Chit Chat Stocks - Evolution AB: A Misunderstood High Quality Stock, With Speedwell Research (Ticker: EVO)

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Starting point is 00:00:42 Welcome to Chit Chat Stocks. On this show, hosts Ryan Henderson and Brett Schaefer analyze businesses and riff on the world of investing. As a quick reminder, Chit Chat Stocks is a CCM Media Group podcast. Anything discussed on Chitchat Stocks by Ryan, Brett, or any other podcast guest is not formal advice or recommendation. Now, please enjoy this episode. Welcome into Chitchat Stocks. This is our Wednesday episode, and we have another guest to come talk about a stock today. It's a recurring guest, Drew from Speedwell Research, which does comprehensive research reports on public companies go check them out speedwell research.com i believe drew that's right well yep drew welcome to the show we're talking evolution

Starting point is 00:01:32 evolution ab for anyone that's never heard of this company because the name doesn't really um it's one of those names that is just doesn't really say much so you have to kind of learn what the company is itself the ticker is evo if anyone that's listening wants to look it up What is Evolution? What does it offer customers? And what are the basics of its business model? Yeah, yeah, absolutely. So Evolution, as it used to be known as Evolution Gaming, they dropped the gaming, so it's even harder now to guess what they do. They are a live casino supplier. And you have no idea what that means if you're unfamiliar with the online gambling world. But the basic idea there is that you go online,

Starting point is 00:02:11 you're able to gamble on various casino games. And very often, it's not actually the website themselves that is producing those games, but it's usually a supplier. And Evolution is a supplier primarily of what is called live casino. So these are games where there's a physical dealer in a physical location with the table design, the background design to look just like a casino. They work on all sorts of different elements of it involved in where the camera positioning is, overlaying a really nice digital UI. So you could bet in a way that seems very normal. There's a chat function and all that. And so that is their primary business. It's called Live Casino. Again, this is a physical dealer in a physical location that is being streamed digitally.

Starting point is 00:02:54 And I'll leave it there and then we can move on to some other aspects. Can we get into... I guess, I think that covers most of it. There's the live gaming and there is 15% of revenue has changed now. What is it? The RNG? Yeah, RNG. That's right. And so this is a much smaller portion of their business. They got into what's called RNG. That stands for random number games or random number generators because these games are digital games. And so in contrast to the live casino business, these are fully digital games. And the underlying mechanism behind them is a random number generator. And they got into this business a few years ago. They made several acquisitions. This is a more commoditized sort of business because it really is just dealing with creating a digital game. And you don't have to worry about having physical people, physical dealers, and all of the complexity that that involves that we could get into. And that is 15% of their business today.

Starting point is 00:03:51 we're probably going to get into more about it, but generally speaking, it's been not a great business for them. And then very recently it kind of inflected up. So it was low single digits doing zero to 2% growth for the past several quarters. And they kept telling people we'll improve it to high single digits. And just in this last quarter, it got to 8% growth. And just to kind of get your bearings here, overall evolution right now is doing about $2 billion in revenues, $1.1 to $1.2 billion in earnings and overall growth is about 15%. And so if RNG is only growing about 8%, then that of course implies that live casino is growing a little bit faster, which they are around 16%, 17%. All right. What are the main costs? I guess maybe for anyone that's listening,

Starting point is 00:04:37 that's unclear on what the unit economics are of this business. Is it the essentially labor you have in the casinos, quote unquote, the ones that you're live streaming, and then the payouts they have to the casinos themselves that they're partnering with? Or are there any other costs? Because they have some profit margins that are really quite impressive. Yeah, yeah, absolutely. And so what Brett's referring to there is that they generate in excess of 60% EBIT margins. And of course, these are phenomenal margins for any business. And so they have some of the best of margins of a casino coupled with an online digital platform. And so their cost involved there, I guess we should first back up and just say how they make

Starting point is 00:05:21 money. And very generally, the way it works is that they take 8% to 15% commission rates off of what's known as GGR, gross gambling revenue. And they'll take that commission rate. These are negotiated contracts. So it's different for every player. It's somewhat opaque. And this will also get into some of the competitive advantages they have. The fact that They do have leverage over the operators and we should get into that. But keep it simple, 8% to 15%. There's some other ways they make money. They charge monthly fees, fees for customization. Sometimes there's a betting fee too, which seems a little bit less popular now. That portion of revenue they're taking, the main cost involved in that are studios,

Starting point is 00:06:00 people, everything involved in security, the digital platforms. Security costs are going up because we're going to talk a little bit about the cyber attacks that they experienced recently. and those i would say are the primary things and then of course on when you're uh moving down from gross profits you got all sorts of things like r&d they spend a lot on developing new games keeping them exciting and uh also a lot on you know just uh snm as well less marketing directly to consumers but it's uh the sales force and the upkeep involved in uh keeping all their operators happy as well as uh you know the contracts and all that and with aggregators uh those relationships which aggregators is something else we should get into. Evolution is a complex business with a lot

Starting point is 00:06:39 of aspects going on. Yeah. There's a whole bunch of questions I want to ask about the competitive landscape, but I guess, can you give any important history to the business? Is there any relevant history today that investors should know about? And then we're going to talk maybe about the recent history and what's happened to the valuation and anything that's caused that, but I guess maybe start with big picture, how this business was developed to begin with. Sure. Big picture history that's important is Evolution pioneered live casino. And so they were the first one into this industry. They had a very high market share right off the bat as a result of it. Very early on, there was a second competitor called Playtech that's basically been

