GAN Limited: What Investors Need to Know

On this Wildcard Wednesday, host Emily Flippen and Motley Fool analyst Clay Bruning talk about a small, under-the-radar play on digital gaming: GAN Limited (GAN). Find out why this company looks promising, how it's done financially, what some of the risks may be when investing in it, and much more.

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This video was recorded on January 27, 2021.

Emily Flippen: Welcome to Industry Focus. Today is Wednesday, January 27th, and I'm your host, Emily Flippen. Today, I am joined by Motley Fool analyst Clay Bruning, as we talk about an under the radar play on digital gaming, GAN Limited. Clay, welcome to the show.

Clay Bruning: Yeah. Thank you for having me today. I'm excited to chat about GAN here.

Flippen: Yeah. I'm excited to have you on. The reason why I wanted to dive into this business today is actually because I heard you pitched this stock to the team a couple of weeks ago. You're actually part of our newest cohort of analysts in what we call our Analyst Development Program. Part of that role is finding interesting companies, maybe companies that have slipped under the radar for other Motley Fool analysts, and then talking about them with the team. When you brought this company to our attention, I was definitely interested in and hearing more about it, especially because it slides really nicely into this whole sports betting theme. You'll clarify why GAN Limited isn't necessarily a pure-play sports betting stock, but nonetheless, we're hearing a lot of hype and excitement around that industry nowadays. So, it's exciting to talk about a business that's doing a different side of the value proposition. But before we get into how GAN is interesting and how it plays into its entire industry. This is actually your first time on Motley Fool Live here when we're taping as well as Industry Focus. I want to hear just about yourself and about how the Analyst Development Program is going.

Bruning: Yeah. So I've been in the Analyst Development Program about four months now, I started toward the end of October. Really, with only self-taught investment research, and stuff like that. I did studies from finance and accounting in college, but I've really taken advantage of having as much time as I want to really research and dive into companies that I've been interested in. Gaming and gambling has been something of interest the last couple of months, especially as the legalization landscape has changed. Luckily, I've had the autonomy in the program to really jump to any companies that I'm interested in. With that, I've jumped into companies like GAN that I think I have some pretty interesting prospects in the coming months, in the coming years for that matter.

Flippen: It's not the only so-called sin stock that you maybe have dug into a little bit. I'm the lead advisor for our cannabis investing service here at the Fool, and I've heard you talk about a number of different cannabis and cannabis-related businesses, and it's exciting to me to have another analyst here at The Fool who gives these businesses a second look when many investors may have written them off. I think the same thing can be said for gambling, sports betting. That industry, I think a lot of investors have some pretty strong preconceived notions about what investing in it means, and it's fun to break down some of those barriers. So, without any further ado, I've teased what GAN Limited does here. But what can you tell us about just, like, a quick introduction to GAN Limited's business?

Bruning: Sure. So just the way I like to think about GAN is it digitally transforms physical casinos. So maybe you have a casino in your hometown that, in the past, I've always had to go to to play, so blackjack or a sports bet. What GAN does is they enable this digitization. So, I like to think of them as the middleman or the toll booth between the customer or the player of, for example, blackjack, and then the casino. They essentially handle the process and power all of online casinos operations in exchange for a piece of the pie or piece of those profits.

Flippen: It's a really interesting part of the value chain to be in, because when people think about gambling, I think their minds just go to the physical casinos. I know I grew up in North Texas, right there on the border of Oklahoma. The Choctaw Casino was just a quick drive, and that physical aspect of gambling, I think, is where most people's minds go. If they don't go specifically to physical casinos, I think the alternative is to sports betting, especially given, as you mentioned earlier, its legalization landscape. But I know GAN does a little bit of everything. They married the aspects of, OK, integrating what casinos have built in terms of retail, with also a growing landscape for e-gaming.

