Deciphering Cryptologic
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By VPMan
January 30, 2007

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I thought I'd put out this piece, since I almost submitted it to VIC, but held back because I was beat to the punch. I have updated some information from my original DD to keep it up to speed. I also wanted to post this because seldom do I actually contribute anything here, and I started a Fat Pitch board where I'd appreciate anyone chipping in, when they feel they have one of their most compelling ideas.

Cryptologic (NASDAQ CRYP) is a high margin/high return on capital business operating in the Internet Gaming Software Industry. Their customers are carefully selected partners that outsource their Internet Gaming and Poker related software needs to a specialized platform provided by patented Cryptologic software, called Wagerlogic. The barriers to entry and the sustainability of the company are far higher than it may first appear, which should be important to would be investors; since, after all their industry is software and its only use is for Internet gambling which was recently banned by U.S. regulators.

The Competitive Advantage
The barriers to entry and the competitive advantages of Cryptologic reside in the numbers. Over 50+% of the employee base at Cryptologic (roughly 200 employees) work in the Compliance/Research and Development departments. It makes little financial sense for their key customers to insource these necessities due to the cost associated with the specialized know-how, the time it'd take them to get to market, the ongoing regulatory and compliance concerns/costs, the likelihood of falling behind with innovative games, and the possible inability of having a large enough platform for players to care.

William Hill (The largest sports book in the UK with a market cap of $4 Billion) recently resigned with Cryptologic for another three years and they have recently signed Betsafe, a Scandinavian company, as a new long term customer. In addition, Playboy will be up and running for the first time on Wagerlogic this upcoming quarter, Q107. These developments demonstrate the value added services of Cryptologic and the strategic use of using Cryptologic as a partner to get up and running in a cost effective, smooth and efficient manner.

In other words, for future customers of Cryptologic, they have much less to lose when they target this business segment by outsourcing to a trusted/experienced company like Crypto. Meanwhile, current customers have little need to leave because it'd likely cost more in house to perform the same functions, and even if it doesn't, by chance, once they're on the Wagerlogic system it'd be a risky bet to transition to another platform as customers become extremely loyal to a trusted site of current branded games, payment system, etc.

Far Less Uncertainty than One Might Guess
While U.S. companies are now prohibited from allowing online wagers, 85% of the rest of the world is already regulated and is growing rapidly. To put this in context, the savvy management team at Cryptologic has been preparing for the Unlawful Internet Gaming Enforcement Act since 2001. In 2001, non-U.S. revenues accounted for 30% of sales while today it's up to 70% of sales. They will likely pass their record sales level achieved in 2006 by late 2008 with non U.S. revenues only (I'm assuming there will never be U.S. revenues again but as the Cryptologic CEO says, "I don't think the debate is over. The benefit of regulating online gaming is overwhelming." So there is, I'd agree, possibly much larger upside to this thesis than there already is -- yet it's already a fat pitch! However you do get the free embedded call option on the potential U.S. changes in regulations but you're probably as tired as me of hearing the words embedded call options).

For now, investing in Cryptologic at this stage is making an international bet and the odds are very favorable: the rest of the world has been outpacing the growth in online gambling over the U.S. in the last several years and Cryptologic is growing right along with it -- and they're seeing some large potential opportunities in emerging markets. According to a recent press release, they recently signed a Memorandum of Understanding with Brilliance Technology Co. and 568 Network to penetrate the high growth, high potential Chinese market, including China, Macau, Taiwan and Hong Kong. This has monstrous potential as these markets make Vegas pale in comparison. Gambling has been an entrenched part of these cultures for a couple thousand years. Even so, this investment isn't about hope, it's about good economics now.

High Returns on Capital/Margin of Safety
A high return on capital business has the potential for disaster if the company can't maintain its high ROC/ROE. However, this is a business in a non-capital intensive industry - software. Plus, Cryptologic has some sticky competitive advantages such as branded games, first to market software launches, sticky products, etc. Should this continue, I'll take a high return on capital business in a non-capital intensive industry with competitive advantages over a low or even high ROC business in a capital intensive business any day. Needless to say, Cryptologic is a Magic Formula stock and as Joel Greenblatt says, if you can normalize earnings out a few years you may be on to good things - especially if it works in your favor.

With a market price of $25, excess capital per share of $10, and projected 2007 EPS of $1.70 that excludes any U.S. revenue, one is paying 8.8x fully loaded this years projected earnings for Cryptologic. 8.8x for a company growing at minimum 15% and more than likely 20+% -- the management's stated goal is 20% growth and they have always sandbagged their numbers or at least have surprised to the upside almost invariably (and remember, the high ROC can compound nicely with future customers scalable software, acquisitions, etc.)!

This is, of course, a simplified snapshot based on EPS. But in Cryptologic's case, EPS is a close approximation to owner's earnings under conservative Cryptologic accounting - they expense everything. Projected earnings aren't for you? Then let's conservatively assume revenue is flat for the year therefore EPS comes in at $1.04 - that's 14.5x EPS net of cash and debt (But there should be at minimal organic growth in a growing market with their current customers, no?). Even with flat revenue and no EPS growth, Cryptologic still positively grows its balance sheet. $10 per share in cash and growing with 90% recurring revenue and the downside is very limited while the upside is at least $40. I estimate a realistic share price of $58 or more with 3% dilution on a 10 year DCF model. Buffett says don't cut it close, you want to be able to drive a truck through your margin of safety. In this case, I believe any way you look at it; you can drive a double wide long-haul Paccar right through it.

A couple of other thoughts
To put companies on equal playing fields, The Magic Formula computes Return on Capital using EBITDA/Net Working Capital. In comparison to many other Magic Formula Stocks, Cryptologic has no debt (which can help whether storms or give the company more options like repurchasing shares, dividend payout, accretive acquisitions, etc.) and are in a 15% foreign tax bracket. Thus, not only can you normalize earnings to come up with a strong margin of safety on realistic assumptions, but with these other statistics it compares even more favorably to the Magic Formula universe on whole.

In my valuation model, I'm also assuming that with over $125 million on the balance sheet that they merely collect interest on it. But with a highly accretive acquisition the IV could get dramatically higher and I think the odds are fairly good. Since the UIGEA the market for online gambling was hit hard with an unexpected bomb which has sent many companies into tailspins, restructurings, and disarray. This is a prime time to be on the prowl. The management at Cryptologic agrees: "Acquisition opportunities have multiplied since the new US law, and the company will continue to evaluate new and existing prospects." Even without any candidates, the stock is ripe for buybacks which would also make a fine capital allocation decision.

Disclaimer: I have a position in Cryptologic and so do my clients. I might buy or sell anytime without notice. This isn't a solicitation to buy or sell stocks. While I believe in this thesis, none of the information may be accurate.

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