Starting point is 00:07:22 nipping at their heels the whole time. However, their primary competitive response has been to copy them. And so they've never been able to lead ahead. They've always fumbled in execution. And so they've really taken the reign. Because of these very lofty profit margins, 60% plus, they've attracted a ton of competition into the live casino area. So there's a lot of competitors. They had a slide a couple of years ago at one of the conferences, and it was in excess of 40. And they said, we're not even sure that we know all these. However, there's really primarily only two competitors you really have to worry about. Playtech, which I mentioned. Another one's pragmatic, which is coming up to a lesser extent. There's micro gaming and vivo gaming, but those

Starting point is 00:08:00 are smaller players there. In terms of other history that you should keep in mind is that a lot of the complaints and sort of fears or risks that people have around evolution have existed for most, if not all of their history. How are they going to continue to keep these margins? I think they charge too high of a commission rate. All of these things have been levied against them as a criticism for a very long time, except if you fully understand their competitive advantages, which we should get into, you understand that these are not new and they do have some formidable moats that are pretty hard to overcome. The second thing that I think is worth mentioning is that we're going to probably talk a little bit about the fact that 60% of

Starting point is 00:08:37 revenues come from these unregulated markets, gray markets, black markets. And this again is another fear that has existed for all their history. Three years back in 2021, they had a big short report that came out against them. They had other short sellers that came out against them since then, they all kind of recycle the same claims, which is that downstream, there's a lot of downstream, there's some illegal activity going on, and somehow the revenues end up being recorded back to evolution. And so we should talk more specific about what all that means and how that happens, because the details there are very important.

Starting point is 00:09:14 But I would say that those two things are kind of the important history on the competition front, people fearing that their margin is going to get compressed, their take rate is going to get compressed. And then on the other side, people fearing that the black market and gray market issues are going to somehow come to fruition in a different way than they did historically. All right. Yeah. And for context for listeners, we're going to talk about competition next, but then the regulation, the black markets, and we'll talk about the recent cyber attack stuff that they talked about a lot in the conference calls in the next section. And it's interesting because this is, at its core, it seems like a simple business where you build these games, you make games that people want to play, and then you license it out and take your take rate. But there is a lot of, as you mentioned, moving parts with this business. And we asked questions on Twitter for, you know, what were people interested in hearing about from someone like yourself that has researched thoroughly evolution?

Starting point is 00:10:10 And a lot of people have, as you mentioned, the same concerns that they had a long time ago. There's concerns about the competition, but then there's also concerns about the customers themselves taking the technology, quote unquote, in-house and just doing this themselves. How does evolution keep a customer from going in-house and why do these casinos stick with them? Yeah. So there's kind of two ways to answer that. one way to answer that is we could talk about all of the complexities of trying to copy what they've built out. The second way we could answer that question where I want to start is just thinking of incentives. And so very generally, if you think you are an operator, and so just to

Starting point is 00:10:50 clarify, the gaming operator is the one who hosts games on their websites, and they're responsible for attracting players who play and embed on their websites. If that is the position you are in, what you want is as many games as possible to offer your customers so that you have all of the options all of the most popular games and so a customer never leaves because there's a better game or a game they want to play elsewhere that's if you're an operator if you're a supplier very clearly you want to just sell to as many operators as possible you're it's the same game once you make it once you want to sell it to as many people as possible and of course you want to get a fair exchange of on your take rate and all that but you want the game to be widely distributed

Starting point is 00:11:28 because there's a lot of leverage on these. Okay. So right there, you could juxtapose two opposing interests. Because if you pretend you're MGM, for example, if you want to in-house this, you say, okay, we have a good brand. We have a betting app. We're going to do live casino, MGM live casino. And we're not going to use any partners. We're going to in-house the whole thing. Immediately, what you're stuck with is the fact that you have to rebuild something that someone else entirely already rebuilt. And then you also are going to have a smaller pool of customers to amortize that cost over. Because if you're looking at the suppliers and the operators, the supplier side of MGM is going to say, well, can we sell to other operators

Starting point is 00:12:08 besides MGM operations, besides our in-house operation? And then a house operation is going to say no, because we want proprietary games that no one else has. That is going to make them less profitable. On the operator side, they're going to say, well, Evolution has this really popular game called Crazy Time, and they also have Monopoly, and everyone wants to play this game, and they're leaving our app because we don't have these games. Can we add them to our operation side? And MGM Supply is going to say, no, you made us exclusive to be together. And the reason why we're exclusive is because we want to drive people to our own games because we're not charged for those. And so we monetize them at a much better rate. And right there, you have these two interests

Starting point is 00:12:44 that are opposing. And so that's just philosophically why it's very hard. And just to kind of better contextualize what they're fighting for here, a lot of these operators are public. So we have a sense of their margins. Maybe they have 10% EBITDA margins on the low end to 25%, maybe 30% on the higher end. And that math comes out to 100% reduction in the gross gaming revenue commission is going to be about a 4% to 10% boost EBIT. And some of these suppliers are... Evolution is charging them 10 points. And so you can imagine if you're eliminating that 10 points of commission, and that's all flowing through the bottom line, that is extremely material to them. And everyone is aware of this.

Starting point is 00:13:26 And so then the question and the reason why I was talking about history, why everyone's trying to fight for evolution's margin, everyone's aware of this. The fact remains, though, that you cannot just disappear evolution because evolution at the end of the day, very simply put, has games that everyone wants to play. They have the best games, period. And if you have evolution's games on your... If an operator has evolution's games on their platform, the players play for longer and they bet more.

Starting point is 00:13:51 So you make more money. And so if you say, I'm not going to carry Evolutions games, I'm going to go in-house, a lot of your players are going to leave. They're going to follow whoever carries Evolutions games because the operators are by and large commoditized. There's a lot of different ways you can play. All sorts of different promotions people are throwing out all the time to try to get new players. And then you're just stuck with the fact that you have fewer games. You have less people playing your games. You may be more profitable on a per-play basis, But overall, your revenue is now shrinking.