Bruning: Yeah. They have three main segments that I'll briefly explain. The first is called 'simulating gaming.' So, I like to think of this as GAN's way of getting the foot in the door. Essentially, simulated gaming is usually legalized in the state before they have any type of real money gaming, which is your casino blackjack or sports betting. Essentially, any money that goes into the simulating gaming ecosystem stays in it. For example, if I were to deposit $50 in the simulated gaming account, I am doing that knowing that I can never withdraw. So, you can never actually win money. It's just if you enjoy playing blackjack or Texas hold 'em, whatever it is, you can go in and play with that, and maybe you get up to $300, but you do that knowing you can't actually withdraw any money. Then from there, it steps up to the real money side of things, which is your typical casino. Think blackjack, poker, Texas hold 'em, or sports betting. Maybe you want to bet on who wins the Super Bowl, the coin toss from the Super Bowl, an NBA game, etc. That simulated gaming again is the foot in the door to eventually get into the casino and sports betting side of things.

Flippen: I really like the simulated gaming business because again, going back to breaking down some of the preconceived barriers that people may have about the industry, I think one of them is how predatory gambling can be in general. But the simulated gaming business is actually much more akin to the monetization strategy that we see with games even. When you talk about exciting IPOs, like another Roblox IPOs coming up soon, it's a similar monetization strategy that they take and they target children in particular. These are people who are making purchases with no intent of getting value back out of them. They're making purchases just for the intent of spending what is essentially in-game currency. So, having the opportunity to put, say, $50 into a game for what you know that you're never going to be able to take $50 back out of is not dissimilar to the way that gaming has typically monetized, even without the gambling aspect being involved. When you say it's the foot in the door, it's easy for me to visualize how states and regulatory agencies can start to make that leap. You have everything bent and you go to simulated gaming, a similar monetization policy that we see with games. Then at some point, as we've seen and as I'm sure you'll talk about, we go toward more full sports betting legalization, and that's something that's picked up quite a bit of momentum over the past few months.

Bruning: Absolutely.

Flippen: When you look at GAN's customers, it's hard for me to visualize where they are in the landscape. Are they competing with casinos, or are casinos their customers?

Bruning: Yeah. Casinos are, at least as of right now, strictly their customers. So, they are completely a business-to-business provider. Granted, they have recently been on an acquisition that could give them that optionality to eventually go to the business-to-customer side of things. But they've stated they are not planning to do that to essentially compete with their casino customers, at least for the time being. Then a couple of their notable household name customers are FanDuel, who is their largest customer. Over the last couple of years, they've been pretty significant. Over 40%, 45% of their revenues. They recently, or in 2020, I should say, they signed Wynn to a contract, which was actually kind of a groundbreaking 10-year contract for them to originally start in the Michigan opportunity, which went live last Friday. Then Penn National Gaming and Churchill Downs are a couple of their larger casino clients.

The best part about this, in my mind, is the fact that the CEO is already talking about how they're in discussions or there are expansion opportunities outside of just Michigan as well. One of the main strategies for this company is to understand that and to a such large concentration, and that creates a risk obviously. So, they really want to focus on diversifying away from FanDuel. Like I said, they hired Wynn, Penn National, or they signed, I should say, Wynn, Penn National, and Churchill, all for just the Michigan opportunity and some of those clients started in the simulating gaming side of things. Then they did that step-up contract to the gaming and the sports betting. So, really trying to focus on expanding those relationships and then, of course, bringing on new customers over the long-term as well.

Flippen: I would think one of the critical risks would be as gaming in general becomes a growing industry, we talked about it when we talked about FanDuel and DraftKings, and the risks for those businesses is that casinos make a more concerted effort to go after the digital gaming business, or e-sports, whatever it may be, to try to compete more directly. I wonder if the same risk exists here. I would wonder, as businesses, say, Penn National or Wynn, look to get more deeply entrenched into digital gaming, whether that be sports betting or just simulated gaming, that they eventually realize that they're paying too much to have a third-party do it for them, and they bring it in-house. But one of the things that you just mentioned I want to highlight that mitigates that risk to me is that they signed a 10-year contract just last year with Wynn. I know that's just limited to Michigan, which is not a small opportunity, but it's certainly not, say, the entire United States. But the fact that such a big casino operator is willing to sign a long-dated contract as early as last year, to me, says a lot about the service that GAN provides.

