the opportunity to buy at the shares' sub-$15 nadir are getting nearly 2% on their money.

The special capital-spending program is nearly complete. This $12.5 million commitment has driven down margins (although they remain healthy) and made short-term free cash flow look lower than it really is. My calculation for trailing-12-month free cash flow (FCF) is $11.9 million. That figure shoots up to $17.1 million when the special spending is excluded.

A quick look at value
Even with the loss of Betfair, CryptoLogic looks like a deal. I'll start with my discounted cash flow model, plugging in 11% annual revenue growth and 10% annual earnings growth (I'm assuming a marginally higher tax rate) for five years, and then immediately going to a terminal 3%. I'm assuming that no new licensees are signed to replace Betfair, and I'm adding higher maintenance capital expenditures, per management guidance. Discounting at 11.5%, adding the cash hoard, and deducting $26 million in value for operating leases and outstanding stock options leaves me with a per-share value of $26. The stock price today is just under $20.

Using a reverse thumbnail (which I've discussed in the past) to estimate expected forward returns (remember, we're already getting 1.3% from the current dividend), we need to see annual FCF growth as shown below:

Desired Annual Return

15.0%

20.0%

25.0%

Price in five years to achieve desired return

$40.15

$49.79

$61.20

Required FCF growth to achieve desired return

16.2%

18.7%

21.2%

But wait. I calculated those numbers using the FCF, which included the spending on the special investment program. Because we could expect this to be a one-time expenditure, what does the table look like using the FCF stripped of that expansion spending?

Desired Annual Return

15.0%

20.0%

25.0%

Required FCF growth to achieve desired return

13.0%

15.1%

17.3%

Are these numbers reasonable? Your call, but know that since 2002, the company has managed annual FCF growth of more than 33%.

Finally, in the original recommendation, analyst Bill Mann said of CryptoLogic: "[The] EV/EBITDA ratio [is] at about 12. Though not brain-dead cheap, it's close." Well, today, that ratio is closer to nine, yet the share price is pretty much dead even with the original recommendation price.

The Foolish bottom line
Even after the recovery from $15 to $20, I still like CryptoLogic at the current price. The business has shown good performance, and management has likely salvaged the Betfair situation as best it could. But that's the plus side; in the next article, I'll highlight what I feel are some pretty big concerns for shareholders.

Yin? Or Yang? You decide. CryptoLogic is aMotley Fool Hidden Gemspick, and you can weigh in with your opinion on the Motley Fool Hidden Gems CryptoLogic discussion board (afree 30-day trialis required). A free trial will also give you access to more than 40 market-beating small-cap investment ideas.

Jim Gillies owns shares of CryptoLogic. He is also short $20 Jan. 2006 CryptoLogic puts and he has a synthetic long position made up of short $17.50 April 2006 puts and long $17.50 April 2006 calls. He's going to need a bigger disclosure section if he keeps this up. Marvel is a Motley Fool Stock Advisor recommendation. The Fool has a strict disclosure policy.


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