Starting point is 00:14:20 So I guess the incentive from the operators to take this in-house would potentially be cost savings. But I guess, do you think it actually saves them on costs to take this in-house to get rid of the evolution commission? Or does it ultimately end up being more costly to operate something like this? And can I add in? yeah has anyone done it yet has anyone done it before people have tried um i'm forgetting the exact name of the casino group there was one i have the name in our evolution report it was based out of um southeast asia it was a gambling company that actually acquired a live casino provider and then ultimately they realized this business wasn't going to work and so

Starting point is 00:15:07 they ended up closing it down or selling it off i have more details in the report i can't remember the specifics offhand. But yes, that is kind of the issue there. And then to your question, Ryan, on the cost involved in it, I imagine a lot of people think it's going to be a lot easier on the outset. And once they start embarking on it, they realize how hard it is because a lot of the games Evolution does provide are regular kind of blackjack games, these regular card games. And so a lot of the casino operators think, well, why don't we just do those? Those have to be easy enough to do. And what they don't realize is that one, it's actually a lot harder in terms of execution to do that. There's a lot of subtleties in getting this right from having

Starting point is 00:15:47 the right video camera angles. It's like a whole TV production aspect to it too, where you're changing the video angles at the right time, go to Twitch, go to YouTube. If you do not get the video angles right correctly, people will be screaming at their screens that you need to zoom in, you need to zoom out, whatever it is. They want everything to be perfect and Evolution got this perfectly. And so they're used or habituated to those sorts of games. And so there's a lot of small aspects involved in it. You have to train a lot of people. A lot of people quit. So you have to have a whole academy to train them. And it's not just about training people to be dealers. They also have to be TV presenters at the same time and know how to navigate chat. A lot of

Starting point is 00:16:22 times, too, they have to have abilities to talk in different languages because you want to localize the audience, different uniforms and all sorts of different aspects involved in that. So it is a lot more complicated, even doing the quote-unquote easy stuff. However, what they do find is that if they do want to just copy the easy stuff, then Evolution says, great, if you are not going to carry all of our other games, we will give you nothing. And their game shows in specific, this was a whole category they created, are extremely popular. And so that is a wedge they could use as leverage over these providers that say, oh, well, we're not going to use you for everything. We just want to use you for non-Blackjack games. It won't work. On top of

Starting point is 00:17:00 that evolution has its own franchise versions of classic games and so they have something called the lightning uh franchise so they have lightning roulette lightning blackjack they basically just change what the betting amounts are they add in some multipliers and stuff uh and everyone's try to copy them playtech try to copy them with quantum uh roulette uh pragmatic had their own version of it too and theirs is still the best and the most popular version and so it's it's hard because even if you are saying okay we're going to do regular blackjack well people want to play uh uh lightning blackjack not regular blackjack and so all of these issues is the reason why people after they start researching this process they end up just outsourcing it to evolution

Starting point is 00:17:37 how much of i don't know if you have a number on it but how much of like engagement comes from evolution games that are unique to evolution as opposed to just like common blackjacks the stuff that a lot of the suppliers have um yeah i don't have figures on on that i will say that if there's instances of operators who eliminate evolution uh as a supplier from their site and they find that their revenues do plummet as a result because customers leave and chase the evolution games and it's not just because of the special game show games and you could prove this yourself by going to twitch or youtube and seeing and just googling or watching people play these games, they yell at the screen sometimes when it's not an evolution

Starting point is 00:18:26 game. There's issues with Playtex games, just the regular blackjack game where the bet button was cut off on an Android version. And so it's not just having the game and all that. It has to be cross-device across multiple different operating systems. It has to always work. The bets have to be synchronized with the video. All of that is very hard to do in practice and evolution just does it right. And you can imagine if you're betting a lot of money and the game you're playing messes it up, you've probably churned forever. You're probably just done with them. And I'm not saying evolution never makes mistakes, but their competitors by and large make a lot more. Yeah, it makes sense. It's a lot harder to do this, especially because it's live streamed.

Starting point is 00:19:04 I think people at first glance give them credit for. One thing that might be easier, but maybe you can correct me if I'm wrong here, are these RNG games, the digital slots, the random number generator games that are almost closer to mobile games i would say uh that you mentioned that we always saw accelerating revenue growth last last quarter um it's getting more profitable what happened there and what's the opportunity within this business and what maybe also why are they going after these yeah so you're right um with with your thinking that it is a more commoditized business because it is a lot easier to just spin up these digital slots a lot of times It's a very similar backend gaming mechanism and they just put a new skin on it and they'll get IP for all sorts of different games and they'll come up with IP sometimes so they could have a gangster version of slots, a Hollywood version of slots, a soccer version of slots, everything.

Starting point is 00:19:57 And so it's whatever you want for the backend, it's very simple to do. And so it's very easy to spin up hundreds of difference of these games every single month and then whatever is the most popular wins. And so it is a much more competitive market. And Evolution doesn't really have the same sort of competitive advantages there or dominance. What they've done differently and what I mean, so they've acquired several slot providers, a lot of the most popular ones. One of them was big time gaming. They had a popular back end mechanism called Megaways, and they still license that to the competitors. But aside from acquiring a bunch of these slots, one of the biggest things that they've done more recently is called OSS or one stop shop. And this was originally rolled out for their live casino games. And the idea is that instead, because they've acquired different businesses over time, and instead of having all these different integrations on the back end, there'd be one single integration on the back end, and the operator would get everything. On top of that, once someone clicked into an Evolution game, and then they backed out into the lobby, they wouldn't back out into the operator's lobby, they back out into Evolution's lobby. And so now Evolution has that player in their lobby, and they could say, why don't you play this game, this game, this game, they'll use AI-led recommendations to try to keep them there. And of course, it all looks nice, and it works pretty well. And so that improved player engagement a lot. And then they rolled that out to slots. And that's what helped improve their revenue a lot.