Bruning: Yeah. I think it really speaks to the technology that they have in terms of value-add that they bring. Another thing I really like about GAN is the idea that their performance is directly correlated to that of their clients. It's definitely encouraging, and management was talking about how it was almost unprecedented to hear of a 10-year contract in the gaming business. So, definitely an encouraging sign on my end. We'll see how that progresses and if they can expand that relationship in the coming months and years.

Flippen: Wait. So, you just mentioned that their success is directly tied to the success of their customer. What do you mean by that?

Bruning: Yeah. GAN operates all of their contracts by a revenue sharing agreement. So, I mentioned at the beginning that they are in the toll booth or middleman business. They essentially take a slice of every transaction that is processed on their technology to, say, I go on to FanDuel's website and I place in $100 bet on XYZ; GAN will take about, at least as of the last quarter, they took about a little over 7% of every transaction that is processed on their technology. That percentage does vary based on the customers. But on average, in the third quarter, that was a little over 7%. Again, like I said, this is really encouraging for me, because if their customers, their casinos, realize some value from GAN's technology, GAN will be the direct beneficiary of that value that they bring. It's kind of the idea that the more value GAN brings, the more revenues and profitability they will bring to their casinos, which will directly correlate to their revenue and profitability in the long-term.

Flippen: I love the usage-based revenue model. It was something that I think Fastly, which is a content delivery network -- Fastly got a lot of attention because it essentially provided the back-end services to connect users to servers and access data on the Internet more quickly. But they were essentially getting paid based on how many people were accessing the data that they were allowing to spread. That gives the company unlimited upside, but it also adds a little bit of volatility. You saw in the second half of 2020, Fastly really maybe 'hammered' is a strong word, but it was punished substantially because of its reliance on a single customer, which was ByteDance and TikTok, when they started to face regulatory issues and transition away from the Fastly platform. So, I love the idea that there is a revenue sharing model, which is based on the usage and the number of transactions flowing through the platform. But it does hearken back to what we experienced to Fastly, which is they're highly dependent on one customer, in this case, FanDuel. If anything were to happen with FanDuel or if anything were to happen with the number of transactions that they were able to engage with customers for, GAN would be substantially hurt by that.

Bruning: Yeah, absolutely. That's one of the major risks, obviously, with the business. But as they've added some of these customers that we've been talking about, and then obviously a couple of smaller customers, and hopefully they have a nice little pipeline of customers coming up as more states open up, I think that's one of their main focuses for 2021, is really diversify that revenue stream so they're not so dependent on that FanDuel relationship.

Flippen: To hearken to another example, I promise I'll move on. But it also reminds me of Twilio with Uber. When Twilio came out, they were really reliant on Uber as a customer, and when they lost Uber, it was a big hit to their business. But because they had Uber in the first place, they are able to make substantial inroads with a lot of new customers and it's continued to be an amazing stock to own over the past few years, even without Uber being that dominant customer, simply because they provide such an important integrated service. Now, Twilio's customers are probably much more numerous than GAN's. But still, while it is a substantial risk and I think every listener and investors should be aware of it, there's some benefits that come along with having such a big name brand customer on your platform, especially when that's set up in a revenue sharing agreement. But to move on, I promise I'll get off that soapbox now.

To move on, you talked a little bit about how there are different segments. You said simulated gaming, casino, and e-sports, how they provide those different services, and they really get their foot in with simulated gaming before upselling to different products. But how does revenue break down right now between those three segments?

Bruning: Sure. Casinos are currently the largest portion of their revenues, at about 66% in the third quarter of 2020. Sports was just under 10%, and then simulated gaming was 24%. I do expect this to change a little bit as the industry develops. Simulated gaming, I would expect to increasingly become a smaller percentage of their revenues, because a lot of these states that they operate in or are going to operate in, are going to go from simulated to real money. I would guess that a lot of the players of simulated gaming are only playing because it's illegal to do online real gaming and obviously in COVID, it's a little hard to even find a casino that's open. I would expect casino gaming to increase a little bit, but sports to increasingly be a larger percentage of their revenue breakdown, especially with this recent deal of a company called Coolbet, which is an international sportsbook technology that they recently acquired. I would expect casino gaming to increase and then sports to increase and eat into that simulated gaming revenue stream.

