Earnings Call Transcript - INSE Q3 2021

Operator, Operator

Good morning, everyone, and welcome to the Inspired Entertainment Third Quarter 2021 Conference Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note, today's event is being recorded. I'll begin today's conference call by referring you to the company's safe harbor statement that appears in the third quarter 2021 earnings press release, which is also available on the Investors Section of the company's website. This safe harbor statement also applies to today's conference call as the company's management will be making certain statements that will be considered forward-looking under securities laws and rules of the SEC. These statements are based on management's current expectations or beliefs and are subject to risks, uncertainties and changes in circumstances. In addition, please note that the company will discuss both GAAP and non-GAAP financial measures. A reconciliation is considered in the earnings press release. With that completed, I would now like to turn the conference call over to Lorne Weil, the company's Executive Chairman. Mr. Weil, please go ahead.

Lorne Weil, Executive Chairman

Thank you, operator. Good morning, everyone, and thank you for joining our third quarter conference call. Here with me today are Brooks Pierce, Stewart Baker, and Dan Silvers. As we anticipated in our last conference call in August, we had a strong third quarter, and we're quite pleased with the results. EBITDA of $30.1 million exceeded the high end of our guidance. We achieved these results despite the modest decline in the value of the pound as compared to dollars and the fact that the U.K. fully reopened in July, a few weeks later than we had expected, effectively imposing headwinds on us for about 15% of the quarter. Nevertheless, some historical comparisons, I think, are very interesting. Excluding last year's one-time VAT income, the $30.1 million EBITDA in the third quarter of this year was 89% higher than the $15.9 million in the third quarter of 2020, which, as we might recall, was a ramp-up quarter prior to the second lockdown in the U.K. in November of 2020. And it was 70% higher than our prior high watermark of $17.7 million established in the fourth quarter of 2019, immediately following the Novomatic Technology Group acquisition. And finally, if we go all the way back to the first quarter of 2019, which was the last quarter prior to the implementation of the Triennial, we're 120% ahead of that. So I think it's safe to say we're hitting on all cylinders at this point. The overarching narrative behind these trends is pretty much what we have anticipated for several quarters. Our retail gaming businesses in the U.K. and elsewhere rebounded to pre-pandemic business levels. And at the same time, our Virtual Sports and Interactive businesses continued unabated along the growth path they had established at the outset of the pandemic. The comparatively high margin and low capital intensity of these content businesses is the primary reason our net cash flow was so impressive in the quarter, about $13 million, as highlighted in the press release. From where we stand now, we expect that the Interactive and Virtual Sports businesses will grow on a combined business to account for about 50% of our EBITDA in 2022, further enhancing our overall margins, capital intensity, and inherent growth rate. At the same time, we believe that by the end of this year, our net debt to run rate EBITDA will have declined to below 3%, the target we established for ourselves at the time of the Novomatic acquisition. Our expectation, of course, was that we would have reached this point sooner. But in the meantime, there was the small matter of dealing with COVID. In a moment, Brooks will discuss in detail some of the developmental activities that are driving our growth. Each of our Virtual Sports and Interactive businesses is growing through expansions into new jurisdictions, new customers, and new products and content. In virtuals, the Major League Baseball Players Alumni Association licensed home run-hitting competition as the latest and most exciting example of new content. In our Interactive business, we continue to exhibit impressive growth as we introduce three or four new games every month and improve our shelf space within the existing customer base. Earlier this year, we launched an initiative to diversify our Interactive business into the lottery space. And a couple of weeks ago, we announced our first iLottery initiative with Loto-Québec, one of the premier lottery operators in the world. And lastly, as Brooks will discuss in a moment, we continue to get great traction in the North American VLT market. And with that, I'll hand it to Brooks.