Starting point is 00:21:22 So now if a player clicks any evolution slot game, they're not backing out to being suggested across all potential slots. They're now only being suggested other evolution slots and they have to back out again to get to the normal lobby. And so just having that extra screen has really helped them a lot, get more opportunities for player engagement. And so that's a big piece of it. Of course, they're still innovating on the games and they talk about some of the games they rolled out. But I think that's one of the bigger pieces. and that's because well they have negotiating leverage with these operators and they say hey we want to add this in here to target our own games or am i thinking about it wrong

Starting point is 00:21:56 i think it's two things i think they can honestly say since they acquired so many different slot providers they could say that oh this is a lot easier just use this one integration instead of maybe using like four or six integrations on the back end and the operator then is saying oh well I am getting a lot of slots with just this one integration. That's a lot easier than having to do all these different integrations. So there is some benefit to them there. But you're right too, it is the leverage where they could say, you're taking everything of ours or you're taking nothing. Or if you only want to take certain things, then we're going to raise the commission rate on you. Let's talk about some of the, I guess, end markets here. I guess, just for context,

Starting point is 00:22:39 What are the biggest markets for evolution? Maybe we can go one by one and just kind of break down if there's any unique challenges slash market share dynamics in any certain one, or is it kind of they're the leader across all their markets they operate in? Yeah, there's definitely a distinction across geographies. So as of about a year ago, a year and a half ago, Asia became the biggest market. Now, that is continuing to be their biggest market and their highest growth market. Growth slowed this most recent quarter because of the cyber attacks that we mentioned recently. We should touch back to that. But right now, it's growing 17% year-over-year. The quarter before is growing 22%. Their second biggest market right now is Europe. Pretty close

Starting point is 00:23:25 in size right now, but growing slower. They did about 11% year-over-year there. And then North America, a much smaller market, less than half the size, but a lot of growth potential there. More states are going to legalize. A lot of states are still ramping up. Even if they become legal in a state, that doesn't mean every game they have is approved. So over time, more games will be approved. They also have to open up new studios and open up game shows within each of those studios to roll those games out because of the Wire Act doesn't allow you to have the same game played across state lines. And so because of that, growth is a little lumpy and it's been slower, but it inflected up this last quarter. It was 8% last quarter. This quarter was 18%. And so that was pretty positive to see. I would expect that to continue to be very lumpy, but long term, a lot of potential there. And then you have Latin America. This is another longer term promising market. In 2025, Brazil is

Starting point is 00:24:21 going to regulate. They just opened up their second studio there in Colombia. This is going to be a studio that services most of South America. They're kind of prepping for Brazil to open up. And on top of that, it does have some flex capacity for the rest of the world there. And so that's kind of big picture, what you're looking at the markets. If you're thinking in terms of regulated versus unregulated markets. Just to give a one-on-one on that, there's basically three categories. There's white markets, gray markets, black markets. White markets is it's regulated and legal. Gray markets is there's no regulation in either way, illegal or legal to gamble. They've just never said anything about it. It's usually still being debated. They're

Starting point is 00:24:59 deciding if they want the tax revenues or don't want the negative potential societal implications. And then black markets is it's explicitly illegal. And so just generally speaking, 40% of their revenues are in regulated markets, which means 60% of the revenues are from unregulated markets, which will be gray or black markets, or we can more politely call them pre-regulated markets. And that is where a lot of the fears and risks come up. And we should touch on that in a second. I just want to say on the market share point that you had, Europe, they probably have around 60%, 70% market share. Playtech's a lot bigger there, but they've been seeding recently. And there's a lot of other competitors that are pretty active in Europe. In North America, I'm going to estimate probably around 90% plus. They were the first and only player there for a couple of years. since then. Playtech opened up the studio. Pragmatic is opening up the studio.

Starting point is 00:25:56 But for all the reasons they succeed, you would expect market share to maybe go down a little bit, but still generally stay pretty high. And then also I'll just say on market share too, on the RNG point in North America specifically, a lot of new providers are coming in as well. So they lost market share in North America on RNG, but they also said it was the first quarter that they actually grow net. So you could potentially see market share continue to fall as the market gets bigger, but they're going to continue to grow. And then Latin America, I really don't have good data on and similar with Asia because of the aggregators. So when they launch into a new market, is there a reason that it sounds like they usually launch

Starting point is 00:26:38 studios in those markets? Is there a reason that it has to be local or can they have all of their studios back in, I don't know, where they're headquartered, maybe Stockholm? Yeah, like Malta or Riga, Latvia. They have a lot there originally. It's all going to be based off of the particular realities of the law in that country. And so in the US, there's the Wire Act, which means that you're not allowed to transmit money across state lines, which requires the gambling operation to be in-house. if you're looking at a small state like uh i believe it was new hampshire or maybe not new hampshire it was uh rhode island in west virginia i think they had an agreement uh they had some sort of uh memorandum of understanding where uh they didn't have to create their own studio in rhode island to service them they were allowed to use the one and uh i'm forgetting the exact state but the point being there that they have to negotiate these things it's all very much

