GAN Limited (GAN) offers investors exposure to the online betting industry through software as a service (SaaS) angle. This has worked for the company as it continues to enjoy more secular tailwinds. For example, it is driving the growing SaaS market, as well as the ban on online gaming lifted at the end of 2018. In addition, GAN has been a fantastic investment since its IPO due to its favorable timing. As investors, however, we must also think about the price of the asset. Unfortunately, GAN's valuation seems significantly ahead of the underlying fundamentals. Thus, I reckon that the stock is a great company, but not necessarily a good investment at these levels.
Source: company website .
As the COVID-19 pandemic began, the economic downturn forced people to stay at home. This also led to important sports betting being stopped or postponed. Thus, the sports betting market was severely paralyzed. After all, there was a shortage of games for players to play.
Source: GANs investor presentation .
Despite this gloomy environment, GAN managed to continue to increase revenues through Q1 and Q2 in 2020 In my opinion, this type of elasticity is typically drawn on a company with an above average value proposition. I gather that this is primarily due to the fact that GAN is not a direct game in the gaming industry. Instead, it's nice about GAN's business model that it's a B2B company that primarily sells software as a service. This type of business model is usually desirable because it tends to yield high margins after it is scaled up. This is because marginal costs go down for more customers after a turning point.
If we look at GAN's income statement, it is clear that it can maintain relatively high margins. For example, GAN's gross margins are quite excellent. GAN's gross margins on the real money internet ("RMiG") are 81% for 1H 2020. In addition, GAN's simulated gaming segment has 59% gross margins for 1H 2020. However, that is only the positive side of the story. You see for some reason that GAN's administrative expenses seem to be solved practically as a percentage of the income. Such costs have ballooned in 2020 and completely wiped out potential revenues from GAN's otherwise fantastic results. scale would kick in now. Nevertheless, GAN's operating margins since 2011 have been generally low (and often negative). Furthermore, it is safe to say that the company has mostly been structurally unprofitable over the last decade, mainly due to operating costs (mainly administrative costs, according to their latest report). This should raise red flags for investors because GAN appears to be praising revenue growth and margin expansion. And without a margin increase, higher revenues would only mean steeper losses.
Nevertheless, most of GAN's administration costs for 2020 can be attributed to two presumably non-recurring items. Specifically, GAN reported $ 6.73 and $ 2.59 million, respectively, in equity-based compensation and IPO-related costs. These two items totaled $ 9.32 million and caused GAN's net income to fluctuate toward a loss in the first half of 2020.
Source: GAN's September 2020 6-K report.
In a way, it could be argued that the real recipients of GAN's IPO were the management team and the investment bankers who were responsible for the agreement. After all, this listing gave the long-awaited liquidity to the managers' share-based compensation, which was triggered by GAN's 2017 compensation plan for managers. In my opinion, posting GAAP losses while paying hefty compensation plans to executives is a big red flag for investors.
Fantastic stock development
It is nevertheless undeniable that investors who bought on the stock exchange listing have also done relatively well. For context, GAN originally traded at around $ 13 per share back in May 2020 and is now trading at around $ 16. Thus, investors who bought and held are still up an excellent 23%. But even more impressive is GAN & # 39 ;s high-time, which is a full $ 28.95. In other words, the stock reached an incredible 122% increase in a few months.
Naturally, such insane price fluctuations are probably due to the confluence of unique events. First, the market grew significantly from March low after the Fed injected a unique amount of money into the markets. This caused shorts to panic over the stock markets, and investors became bullish when everyone tried to drive the incoming liquidity wave. During this unusual dynamic, many stocks recovered, and some even gained new full-time highs. All of this benefited GAN's share price. But even more surprisingly, the GAN also tangentially became part of the "Dave Portnoy euphoria," which further exacerbated the price increase.
Yet, in the end, basic things matter. To paraphrase Warren Buffett: "intrinsic value and fair value may vary for a while, but in the end they meet." And one thing is for sure, GAN's share price is undoubtedly far ahead of the basics. I still reckon that the company has a well-run business, and the core products are good. Thus, GAN's growth will probably continue in the years to come. However, by July 2020, GAN had priced into its shares decades of future growth. Even now, after a significant 50% + setback from all-time highs, the stock remains relatively expensive under optimistic conditions.
As you can see, my valuation model suggests that the stock has a potential downside of 18.5% at these levels. . Note that these results are under incredibly optimistic assumptions. For example, I assume that GAN will maintain its previous growth rate for the next five years. However, growth tends to slow down over time as new competitors emerge or the market becomes saturated. Unforeseen events can also disrupt GAN's growth history, and I am sure that over the next five years there will be more unexpected events for GAN.
True growth potential
Nevertheless, I believe that GAN has more growth opportunities for now. The company is still relatively small, with an annual revenue of less than $ 40 million. Nevertheless, GAN's target market is a multi-billion dollar industry, so GAN's TAM remains largely unused. You see, GAN operates mainly in the United States (85% of revenue) and receives some business from Italy (15% of revenue). And within the United States, GAN's operations are focused on New Jersey and Pennsylvania. Thus, the company has 1) plenty of international growth opportunities, and 2) many more states for future expansion.
Sources: Author's GAN Monthly Income Estimates and Legal Sports Report .
This is important because both states have relatively low hold percentages, which represents how much revenue sports books hold from the amount deposited. Intuitively, higher hold percentages should translate into favorable secular tailwinds for GAN. Fortunately for investors, these figures have been trending higher since February 2020.
Source: Legal Sports Report plus the author's elaboration.
Furthermore, if we look at US nationwide team statistics, it is clear that GAN's markets still have a lot of room for improvement. For context, Washington DC's holding percentages are about 15%, about twice as much as GAN's target markets. Therefore, GAN could also expand to these other states, which would be much more favorable to the business. And fortunately for investors, I think GAN has large cash reserves to draw such expansion ambitions. So I would say that GAN undoubtedly has all the ingredients for a lasting growth history.
Overall, I consider GAN to be an excellent company. The value proposition seems to resonate well with its customers, and more importantly, the company has a significant growth opportunity. There are some red flags regarding long-term profitability, mainly related to sky-high administration costs. But as a whole, the company shows a lot of promise, and the recent huge administrative costs can actually only be one-time items.
Nevertheless, the stock is undoubtedly expensive from a valuation perspective. In my opinion, even the most optimistic assumptions are not enough to justify the current valuation. Therefore, I consider GAN's investment proposition not good enough at these levels. I would argue that even if GAN's shares fall to $ 13 again, the valuation will still praise many years of growth without hiccups. Finally, I think GAN could be a viable investment of around $ 10 per share. Until then, I think the stock should only be on your watch list, not your portfolio.
Thank you for reading and good luck.
Information: I / we have no positions in any of the aforementioned shares, and plan to fill some positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I do not receive compensation for that (other than from Seeking Alpha). I have no business relationship with any company whose shares are mentioned in this article.