Flippen: Is that a good thing, though? When you look at the margin profile between each of these segments, do you want them to lose their simulated gaming to go to casinos and sports?

Bruning: Yeah, that's a great point, and I do. So, their iGaming segment, which is a combination of sports and casino, gaming is going to have a gross profit margin just under 80%. I think as of the third quarter or the first three quarters of 2020, it was about 78%, and that's up almost 10% from 2019, where it was about 67%, 68%. A substantial increase in their gross profit margin there, versus simulated gaming being around 60% the last two years. Simulated gaming, albeit does have a higher take rate on average, it's not going to bring as much profitability to the company. The iGaming, and again, iGaming is the sports and casino segments combined, is going to have a substantially higher gross profit margin, which in turn will hopefully bring better profitability prospects down the line.

Flippen: I can hear their curmudgeons listening to this podcast right now, saying to themselves, "Sure, this is interesting, but this type of product has been around forever." It's the same thing we heard when we saw these meat alternatives come onto the market and their curmudgeons, much like myself, were like, "Wait a minute, meat alternatives have been available forever. Why are they interesting now?" So I have to ask you, this is clearly an old business. I'll admit it, the landscape is changing a little bit, but why are you interested in GAN Limited today?

Bruning: Yeah. I mean, the inflection point of this industry, in my mind, was May 2018, the Supreme Court overturned some laws regarding sports betting in any state really. Since 2018, there has been a massive shift. I think that almost half of the states in the U.S. have legalized online or sports betting to some extent. Just last week, Virginia and Michigan both went live. There are encouraging signs that New York and Texas are showing promise, which, when you consider just the adult population of those two states, could add a potential of 35 million new betters. Specifically, New York Governor Cuomo, a couple of weeks ago, talked about how New York could be the single largest state in terms of wagers, and this is just a couple of months after he'd been very much so against online betting. You can see how COVID and the tax budget shortfalls and things like that have really put a squeeze into a lot of states, which is a tailwind in and of itself. Then, you have high profile people in Texas, three professional sports owners: Tilman Fertitta, Mark Cuban, and Jerry Jones, are all expected or rumored to support sports betting run, online betting bills in Texas. So just a lot of things pointing in the right direction. Of course, nothing is guaranteed until the bills are signed, but a lot of promise in some of the biggest states across the U.S. GAN, specifically, they're a U.K.-based company, but over the last four or five years, they've completely shifted their focus to the U.S. really after that 2018 paradigm shift in the industry. That's the reason the industry I think is so interesting to research and read about.

Flippen: Now, I know that you have some questions about the management team, and we'll circle back around to that when we get to some of the risks associated with this investment. But I'm interested in their financial performance, because with businesses like this, I feel like I could flip a coin, it's either going to be the highest margin, most profitable business I've ever seen, or they're not going to be able to make a penny to save their life. What can you tell us about their financial history here?

Bruning: Yeah. So, over the last five, six years, pretty staggering growth in terms of the revenue. In 2015, they were at amusedly $6 million or so in revenue on an annual basis. Then you fast forward to 2019, they were just under $30 million annual revenue. Over the last 12 months, they are at $37 million. Again, this is all tied to their revenue sharing agreements, which is linked to gross operator revenues, which I just like to think of as total wagers placed by players. One of the most staggering statistics of their 2020 performance, in just three quarters, is that they've already experienced 31% growth in their total wagers process on their technology, versus all of 2019. I'll say that one more time, just because I think it's a pretty important thing to know about the company. In nine months of 2020, they have 31% growth in gross operator revenues or total wagers process versus the entire fiscal year of 2019.