Starting point is 00:27:32 regulatorily driven. They would love for all the studios to be in one area and service everything, but that usually doesn't work that way. On top of that, though, there's also the language element. A lot of times people would prefer to bet with someone who speaks their local language. And so that is part of the impetus too. They're opening up a studio in the Philippines, which we can touch on, and another one in the Czech Republic. And so generally speaking, they used to run them all at Malta and Latvia, and then they just started expanding elsewhere. Part of that's just for flex capacity, employee diversification, language requirements, but part of that's also regulatorily driven. All right, listeners, if you're a regular

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Starting point is 00:28:56 notes. Listen up, folks. Time could be running out to lock in a 6% or higher yield at public.com. But you can lock in a 6% or higher yield with a bond account, but your yield isn't locked in until the time of purchase. So you might want to act fast. Lock in a 6% or higher yield with a diversified portfolio of high yield and investment grade corporate bonds only at public.com forward slash chit chat stocks yeah i have a question on and we'll hit kind of the labor aspect and the union dispute that they're they're having and we can talk about the new studios along uh with that but i want to hit these cyber attacks the way i heard it described it makes it seem like it's almost an illegal stream like with one of those sports streams

Starting point is 00:29:46 that is very popular for various sports in North America, probably globally. Is that what's happening? And how does that even work? And what can they do to mitigate it? Is this just going to be a permanent problem? Yeah. I think that's generally correct the way you depict it. So the way the business works in Asia is that they provide their games to aggregators. These aggregators then serve basically as a sales force to sell it to different operators. and so there's one layer in between that the operators then are the ones who show the games to the players and what's happening is basically someone is able to hack into this this game they're able to live cast the stream onto another site and then they get players to bet on the game

Starting point is 00:30:30 even though it's really evolutions games and the bets they're collecting are not going to evolution and so that is uh essentially what's happening in terms of the way they're handling that they didn't talk much about it they just said they found some solutions and it's going to take a quarter or two to work out, but they seem confident they would return that area to growth. But that was weighing on Asia growth. And so in Asia too, it's important to know that a lot of the operators are operating illegally, if not semi-illegally. And so a lot of times they're going in and out of business. It's a shadier market, generally speaking. And so it's also possible a lot of the consumers are used to that. And so if someone is saying, seems a little shady,

Starting point is 00:31:12 maybe they're a little used to that in terms of receptivity to betting online there do you think there's any potential repercussions for evolution if they are a provider for some of these i guess you can call them uh black market businesses um like is there any chance that the local governments there just say you know basically frown upon evolution in any way where it hurts them long term? Yeah, I mean, they can frown. Not to dismiss the concern, at the end of the day, it's just very hard to regulate anything that's really happening on the internet. And so even if you look to China that has its own internet, basically, people are still able to get onto the social media websites, which are illegal there for a Chinese consumer to go on Facebook,

Starting point is 00:32:03 for example. It's illegal for them to do that, but they're still able to get around it. essentially the impetus lies on the person and what they're willing to do to get around it. And people in Asia currently, just to set the frame, it's basically illegal everywhere in Southeast Asia, except for the Philippines to gamble online. And so there's something called POGOs or these Philippine Offshore Gaming Operators. There's a bunch of them and they service all of this different business outside of there. It's legal for them to operate in the Philippines. But then the consumers will either VPN, spoof their address, use cash sometimes, however they have to do it, crypto, to illegally gamble because they really want to do it.

Starting point is 00:32:44 And so they're the ones that are getting around all of the rules and requirements in order to do so. And so, yes, a local government will frown on that and they may not like it. But to the extent they can crack down on it, they've been cracking down on it. And so, as I mentioned, a lot of these operators are going out of business all the time, and then they're popping back up somewhere else. And if it's someone just getting in to a website on a VPN on their phone, that's generally pretty hard to crack down on. It seems almost similar to the sports betting in the United States where you have some of these states like the one that Ryan and I lives in. It's not legal here except at certain casinos. You can't just download something on a mobile app.

Starting point is 00:33:25 But for the people that really want to bet, they can find those offshore betting sites. My question, I think, is from an investing perspective, are you looking for or are you expecting regulation to open up, I guess, especially in the United States? And is that a tailwind for the business? Because I know that when sports gambling gets fully legal in some states, the amount of people that bet is higher just because that friction is reduced. Yeah. The way to think about regulation is that you either want no regulation or you want

Starting point is 00:33:56 good regulation. The preference would be for good regulation. But if the regulation is going to be bad, then evolution is going to be hurt the worst. And so we have an example of this too, actually. In Germany and the UK, they changed the online gambling regulations. In Germany, they set a monthly deposit limit to something like 1000 euros. So you can imagine these sorts of businesses really take advantage of the fact that there's a few big whales. And now if you're a big whale, and you used to bet a million a month or whatever, $100,000 a month, and now you are limited, that is going to disproportionately impact their

Starting point is 00:34:31 business. And Evolution, as a publicly regulated entity, is always staying to the letter of the law. And so when this happens, they have to, and since in Germany in specific, they work directly with the operators and they do their own diligence on them. If an operator is not operating legally, they cannot provide them the game because they could be responsible for that. And so they're having to stick to the letter of the law, whereas some other operators may say, regulations are ridiculous. I'm going to skirt them. I'm going to operate illegally, but I'm going to allow people to deposit as much as they want a month. And something similar happened in the UK with how much you could place on a per bet. And so that hurt them because it was bad

Starting point is 00:35:11 regulation. People bet less and then some people just bet illegally instead. That's not good for the countries or the nationalities because the sovereignty is because now they're collecting less in revenues, tax revenues. And so it's kind of a lose-lose because it's not like it's stopping people from betting anyway. And so that is what the real concern there is. If you were to say that we're going to make gambling illegal in these countries like Europe, where they do operate directly with the operator, that could be problematic. There's no push to do that whatsoever. These countries like their tax revenues, but that would be the risk there. However, in Asia, it's a different story because you do have these aggregators they're working through. And so

