Evolution AB: Leading the iGaming Revolution

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Overview

Mr. Market is notorious for trend chasing. Whether it be 3D printing, cryptocurrency, NFTs, virtual reality, or artificial intelligence, there is no shortage of investors looking to get rich quick by simply trying to ride trends, often predicated on a new technology. Besides the ludicrous valuations that often come with chasing these trends, there is a complete disregard for the (potential) economic value, or lack thereof, in these types of companies. That is why I found it baffling when I found Evolution AB (Evolution) - a clear market leader in the extremely fast growing iGaming industry, with jaw-dropping growth, economics, and competitive advantages. Based in Sweden, Evolution provides a suite of Live Casino and Random Number Games (RNG) solutions to the iGaming, or online gambling, industry. Think of them as the industry’s arms dealer, agnostic as to who the winners will be on the consumer side. With a dominant competitive position in a quickly expanding market, with seemingly indefinite room for growth, Evolution is set to prosper from this trend for many years to come. 

iGaming Market

Though gambling as a whole is largely a worldwide phenomenon, the iGaming market is less than one third the size of the land-based casino market. While the industry as a whole is expected to continue to grow at a low single digits rate over a very long period of time, iGaming is set to continue to take share as it has been for many years now. As in many other industries, physical interactions moving progressively and continuously towards online experiences is all but ordained - it's simply the direction the world is moving. iGaming in particular is set to benefit from this trend. As the gambling industry becomes more prominent with new markets being opened by regulators around the globe, iGaming is the natural beneficiary as these new markets do not have the physical infrastructure in place. In addition, there are benefits to both consumers and casino operators. The consumer benefit is largely inherent, with a value proposition similar to many other industries - ease of access from anywhere (within legal limits), at any time, at a lower cost. Whether it be Las Vegas, Atlantic City, or Macau, gambling trips are often expensive and time consuming. iGaming removes much of this friction. The case is similar on the casino side. By giving customers more access with less costs, casino operators increase the accessibility of consumers. There are a couple of other less obvious benefits as well. The first is table size. While at an in-person casino the games are limited by physical constraints, iGaming allows for many times the number of players at any given game at any given time. The other benefit to casinos is the ability to better control the odds. You don’t need to be a math whiz to figure out that by further stacking the odds in their favor casino operators are able to make more money with the same base of players. 

Business

• Live Casino 

  • Live Casino is an immersive online experience based around card games. While there are different forms that are implemented by the different casino operators, at its core Live Casino involves a live dealer in an Evolution studio conducting games and dealing cards to the various customers at the table. 

  • While in the context of the broader market it accounts for about a quarter of the iGaming revenue, Live Casino is where Evolution makes the bulk of its money. In its 2022 fiscal year Live Casino accounted for 81.6% of the company’s revenue. In this arena Evolution is unmatched. They are absolutely dominant, and competitive threats are minimal at most.

• Random Number Games (RNG)

  • RNG is all the other types of casino games, and makes up the last 18.4% of Evolution’s revenue. Slots, roulette, and other games of a similar ilk fall into this category, which is triple the size of the Live Casino market.

  • Evolution has a large presence in the RNG market through its acquisitions of NetEnt, Red Tiger, No Limit City, Ezugi, and Big Time Gaming. Still, the company has been losing ground on this front. Over the last couple of years Evolution has struggled to release new games that takeoff with consumers, largely relying on a backlog of older games to generate revenue. In this time, their market share has eroded, with industry insiders saying they are spread thin, causing the quality of its games to go down. As management makes very clear, they intend to lean into this market, and certainly have the scale and balance sheet to do so.

• One Stop Shop (OSS)

  • Though not its own operating segment, as it folds into the others, Evolution’s OSS is going to become an increasingly important part of the business over time. As we will discuss later, the iGaming industry has many barriers to entry, particularly for a company without scale. OSS provides a platform for sub-scale players to quickly, and cheaply go to market. This makes Evolution an industry gatekeeper, turning potential competitors into partners. 

Moats

As can be seen by the spectacular numbers, which we will touch on in the next section, Evolution is one of the most competitively advantaged businesses I have everseen. CEO Martin Carlesund is not shy about his ambitions of wanting to build the world’s best company - and he may be on track to do so. The following are the competitive advantages currently benefiting the company:

• Economies of scale 

  • Evolution offers hundreds of games running twenty-four hours a day seven days a week. This simply can’t be matched by smaller operators with smaller budgets. 