Again, pretty staggering growth in terms of the specific metric that is correlated to their revenue. That's one really impressive aspect of the business, and then some of their key business metrics are expanding year-over-year. Active player days is one important metric that they talk about, which is just the number of days any player logs on and makes at least one bet in any three of their segments. In the third quarter of 2019, the average player day was 5.4 days. In 2020, it was 7.5. So, about a 40% increase year-over-year. Then average revenue per daily active user, which is total wagers placed divided by that active player days that I just mentioned has grown 30% year-over-year. Clearly, these key business metrics that they are talking about on a quarter-in, quarter-out basis and an annual basis, they're showing pretty encouraging signs.

Flippen: To put the cherry on top there, one of the financial metrics that you noted was that they were profitable in 2019 and they've had three consecutive years of positive operating cash flow. This is not a business that is, I won't say the most profitable business, but it's proving that, because it is so small, it's reaching a certain level of scale that's letting it become profitable, which is definitely what I would want to see at least when looking at this business. But I will take the opportunity, highlighting that $6 million in total revenue in 2015, to remind people that this is a very small business. The market cap, as of the day we're taping it, which is the 27th, is less than $1 billion. So this is a very small business, very risky business. Just keep that in mind as we're talking here. This is an interesting company and we're having it for a conversation, and Clay is obviously a big fan. I even think you're an investor in it, if I'm not mistaken? But just keep that in mind for your own personal situation as we talk. But I won't harp on it too long.

I am curious to know if you think there's anything special about GAN, because the business, the market opportunity is interesting, but it also says to me that maybe this is something that they're either facing a lot of competition or somebody could roll out a very similar product pretty quickly. What do you think is unique and special about GAN as a business?

Bruning: Sure. Obviously, I did an extensive research for my pitch a couple of weeks ago. But the first thing that stood out when just doing a top level financial analysis was they're showing signs of some impressive economy of scale. From 2018 to 2019, revenue has doubled and they were actually able to decrease their cost of goods sold over the same time period. You think about doubling revenues and decreasing the cost of those revenues, that shows pretty encouraging signs of being able to scale their business very efficiently. Then once again, over the last 12 months, they've grown revenues over 20% and again, the cost of goods sold have been able to decrease. That's the first thing that stands out.

Then on the contract side of things, we've talked a decent amount about the simulated gaming side of things. Management mentioned in their earnings call that the simulated gaming contracts typically have a right of first refusal clause. This means that, say, when, for example, if they only signed a one-year contract for simulated gaming, if Michigan, when they went live Friday, GAN would be the first company that has the opportunity to sign Wynn on for additional business. Wynn has to negotiate with GAN or specifically reject their proposal before they can go to any other clients. I think this is a really impressive contract that they have that, like I said, simulated gaming gets their foot in the door, and it gives them the first chance to win that additional business and expand their relationship to the more profitable and meaningful iGaming, which is, again, the casino and sports betting side of things.

Flippen: I was just going to ask about if there's anything special about this business versus their competitors because that's all great. But I still happen to think, look, if I'm Penn National, what's preventing me from literally creating the same product internally and just rolling with that?

Bruning: Yeah. Again, I'd go with what they've been able to build in about 20 years of operations on the technology side of things. They have a couple of different technologies that they roll out or license to operators. The one that really stands out to me is their iBridge patented technology. As the name alluded to, iBridge is a way to connect a physical casino loyalty program to a digital casino loyalty program. Again, one of the quotes that management said that really has just imprinted itself in my brain is the fact that 7% of all casino players are going to generate 80% of an operator's revenue overtime. You have 7% of these what I would consider high lifetime value players, who are going to generate 80% of an operator's revenue over time.

Not only does GAN provide that bridge between the physical and online footprint, but they also have analytics and that's cost analytics or real-time analytics. If you think about a company like Wynn when, at the expiration of their 10-year contract, when they have 10 years of player data, they have all this information to help focus and hone in on those high lifetime market players, I think that brings a substantial competitive edge for Wynn. They really understand their players. They're going to focus their marketing efforts on those high lifetime players. I think that's something that sets themselves apart in terms of being a sticky product that if you leave, you're about to lose 10 years or however many years of customer transactional data, wagering data, whatever it is, which I think is based on that 7%. High lifetime value customers is a pretty substantial asset to lose if you want to transfer your business either internally or to a competitor.