Starting point is 00:35:50 The difference there is that they're not responsible for the ultimate KYC, know your customer, they're not touching any money or getting it directly from the customers. All that's happening is they do diligence on the aggregator. The aggregator says they're following the rules and all that, and then they're selling the game to the game operator. So the analogy there is it's kind of like if you were to sell a roulette table to a casino. Once you sell that roulette table to the casino, you're not responsible for monitoring how the roulette table is used. Okay, I might be jumping the gun here, but if I look at Evolutions Financials, and I'll give a quick shout out to FinChat for making this easy, 47% revenue cagger basically over the last decade. The margins are some of the highest I've ever seen among companies at this scale, 60% plus EBIT margins, as you mentioned, Drew, earlier in the show.

Starting point is 00:36:47 And the earnings multiple has come down to – well, it's collapsed pretty quickly over the last, I guess, three years to mid-teens. So it feels kind of like maybe too good to be true, I guess. So what do you see as the, I guess, risks here is – or maybe what do you think investors are concerned about? Is it just the overall exposure to Asia as its primary market or is there anything else? I think a lot of times when a stock price drops, people try to attribute reasons to the narrative to why it is that it dropped so much. And I think to some extent, this is very much a case of that because people are trying to scramble to figure out why that is. They're saying, oh, well, you know, the Asia business is unregulated. That could be an issue. Maybe growth is dropping there.

Starting point is 00:37:38 They're saying, oh, well, what if something happens in Europe? You get more taxes. Oh, maybe North America growth is slowing. Oh, and there's competition from Playtech and Pragmatic. And you could continue along that line of thinking. And I'm glad we had that question on the history up front, because this is nothing new for them, really. And so in terms of those risks, I don't really know, because you would need multiple things to happen all in a row in order for there to really be a material risk to evolution. I think the one single thing that could be the most problematic is if, for some reasons, the Philippines decided to go the opposite way and make gambling illegal. That could be problematic because a lot of the Asia businesses run from there. Having said that, they're building a studio there now, just showing how much they trust the regulatory environment there.

Starting point is 00:38:26 And from the Philippines perspective, they're getting a lot of tax revenue. And so I'm not sure why they would do that. But there are things like that that could happen that could be problematic. I think just generally speaking, as maybe some of your listeners have figured out, this is kind of a confusing business. It's simple, but there's a lot of aspects to it. And I think there's a lot of people just kind of punted and say, I'm not sure. I heard something about black markets. I'm out. I don't think this company will ever get a multiple. Oh, growth slowing. I don't know what to think about that. Which is why, by the way, our podcast we did, the deep dive on evolution on the synopsis, was over 2 hours long. It's because

Starting point is 00:39:03 there are all of these different elements to the business, really a lot to get into there. And a report was like 80 some pages. And so I hate having to attribute reasons to a stock price move, so I'm not going to. Yeah. And I agree that that black market stuff, hearing that, I get kind of turned away from it. And what I like having you come on the show is that you do research that is not just looking at, you know, the stock chart or the financials you can get and anyone can look at. And one thing that's potentially concerning the company, at least this is what analysts were talking about on the conference call, is the labor dispute in Georgia. Now, the labor around the tables is probably one of the most important stakeholders

Starting point is 00:39:48 in the business. And this is Georgia, the country. I actually got confused for a couple minutes reading that without knowing where it was i thought it was the state and i was like i thought this company was in europe but yeah it is the country i gotta say that's an interesting choice for a place to have this but maybe there's a reason they they put a lot of the labor there what happened how could this impact the business because the reports i was reading i heard it actually got semi-violent some fights and stuff but i don't know what is this impact could this impact the business? And maybe this is all really one question, but can the profit margins come down because labor sees that they can get higher wages? Yeah, it could impact the business and it did

Starting point is 00:40:31 impact the business. So generally speaking, what you're talking about is there's one of their studios in Georgia. This is one of their largest studios. It has 7,000 to 8,000 employees. And so you're talking about a lot of dealers, a lot of games going through. A lot of times, if it wasn't clear before, the gaming operator will customize the tables and the uniforms of the player and all sorts of aspects of the game. So it's not like you could just very easily switch the feed from Georgia to Latvia to Malta. It is very often customized for that particular location. And so that's an issue there too. So you have a studio with 7,000 to 8,000 people. What happened in mid-July was about 550 of them decided to go on strike. They're all

Starting point is 00:41:10 union-associated employees. And so keep in mind that's a minority of employees that were going on strike. And that was fine until they started getting a little violent around August, in particular towards employees that just wanted to get to work. There was reports of them trying to close doors, vandalizing graffiti, throwing stuff at people. And it was at that point that they really made a material change to the way Georgia was going to be run. They fired a bunch of people. They did not cede to the demands at the time. And so instead, they just downsized the studio. Now it's going to permanently run at 60% capacity.

Starting point is 00:41:46 They moved a lot of the activity that was going through Georgia to their other studios. Luckily, they did have some flex capacity. And so they're going to be building out more studios basically elsewhere to take over that. And for now, they say the situation in Georgia is stable. In terms of weight on margins and all that, Of course, if you're going from 100% capacity to 60%, yeah, you're going to see some operating deleverage there. As the other studios build up, some of that will be offset. But if you're saying, are they going to have some minor hit to profitability? It certainly seems likely.

