CryptoLogic Rolls Snake Eyes?

Robert Kennedy purportedly spawned the phrase "may you live in interesting times," but it's online gaming software provider and Hidden Gems recommendation CryptoLogic (Nasdaq: CRYP  ) that lives it. CryptoLogic's fourth-quarter numbers and accompanying conference call tell the story of a company buffeted by a legislative maelstrom. But they also tell of the continuance of a long-term strategy for company success.

Snake eyes
A first glance suggests a fourth-quarter disaster:

(In millions)

Q4 '06 Without Re-org Costs

Q4 '06

Q4 '05*

Growth

2006

2005

Growth

Revenue

$19.0

$19.0

$24.3

(21.8%)

$104.2

$85.5

21.7%

Casino Revenue

$10.0

$10.0

$15.5

(35.9%)

$59.2

$53.0

11.7%

Poker Revenue

$6.7

$6.7

$7.9

(15.8%)

$33.9

$27.0

25.6%

EPS (Diluted)

$0.19

$0.12

$0.45

(72.5%)

$1.81

$1.49

21.0%

EBITDA margin

13.7%

8.0%

30.8%

N/A

26.1%

29.0%

N/A

Net margin

13.7%

9.0%

25.5%

N/A

23.9%

24.2%

N/A

*All 2005 figures reflect on-time Q4 '05 financial adjustments.

Full-year results appear impressive, but they're largely meaningless. The fourth quarter represents the first period following passage of the Unlawful Internet Gambling Enforcement Act (UIGEA), which removed U.S.-based players from the mix. (This was previously responsible for around 30% of CryptoLogic's revenue.) Quarterly results were negatively impacted not only by the UIGEA, but also by the departure of former poker licensee Betfair at the end of October, and by one-time restructuring charges associated with CryptoLogic's relocation of its headquarters to Ireland. Going forward, it's the fourth-quarter number upon which we'll build a base.

Always a strong cash generator, CryptoLogic finished 2006 with $128.4 million in cash ($9.35/share), although $11.9 million has subsequently been spent on an acquisition. Still, even ignoring the Ireland-related reorganization costs, note that a 22% revenue fall in the quarter translated to a 58% drop in earnings per share. That's a powerful reminder that operating leverage cuts both ways. Replacement of that lost revenue, conversely, offers the opportunity for greater profit growth.

Reshuffling the deck
For better or for worse, the UIGEA clarified the situation for prospective U.S. online gamers. Simply put, Americans seeking to scratch their gaming itch will need to find a land-based Ameristar (Nasdaq: ASCA  ) or Harrah's Entertainment (NYSE: HET  ) offering, or go underground to work around the legislation. (And U.S. players who do so may find themselves at sites that do not have CryptoLogic's history of ethical, fair, and responsible gaming.) CryptoLogic's licensees have refused to accept U.S. players since the passage of the UIGEA, as have most of their public company counterparts. And that's not been good for online gaming providers with a heavy U.S.-player focus; they've been crushed (see Partygaming for exhibit A).

But CryptoLogic has been eschewing U.S.-player growth for most of the past five years, focusing on growth in the U.K. and Europe (of course, post-UIGEA, 100% of CryptoLogic's revenue comes from non-U.S. players):

Q3 '06

Q2 '02

Trailing 12-month Revenue (in millions)

$109.3

$39.4

Revenue from non-U.S. Sources

70%

40%



This illustrates the value of a long-term strategy -- following the UIGEA, CryptoLogic was hurt far less than its compatriots -- as well as the options that strategy has imparted to CryptoLogic today.

Options? Roll the bones!
Post-UIGEA, CryptoLogic has been extremely active. New games were rolled out, featuring Marvel Entertainment (NYSE: MVL  ) characters like Ghost Rider (coincidentally also hitting the big screen this weekend). Arguably the largest and most important licensee, William Hill (LSE: WMH  ) , was re-signed to a three-year contract. A non-U.S. Playboy (NYSE: PLA  ) Poker site was launched, as were new poker sites for William Hill (Spain), DTDPoker, and new licensee BetSafe. CryptoLogic also acquired Scandinavian poker room Parbet (and licensed it to a private Maltese operator). Still to come in the first half of 2007 are the launch of a Playboy-branded casino, and poker and casino offerings from its newest licensee, Dutch government-owned Holland Casino.

The Parbet acquisition was CryptoLogic's first in a long time. CEO Lewis Rose discussed acquisition criteria on the conference call (potential acquisitions must complement existing strategy and be immediately accretive). He admitted that the past couple of years have seen asset valuations too high to pique the company's interest. With the UIGEA-induced price implosion, its potential acquisition list is decidedly more "fertile," and that balance-sheet cash hoard may finally be deployed. Ironically, though, the UIGEA may pave the way for U.S.-based operators like MGM Mirage (NYSE: MGM  ) , seeking to expand their brand equity online, to buy U.S.-based player-restricted foreign operators. Such action could be both boon and curse to software providers like CryptoLogic, depending on whether the large players want to bring software design in-house.

But the most interesting wild card announced post-UIGEA may be the joint venture to move into the Asian market, seeking to adapt CryptoLogic's existing suite of games for Asian audiences, as well as to develop online game variants more familiar to citizens of such locales. CryptoLogic's partners come bearing a gaming license from the Chinese Welfare Lottery (the applicable regulatory body), as well as a proprietary payment processing system accepted by both big local banks and by the populace using those banks (payment methods have been an oft-cited barrier to Asian entry). CryptoLogic also talked of the region's current base of Internet users (135 million) and mobile phone subscribers (400 million). That's important, because on seemingly every conference call, management is asked about their thoughts on alternative gaming platforms like mobile handsets, interactive television, etc. And on seemingly every conference call, Rose demurs, saying that they "remain on the nearest branch, looking interested," but no more than that. With specific citing of the opportunities presented by the massive Asian 3G-enabled mobile market, I think CryptoLogic has just taken the first step off that branch.

The Foolish bottom line
Reaction to the quarter has been decidedly negative. But frankly, I consider this a very short-sighted reaction. CryptoLogic has solidified its licensee base, is busily adding new revenue sources (remember the effects of operating leverage), and has moved into two heretofore uncharted areas -- government-partnership monopolies and Asian expansion. And it's done this with a third of the current share price backed with cold, hard cash, and with a 2% dividend paid while shareholders wait for the new revenue sources to come online. Sounds good to me.

For more details on CryptoLogic's fourth quarter, see our Fool by Numbers.

CryptoLogic and Ameristar are Motley Fool Hidden Gems recommendations. You can find out why with a 30-day free trial of the newsletter.

Fool contributor Jim Gillies owns shares of CryptoLogic. He is also short Jul07 $20 CRYP puts and long Jul07 $20 CRYP calls. Playboy is a Rule Breakers selection. Marvel is a Stock Advisor pick. Jim welcomes your feedback. The Fool's disclosure policy is a ramblin', gamblin' disclosure policy.


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