Flippen: Okay, you win. [laughs] You've convinced me. When you think about this investment, obviously you're personally invested in it and you like the business. But what's a thesis-breaker to you? What do you think are the principal risks with going out and buying GAN today?

Bruning: Yeah. I mean, we've talked about it. Obviously, the customer concentration is the thing that really stands out. Over the last few years, FanDuel has been 45% or more of annual revenues. Along those lines, if they were to migrate to an internal or competitor, that could materially affect them. Actually, in 2020, FanDuel did discontinue some of their business. So, FanDuel was using some of their sports betting wallet technology. Albeit this migration away from GAN, GAN sports betting was built in the contract, so it's not like GAN was blindsided by this. This was discontinued in the middle of the third quarter in 2020 and represented 10% of all GAN's revenues in 2019. That's a material loss of business for GAN there. But on the encouraging side of things, in the third quarter, GAN still increased revenues 56% year-over-year. It did take a big hit there, but it's encouraging to see that they still grew those revenues pretty substantially year-over-year.

Then the other one is management and the board. I definitely have some questions about the CEO, Dermot Smurfit. He's been with the company or been involved since the early 2000s. He was the COO for a couple years. In 2010, he became the CEO and he's been the CEO for a while, but he has two other family members that are tied to the business. His first cousin is on the board and, in my opinion, there's no reason for him to be on the board. I suspect he was an early investor in the early 2000s, which is why he has that board seat, but nothing on his background or his experience really gives me any comfort for why he's on the board. I hope in the coming quarters or years that he's replaced with someone with more industry experience. Then, his uncle is on the board as well and actually owns about 10% of the business. So, just a lot of family ties that I need to dig deeper in and try to get more information on. Those are counted as three things that stand out to me in terms of some risks that could cause some adverse effects for GAN's performance over the next couple of years.

Flippen: Yeah. I'm surprised his family is so close. If I had a family that named me Dermot Smurfit, I'm not sure I'd want them on my board. [laughs] I'm joking, I'm joking. But those are good risks to note. I love when analysts dig into management, especially board, because it's not something we spend a lot of time talking about, especially in a short podcast like Industry Focus. But it is really important. These are the people who hold management accountable, management makes a long-term strategy, and ultimately determines the value that average investors get out of the business. So, I appreciate that due diligence. I want to wrap up with a single question here. It's unfair, it's totally selfish of me, but my curiosity is piqued. Now I have to ask it. I'm stealing a play for Mac Greer's playbook and I'm going to ask you the desert island question. Pretend you're on a desert island and you can only pick one of these industries to invest in. Are you interested more in digital gaming or cannabis?

Bruning: That's a tough one. I'd probably lean toward digital gaming right now, just because of, in my opinion, the glut, especially in the U.S., of potential investments. Whereas digital gaming, it's kind of FanDuel, MGM, soon to be Caesars as they merge with William Hill. Then you have a very niche amount or some niche providers of the technology behind it like GAN and Kambi is one that specializes in sports gaming. So, I think it's a little harder to find those sure things or what you think to be sure thing winners in cannabis versus digital gaming. So, I think I'd have a little bit more high conviction in terms of stock picking in the digital gaming side of things.

Bruning: Well, it's been nice to have you on, Clay. You'll never be back, because I hated your answer. No, I'm joking. That's fair enough. I go cannabis, I have to. But I can see how both these industries have a lot of the same issues when it comes to regulatory policy. So, I thought it was a fair question. But in all seriousness, thank you so much for joining me. I realize this is not just your first time taping for Industry Focus, but you're doing it in front of around a thousand people right now live and I appreciate you being willing to jump into the Motley Fool fire and join me today.

Bruning: Absolutely. It was a pleasure and I appreciate you inviting me on here.

Flippen: Listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out to say 'Hi,' feel free to shoot us an email at [email protected] or tweet at us @MFIndustryFocus. As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for his work behind the screen today. For Clay Bruning, I'm Emily Flippen. Thanks for listening and Fool on!