  • Its immense scale also allows it to continue to reinvest into the business at a rate others cannot. This has played out in the Live Casino business and I expect the same will occur on the RNG side over time. 

• Intellectual property

  • Evolution has more than 120 proprietary games. This is essential as these games drive customer loyalty making it harder for casino operators to remove. If a popular game is removed from a casino, consumers can quickly switch to another operator who offers the same game. In other words, customers are more loyal to Evolution’s proprietary games than they are the operator that provides them.

• Network effects

  • Tying into its intellectual property, popular proprietary games come with network effects that benefit Evolution from both a consumer and operator perspective. From the consumer perspective, as people start to see their friends all playing a game they will follow, creating a hobby amongst social networks built around this intellectual property. In a similar vein, as a game becomes popular with consumers, more casinos are likely to add that game in order to attract customers. 

• Preferred seller status

  • This is the inverse of Berkshire Hathaway’s preferred buyer status. The iGaming industry is highly regulated leading to a lot of potential missteps in execution that could be costly to operators. Evolution has best in class regulatory understanding and compliance. Even if Evolution were to take a misstep, as the old saying goes, “Nobody ever fired for buying IBM.”

• Regulatory

  • Folding into the preferred seller status advantage, Evolution is a major beneficiary of the highly-regulated iGaming market. Understanding, execution, and trust amongst regulators make it harder for a new or smaller entrant to try and eat Evolution’s lunch. 

• High switching costs

  • Like many other tech companies, switching costs create stickier relationships. For Evolution this comes to fruition in a few forms. With the cost needed to set up and train employees on a new system, as well as upfront fees paid at the start of contracts, the most economic decision is almost always to stay with Evolution. On top of this, Evolution tends to sign multi-year contracts with high break fees, making it highly unlikely that these contracts will be terminated before their maturity. 

• Distribution 

  • Due to its large install base, Evolution is able to quickly, and cheaply get new products out to a large number of casinos, and therefore consumers. This distribution network is unmatched in the industry.

• Gatekeeper 

  • We discussed Evolution’s OSS before but it’s worth touching on again. OSS is the easiest way for newer, smaller operators to bypass the other barriers and quickly go to market with a product. This makes competitors into customers and partners.  

• Long-term mentality

  • Though not an actual part of the business I believe this is essential to the company’s success. Its co-founders, Chairman of the Board Jens Von Bahr and Director Fredrik Österberg, own 10.4% of the company and are heavily involved in mapping out the long-term vision. In addition, CEO Martin Carlesund has been at the company for seven years, with seemingly no intention of stepping down any time soon. In conjunction, these figures allow the business to make decisions that will continue to grow their moats and competitive position over time. 

Valuation

By just about any valuation metric Evolution is far from cheap. It currently trades at a P/B of 7.2x, EV/S of 16.8x, EV/EBITDA of 24.3x, EV/EBIT of 27.0x, and an EV/FCF of 29.1x. In just about any situation this becomes an automatic pass for me, or at least falls into the too hard pile. With Evolution this changed when I saw the eye-catching economics and business performance. Over the last 10 years the business has grown revenue at a compound annual growth rate (CAGR) of 43.7%, earnings per share at a CAGR of 51.4%, and free cash flow at a CAGR of 51.4%. This was all done with a median return on equity of 57.4%, median return on invested capital of 55.3%, median of operating margin of 37.0%, and median free cash flow margin of 31.3% - staggering figures. All of that is a long-winded way of getting to the point that the current valuation is more than justified, even if lofty by convention standards. So where does the upside come from? I believe that this fair multiple on the valuation leaves you with the returns equal to the growth of the company. While I struggle to underwrite growth at its previous torrid pace of more than 55%, I believe that the company can continue to knock out revenue growth above 30%, a number which it has only gone below once in the last eight years, plus greater growth in free cash flow from continued operating leverage and efficiency. 

Summary

Evolution presents an opportunity to get in on one of the most exciting, yet under the radar technology-based trends. Even better, it allows you to do so through a business with almost unbelievable economics and competitive positioning, that will benefit no matter who the big winners are on the consumer facing side of the industry. While you will have to pay up for it, Evolution seems well on its way to achieving its goal of becoming the world’s highest-quality companies.