Starting point is 00:42:21 I don't know how to actually calculate exactly what that number would be, but it's really probably not going to be that material longer term. Yeah, it makes sense. And hey, 60% profit margins, given where the stock's trading at, given what their growth prospects are, that wouldn't be perhaps the end of the world. Yeah. Actually, sorry. I want to say one thing on that, which was that if you rewind like a decade and a half ago, they were saying, okay, we think we could get mature margins of around 35%. And everyone was a little skeptical, but they're like, okay, in theory, you could do that. And then they hit 40, 45, 50, 55. Now they're at 60 plus. And I feel like people are kind of losing a little perspective that if you

Starting point is 00:43:01 have a business that's doing 60% plus margins, it's a little crazy to then kind of critique them for slight margin compression on something that's generally out of their control. And so if you can keep or maintain anywhere near that level, that is already very impressive in and of itself. You don't need to necessarily hit 65. Yeah. And even with that, it seems like only a small amount of the employees actually were upset. So I guess I didn't even realize that when I was reading about it. Only 500 of them. Let's move to capital allocation. This is one that they're at an interesting point of their business lifecycle because they've been proven to be fantastic at growing revenue and generating profits. I mean, 47%

Starting point is 00:43:45 revenue. CAGR since 2014 in euros, that's highly impressive. Very few companies can match that. However, they're now entering a, I'd say, transition where they're going to have a lot of excess cash that they can choose what to do with. I guess they can return it to shareholders, they can reinvest in new businesses, they can acquire businesses. And this is a very important time for any business because there's maybe some managers, some founders, some executives are not perfect at, you know, if they're good at growing a business, maybe they're not good at capital returns and optimizing that. What is your assessment following this business for a while now on how intelligent management is on capital returns and this important part to the equation.

Starting point is 00:44:52 or just find reports on companies we've already heard of. Try it for yourself. Simply go to joinyellowbrick.com slash chitchat and search a company or ticker you are interested in. You are bound to find a great report on just about any company. That's joinyellowbrick.com slash chitchat. Yeah. I think the one thing I would critique them for was an acquisition a few years ago for a large slot provider called NetEn where they use stock to purchase it. But since then, they've been using a lot more cash and also earnouts. And so you may have noticed from this quarterly press release that they had a reversal of an earnout contingent liability, how much was going to be owed. And so it showed up as a gain. They basically adjusted that out and ignored that. The point there being, though, that they are getting a little smarter with these acquisitions and they're fine posting a high price, but it's going to be contingent on the business actually performing. And so that is something you would want to see in terms of capital allocation. I think one of my biggest issues with Evolution is a policy that was set, and this was set a long time ago, and I think has to do in part with the particularities of being a European company, is that they do have a set goal of doing a 50% plus dividend payout ratio. And so I would like to see them do away with that and be more flexible with the capital returns.

Starting point is 00:46:09 However, if you're looking back in 2021, 2022, they did these very small trivial buybacks in 2023, November for the first time, they authorized a 400 million euro buyback. So now you're getting a little bit larger. And year to date, they did about, I think it was 680 million in buybacks. It's a different number than in the financials. You have to read what they said on the call because they did a little bit more after they reported. And they still have another half a billing and cash on the valid sheet. And so they are shifting a lot more of excess cash flows to buybacks, which is what you would want to see. I would want to see them get rid of the dividend, but that's probably never going to happen. And then in terms of acquisitions, they have been

Starting point is 00:46:47 pretty savvy on that lately. A lot of them are really small too. They did an acquisition of something called Arcade Gaming, I believe. That was only 2.5 million euros. So pretty small in that respect. And then in terms of CapEx requirements going up, they are a little bit, But this is all on their studio build-outs globally, and they'll continue to add those. They have over 20 studios now. And we looked at ROIC in the report and all that, and you're looking at very high ROICs. Incremental ROIC last year we ran it was about 80%. And so you really don't have fears there on them spending CapEx.

Starting point is 00:47:19 In fact, you want them to spend as much CapEx as possible. Okay. I think that kind of leads to our closing questions because we've hit on pretty much or you've hit on pretty much everything about the business. So I guess, what are the metrics, two or three metrics that you are closely tracking to see evolution's progress? In terms of financial metrics, you don't really have to worry about margin. It's going to bob around a little bit, but that's not going to be a game changer.

Starting point is 00:47:53 It's probably just top line revenue growth and in particular, looking at the markets. I would say it's more a qualitative thing I would look for, which is what's happening on the competitive front. Maybe should we just run through their competitive advantages really quick and why I said that? Yeah. Yeah. Let's wrap things up with kind of bring it all together. Big takeaways investors should have. Sure. Yeah. So if you think about trying to compete about evolution and it ultimately all starts with their studio build-outs. And so not only do they now have 20 plus global studio build-outs, which requires all of the expertise of building out an individual casino studio with the design sets, the tables, the customization, it also requires

Starting point is 00:48:33 hiring thousands of employees in a year. And on top of that, a lot of employees turn, a lot of them are part-time students. And so you have to be able to hire about a thousand plus employees a month. In order to do that though, they need to have their own academy. And so Evolution has their own academy that trains people, that allows them to be dealers at a very high rate because there is a very high rate of return. On top of that, the employees themselves need to be able to speak multiple languages. They have to be able to schedule them in different uniforms and different times globally. And on top of all of that, you also have this whole security apparatus layered on top of it. And so if you're thinking about what's happening with the cyber attacks in Asia,

Starting point is 00:49:07 even before that, there are security issues where when you're sitting at home, you're able to do anything you can on the computer to try to cheat and no one can really catch you. And so a lot of operators and suppliers have had issues in the past where they didn't realize all these small sort of security aspects they layered into the game, which prevents these neural nets from being able to estimate where, for example, the crazy game show time wheel is going to land. And so all sorts of different little aspects like that. On top of that, you have everything involved in making sure that dice are not loaded, cards are not fixed when you're running a casino. And so there are all these aspects that play into it. And that is just on the operational front.

