Paddy Power Betfair is a difficult nut to crack. There are a lot of things to be excited about with the company, but there’s quite a bit to worry about as well. Great placement in preparation for expanded US sports betting legalization is on the top of the list. Very low leverage is also a big plus. The company is a staple of the gaming industry that returns a hefty amount of cash to shareholders. It isn’t going anywhere any time soon.
But despite Paddy’s merger with Betfair three years ago, the results so far have not been particularly encouraging, especially in regards to capital growth for shareholders. Shares are down about 16% since the merger, not what most, myself included, were expecting when Paddy Power and Betfair first joined forces.
But let’s put the recent underperformance in perspective. Zooming out over the last 5 years, capital growth has really not been an issue at all. Shares are up 150%. Compared to Britain’s FTSE 100, of which Paddy Power Betfair is a part, it’s no contest. Paddy has outperformed the broader FTSE by an astonishing 1000%. It’s hard to really complain about that, but investors always want to know, What have you done for me lately? Since topping in February 2016, bottom line, just dividends and buybacks, which makes you wonder where the stock would be without them.
There is still a good long term bull case for Paddy, but the increasing instability in Europe and the ever-worsening fiscal trainwreck that is the United States puts it in a difficult position over which it has no direct control. Granted, it’s not much different for the competition either, except in one area where Paddy may have a significant balance sheet disadvantage, which I’ll get into in a minute. Just two sentences on the general background here which I have covered many times before. The US is a major positive growth prospect for Paddy, but the US just ballooned its debt by $1.3 trillion as of the close of fiscal year 2018 ended two days ago, and interest rates are climbing again towards 7-year highs. Meanwhile, the Eurozone continues to teeter with Italian 10Y rates at 5-year highs and short term rates at 6-year highs. A hard Brexit looks to be around the corner and the European Central Bank is supposedly pulling the plug on money printing by the end of the year. We are on the verge of something big here. Let’s just leave it at that.
True, none of this has anything to do with Paddy Power Betfair directly and is more a note of caution on equities in general. So why single out Paddy as – let me emphasize possibly – particularly dangerous now, despite the fundamental soundness of the company? Even its debt is thankfully miniscule, so what could possibly be the problem?
The answer is goodwill. It’s enormous. At nearly £3.9B, it totals 71% of its market cap. Most of this is due to the 2015 merger with Betfair. Now, a sound argument can certainly be made that the gargantuan size of its goodwill relative to market cap really just shows how undervalued the shares are. I can’t really say that this is not the case. All I can say is that the ratio warrants a certain amount of caution. It needs to be considered carefully when deciding how much Paddy Power Betfair you want in a gaming investment portfolio, and it needs to be factored in to any assumption about the inherent stability of its stock.
We’ve seen goodwill impairments before that take huge bites out of market cap through no real fault of the companies involved. This was a very big deal in 2008. I did look back at the old pre-merger 2008 and 2009 balance sheets and goodwill impairment was not actually a significant factor for Paddy Power during the financial crisis. Maybe it won’t be this time either, but with an intangible asset like goodwill it’s really hard to tell.
Here’s some perspective on its goodwill to market cap ratio compared to industry peers, some more directly related to Paddy’s markets, some less so.
1) William Hill – 44%
2) Rank Group – 24%
3) The Stars Group – 42.5%
4) MGM – 12.4%
5) Boyd – 26%
6) Churchill Downs – 8.5%
7) 888 – 18%
So yes, 71% is quite heavy, and at the very least it’s a number that should be monitored.
That said, and discounting the broader economic issues, there is plenty to be happy about with Paddy Power Betfair, notwithstanding its poor performance since 2016. Besides its partnership with Boyd that covers 12 states and sets it in a great position to capitalize on eventual US sportsbook growth, there is also its acquisition of FanDuel back in May, further setting it up for US growth.
There is also the fact that what has been hurting the company lately has been taxes and regulations, particularly point-of-consumption taxes and fixed odds betting terminal limits to £2 a round. Despite revenue growth, POC taxes are eating into its profits heavily, especially in Australia, where revenue growth in constant currency for the first half of the year topped 22%. The bad thing about taxes of course, is specifically this. But the good thing is that taxes bring down the competition as well. Taxes and regulations hurt the smallest companies the most, favoring the largest longer term, of which Paddy Power Betfair is definitely one. As long as you can deal with the initial hit, in the long run they don’t mean all that much unless you’re really struggling to make a profit in the first place. Paddy isn’t. As for the FOBT limits, they will eat into between 2-2.6% of group profits by forward estimations, a bad hit but again not one it can’t handle and it hurts the competition just as badly.
Fundamentally and technically, Paddy Power Betfair is healthy and set for growth. We are still 13% above 3-year support levels. Dividends are still decent at 3%. The balance sheet is quite healthy, at least from a debt perspective. It’s just a perilous time right now in the capital markets generally, and investors need to keep this in mind. Of course, if a crisis does hit whether from Brexit or the US or Italy or anything else, Paddy Power Betfair will get through it, and it will be an even more attractive buy.