Brooks Pierce, CEO

Okay. Lorne, thanks. It's great to be able to speak about the operational aspects of the four segments of our business when, as you say, everything is hitting on all cylinders. I'm also excited to give some additional color on a number of the business developments that we've discussed in previous calls. I'd be remiss if I didn't thank the entire Inspired team for their hard work to produce the results that you just covered in your remarks, and it's rewarding to see what this business can do when so many of the headwinds which we had faced have dissipated. I know I speak for the entire team when I say that we'll continue to stay laser-focused on the things that have brought us to this stage of our development, and we're incredibly encouraged with the opportunities yet in front of us. As Lorne mentioned, we increasingly see our business evolving into content-led, primarily online businesses on the one hand and retail gaming on the other hand. So let's start with retail gaming and the Leisure segment specifically, as they just finished a record quarter with 92% revenue growth over the comparable period. And for the first time, we've been able to see the true earnings power of the business that we acquired from Novomatic in 2019. Across the holiday parks part of the business, we've seen excellent results that have continued through October as well. In our pubs business, we've seen the business rebound as restrictions have abated, and we continue the investments we've previously discussed in this business to get us to 100% connectivity and a larger portion of the estate being digital going forward in 2022 and beyond. We believe we already have the highest-performing content and cabinets in this business, but we also believe that we have plenty of runway left as we develop content specifically for the sector that can widen our lead. Our motorway services businesses benefited from the increase in travel within the U.K., which led to growth in this segment. We're looking to build on this momentum in 2022. Moving over to the Interactive business. We continue to see growth in mature markets like the U.K. and Greece, which we built upon with growth in the North American market from existing jurisdictions like New Jersey, Michigan, and Québec as well as the prospects of additional jurisdictions, including Pennsylvania, Connecticut, Ontario, and Alberta. Our Interactive revenue grew 73% over the same period last year, and we currently sit at just over 60% penetrated in New Jersey and Michigan with the addition of DraftKings in the Michigan market. We've also gone live with bet365 in the Netherlands as one of the early operators in the market. This growth in the number of markets in which we operate and our share in these markets is being driven by the quality of our content, as well as the number of games we're releasing every month. This is truly building a network effect and we expect this trajectory to continue. An example of some of the product innovation that we've also brought to the market is in the fourth quarter of this year, we'll be launching our Space Invaders licensed game, which is getting a lot of anticipation from operator customers. We're also able to announce, as Lorne mentioned, our first iLottery customer recently with the first two games going to Loto-Québec. Already we've had great feedback from the lottery industry on our entry into the market as they believe the addition of EA instant games will be a big part of the digitization of that industry. We expect this to be an area of focus for our business going forward and we'll report on the progress of that as it develops. Next, we're excited about the growth of the overall Virtual Sports segment around the world, and in particular, the growth online. Virtual Sports overall revenue grew 27% compared to the same quarter last year and grew 67% online. As we've mentioned in our last call, we believe the North American market has vast potential. And we've now gone live online with BetMGM in New Jersey and are in the process of understanding the nuances of growing a product that is completely new to players in this market. BetMGM is a great partner, and we've done some joint promotions that have proven successful. Furthermore, we are in the midst of doing a major customer-focused project with their players to make sure we are hitting the mark with the product or if there's anything that we need to tweak. In terms of the rest of our markets, we're seeing great results and traction with new products in Italy, including Marbles, Matchday Ultra, and Penalties and with the U.S. basketball product in Greece. And finally, on the product side, we're excited to announce our licensing deal with the Major League Baseball Players Alumni Association for our Home Run and Shoot Out, and we think this product will resonate in North America, Latin America, and Asia. We mentioned previously a number of players that were part of the deal, but I'm happy to announce today that we have secured a license to now include Babe Ruth in the game, and our development team has already started creating some interesting ways to showcase this property. In our core gaming business, we're happy to see that the business returned to at or above pre-COVID levels in our key markets of the U.K., Greece, and Italy, even with some of the restrictions on needing to show proof of vaccination or a negative COVID test in some key markets to enter a betting shop. I think this demonstrates the resiliency of this part of our business. In Italy, as we've discussed in the past, our plan is to move to a content and platform business as opposed to a full-service business. We took the first steps in that process with the sale of our existing terminals in Italy to our customers, Caesars. We have plans to be fully completed with this plan by the end of the year, and we expect modest improvements in the margin contribution of our Italian retail gaming to our bottom line. Our Virtual Sports and Interactive businesses in Italy are not impacted by these changes, and as discussed, we see tremendous growth potential in both. Moving over to North America. We continue to see growth of our machine count in Illinois, and we've already exceeded our Q3 sales in the first month of Q4. In Western Canada, our VLTs are the top performers, and we will be responding to the WCLC RFQ with that experience now under our belt, which we believe can only help there and in other provinces in the future in Canada. Finally, we've shipped our Valor terminal to the Oregon State Lottery for their early review, and we hope to qualify it to go to trial there in 2022. We see not only Oregon but West Virginia as key future markets for us. So with that, I'll hand it over to Stewart to go through some details on the numbers. But needless to say, we're excited about the business we've built and its prospects going forward.