Starting point is 00:49:43 Now we get to the actual games. And the game development and design itself, it's led by Todd Hochalter. He's been known as the Steve Jobs of the industry. He created the game show category. they have not only very popular games, they have their own franchise games. And so I mentioned the Lightning franchise earlier. They have all sorts of game shows. These are the most popular games to play. Players play Evolution games more than any other game. They like that it's flawlessly run and executed. And all of that really adds a lot to the player experience. And so if you're trying to copy them, you try to copy their franchises, which would seem like a very poor facsimile of the real thing. On top of that, they have One Stop Shop, as I mentioned, which is an integration of

Starting point is 00:50:21 all their games that go in together. It makes it a lot easier for suppliers. But on top of that, there's also a promotion aspect to it too, where now it's a lot easier for them to know that if a player is about to churn because they lost three games, they could offer them a free spin, a free slot game, whatever it is, and that'll allow them to stay on the platform even longer. And you can't do that unless you have this kind of integration and all the data on the backend. On top of all that, then we just get to the licensings, the regulations, dealing with all these different regulators on a global basis, having the history of knowing that you're going to do all this well and execute well. And then with all that kind of said,

Starting point is 00:50:56 it all comes back ultimately to what players want and who is really delivering the best player experience. And without a doubt, that is evolution today. Some competitors have come kind of close with some of the games they're offering, but the whole holistic experience and who has the most popular games, the games that players play the most and are most engaged with, it's still evolution. And so as long as that continues to be the case, they're going to continue to have leverage over their suppliers. And so that is why they're able to continue to maintain this, call it 10% to 12% average commission rate when some competitors could come in much cheaper, maybe five points cheaper. It's because they deliver all of this together. And if you want to compete against them,

Starting point is 00:51:34 you can't compete on just one aspect. You have to be able to do it all. You have to deal with the fact that some hours are going to have a lot more activity than other hours. So you need the flex capacity. You have to deal with the fact that you may very quickly need to move activity from one studio to another because there is something like a strike. There's all these different elements that go on in this and being able to run your operation with almost flawlessly 99.99% of the time, all that is very important to operators. And ultimately, as I was saying before, it comes down to the player and the operators are kind of this commoditized layer, if you will. They all fight to try to win players over with different promotions and all that. But

Starting point is 00:52:08 the loyalty really lies with the games they're actually playing and Evolution tends to have the best games. All right. That's a fantastic summation. We're talking the stock. This is what I want to close out with. I'm seeing today, let's say, depending on what earnings ratio you're using, let's say it's around 15 times earnings. I know you can't do a reverse DCF live, but But what sort of figures would someone need to look for for the stock, say, to work from here? And I don't know what the definition of work is. Maybe that's 10% returns, 15% annual returns. What sort of numbers should investors expect for this thing to be a successful investment? Yeah. I'm a little higher on my normalized earnings because the tax rate did go up. And

Starting point is 00:52:58 so I'm a little closer to 18 times. But that aside, ultimately, it's going to come down to the return that an investor acquires. And what we do in our report is we sensitize around various growth rates. We just did this in an update. And you can see under what we did was an 8% to 17% growth rate range. And then we showed what the associated returns would be with that. And you could see in a lot of the scenarios, it is higher than what the stock market has returned historically. And so you could say that's your equity risk premium there for an individual stock. I am always a little dodgy around answering these sorts of valuation questions, but you can look at the table there and see the assumptions you're comfortable with and whether or not

Starting point is 00:53:38 the returns associated with that make sense for you given the inherent risk that you perceive in an evolution investment. And given where the stock price has gone over the last couple of years and what the business has done, the expectations have definitely come down compared to 2021. I think that's going to do it for this episode. For anyone interested, we will include the link to, I think, either the Speedwell research website or the specific Evolution Gaming stuff. Either way, the website is easy to navigate and you can find the Evolution reports and

Starting point is 00:54:09 updates on the website. If you're an analyst, I'll give a quick pitch. Anyone working in a professional investing capacity, they are well worth the research if this is a company that you are interested in. There's other companies out there. We've covered Coupang before, I should say, up 65% this year. not that we're... We focus on the long term, but that's not a bad outcome from the beginning of this year. But as we close out, Drew, where can investors find you as we end this episode?

Starting point is 00:54:37 Yeah. All of our free writings, business memos, some novel ideas there. You could go to speedwellmemos.com. Everything there is free. For our paid research, go to speedwellresearch.com. And if you want to listen to our podcast, which includes a two-hour episode on evolution, as well as a recent Evolution update. A lot of other business content, go to just search the synopsis in Spotify or any of your podcast players. And then we're on Twitter too

Starting point is 00:55:02 is speedwellresearch underscore LLC. If you do all four, I'll love you. Yeah, beautiful. Everyone, all listeners do that. If you got to this point in the episode, you'll be definitely interested in Evolution. So at least check them out. But yeah, let's hit the disclosure

Starting point is 00:55:16 before we get out of here. We are not financial advisors. Anything we say on this show is not formal advice or recommendation. Ryan, I, or any podcast guests may hold securities discussed in this podcast, may have held them in the past and may buy, sell, or hold them in the future.

Starting point is 00:55:30 Thank you everyone for listening to this episode and we'll see you next time. Until next time.

Chit Chat Stocks - Evolution AB: A Misunderstood High Quality Stock, With Speedwell Research (Ticker: EVO)

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