Stewart Baker, CFO

Thanks, Brooks, and good morning all. I wanted to take a little bit of time running through the financials while still making sure we have a lot of time for Q&A afterwards. Now we've been saying for a while that the third quarter of 2021 would be the first quarter where we would be able to demonstrate the benefit of the Novomatic acquisition and the associated synergies, as well as the growth in the online businesses, which continued to grow strongly even as the land-based businesses have come back, all without lockdown impacts in some part of the business. And that is exactly what we've seen in the numbers reported today. Overall, revenue grew 29% on a reported level or 21% on a constant currency basis against the same quarter a year ago. Now with the changing lockdown landscape over the past 20-or-so months, I think it is worth reminding you where we were for the relevant comparable quarters. The answer to that is, in most areas, we were in a similar position in terms of what was open. All of our segments were fully operational throughout this year's third quarter, although we did have some headwinds in terms of relaxing social distancing in England not happening until the 19th of July, and the introduction of vaccine passports in Greece and Italy in the second half of the quarter. During last year's third quarter, land-based venues were pretty much all open in gaming and retail Virtual Sports, but we did have a more challenging landscape in Leisure, where venues were opening and ramping up last year; and in the holiday parks, where they were capped on visitor numbers. Additionally, last year's number included VAT-related revenue of $9.3 million. And to be clear, there is no VAT-related income in this year's third quarter. Excluding this VAT-related income for last year's results to give a more comparable basis, revenue grew 53% in the quarter with all segments growing versus the same quarter in the prior year: Virtual Sports by 27%, Interactive by 73%, Leisure by 92%, and Gaming by 28%. In this segment, I think it's noteworthy that in the U.K. LBO area, gross win per terminal per day was the highest since the reduction in stakes in April 2019. In terms of how these revenues compared to pre-COVID levels, we saw land-based incomes overall at 94% of pre-pandemic levels in July and approximately 100% in each of August and September. Within these numbers, as you'd expect, some parts of the business are higher and some are lower. But the key point is we don't see the overall returns being driven by pent-up demand that will wane over time. Instead, we believe these results are reflective of a return to normalcy. It's also worth noting that by the time we got to September, online incomes were approximately 250% of pre-COVID levels. Now moving further down the income statement, again, excluding VAT-related income in the prior year. Adjusted EBITDA grew 89% on a reported basis and 80% on a constant functional currency basis, growing across all segments: Virtual Sports by 28%, Interactive by 54%, Leisure by nearly 300%, and Gaming by 49%. And within that, overall, adjusted EBITDA margin was 38.8%, up from 31.4% last year, again reflecting the operating leverage and scalable nature of our business. Now below adjusted EBITDA, we incurred no integration expenses during the quarter, reflecting the effective completion of the program. And depreciation expense declined by 20% year-on-year, reflecting our reduced capital expenditure in recent years, something we continue to be quite focused on. One area which does merit an explanatory comment is the change in the fair value of the warrant liability, which resulted in a $17 million benefit. Now as we touched on last quarter, since warrants are now treated as a liability, the fair value movements are taken through the income statement, which does cause some big swings. The movement this quarter was driven by changes in the share price and also the quoted price of the public warrants. However, I think it's important to note that even absent this warrant liability gain, the net income or profit after tax would have been positive by nearly $8 million. And turning attention to cash flows. We started the quarter with $24.5 million of cash and ended it with $37.1 million, resulting in an increase of $12.6 million. Whilst there was no cash interest payment in the quarter, there was a meaningful working capital outflow, particularly with an increase in accounts receivable, as you'd expect for the business having effectively restarted. So not only did we grow from a revenue and EBITDA viewpoint across all areas of the business, we also saw the fruits of what we've been spending a long time focusing on in recent years: increased cash flows. To reiterate what Lorne and Brooks have said, we do feel that we're hitting on all cylinders. And with that, I'll hand back to the operator to open up to Q&A.

Operator, Operator

Our first question comes from Barry Jonas with Truist. You may go ahead.

Barry Jonas, Analyst

I wanted to start with iLottery. How are you thinking about the ramp in that business? And should we expect some early investments to flow through the P&L before revenues start to meaningfully grow?

Brooks Pierce, CEO

Yes, Barry. I think we will likely see meaningful income from that only in the second half of next year, although we plan to go live with Loto-Québec in the first half. We're also in talks with several other customers. The spending will largely be focused on building a library of games, which will involve adapting existing content from our iGaming business and creating some new content. So there will be increased spending on game development in the short term, but we anticipate that the revenue impact will come in the second half of the year.

Barry Jonas, Analyst

And just as a follow-up, do you have any thoughts on the M&A environment here and the pipeline? Is there anything out there that interests you?

Lorne Weil, Executive Chairman

Well, most recently, Barry, I think we've been focused on all of the things we need to do to take full advantage of the opportunities we already have. But we're always open and looking for M&A ideas. As I mentioned, I think our leverage is now going to be down to where we have significant financial flexibility. Our share price has obviously moved in a way that helps us. So the M&A search process continues to be an important part of what we're doing from a business development point of view. But obviously, if there were anything specific right this second, I wouldn't be able to talk about it anyway. But certainly, the opportunity to enhance the development of the business through M&A is something that we're well aware of and we're pretty heavily focused on.

Barry Jonas, Analyst

And if I could just sneak in a quick one. Any updated timing for PA for interactive license or any expectations there?

Brooks Pierce, CEO

No. Unfortunately, we kind of hope that this is going to be the month that it happens. Now internally, since we're through a good portion of November, we would expect even if we got on the agenda in December that we wouldn't be live until the first quarter of next year. But it's completely subject to the Pennsylvania Gaming Control Board putting us on the meeting agenda.

Operator, Operator

Our next question comes from Ryan Sigdahl with Craig-Hallum Capital Group. You may go ahead.

Ryan Sigdahl, Analyst

Nice results. One question to follow up on the iLottery opportunity. How much of your content do you think can be used for iLottery relative to iGaming? And then do you think there's an opportunity to be integrated into the U.S. iLottery states?

Brooks Pierce, CEO

Yes, our focus is definitely on North America. Although our first presence was in Canada, we are currently in discussions with several lotteries across the United States. Regarding our content library, we now have over 150 games. There are a few mechanics that will need adjustments, along with some game styles and themes. However, we have a solid foundation to adapt to the specific requirements of iLottery games. We are not starting from zero, which is advantageous. Furthermore, we believe that some aspects we have presented demonstrate how the lines between iGaming and iLottery are beginning to blur. The experience we have gained in iGaming is expected to resonate well in the iLottery market, which aligns with the feedback we are receiving from customers as we share our content with them.

Ryan Sigdahl, Analyst

On Interactive, switching over, any update on the launch timing with FanDuel and Rush Street Interactive there?

Brooks Pierce, CEO

Yes. I would say that the launch with FanDuel is going to take longer than we anticipated. We've had some discussions with them earlier this week, and they are currently addressing a significant number of technical issues. Therefore, it will likely take a bit more time than we had expected, but I hope it will happen in the first quarter, or at least in the first half of next year. As for Rush Street, we are close to finalizing our last issue with them, and I expect that launch to happen soon.

Ryan Sigdahl, Analyst

One more for me. Anything that would lead you to believe Gaming, Leisure, and really the whole company, is down year-over-year in Q3? Trying to get a sense of kind of normalized earnings profile here and then adjust for seasonality from there?

Lorne Weil, Executive Chairman

Yes, Ryan, it's Lorne. To the best of our knowledge, there’s nothing that would prevent us from accurately modeling the third quarter, aside from the point I mentioned about not being fully open for the entire quarter. The half of July we were closed was a setback. Therefore, a normalized third quarter without the delay in opening would likely have resulted in better performance.

Operator, Operator

Our next question comes from Chad Benyon with Macquarie. You may go ahead.

Chad Benyon, Analyst

I wanted to ask a similar question but phrased differently. If we combine Virtuals and Interactive, which are less affected by seasonality, you generated over $16 million in revenue and $12 million in EBITDA. Together, that was up about $2 million sequentially. Is this a solid foundation for those combined businesses? I believe the only seasonal factor is the retail Virtuals in Italy. So, I’m asking again, do those segments provide a good starting point for growth going forward, especially considering the content and new partnerships you've mentioned?

Lorne Weil, Executive Chairman

Yes. As I mentioned earlier, we anticipate that the ongoing growth in Virtuals and Interactive will continue, and we expect the retail segment of our business to grow modestly and not decline year-over-year. Based on this, we predict that Interactive and Virtuals will account for half of the EBITDA in 2022, so you can calculate the necessary growth from this year's figures. I think that's in line with your earlier observation.

Brooks Pierce, CEO

Sure. There are some minor differences in the games between West Virginia and Oregon compared to Illinois in terms of bonus features and similar aspects. However, we have teams visiting both jurisdictions this week to review the latest developments. We don't anticipate needing to make significant changes to the content to achieve success in these new markets, as we have in Illinois and Western Canada. In Oregon, the process begins with a review of your terminal to ensure it meets their needs, followed by a trial phase that typically involves 500 to 1,000 machines. If the trial is successful, we can move forward. In West Virginia, they are entering the early stages of a replacement cycle in a mature market for route-based VLTs. We have maintained a consistent focus on pursuing route-based businesses. Considering everything mentioned, along with additional provinces in Canada, we believe there is ample addressable market for us in the coming years.

Operator, Operator

Our next question comes from David Bain with B. Riley. You may go ahead.

David Bain, Analyst

Congrats on a great quarter, and I appreciate the new presentation, bifurcation of segments. It's nice. I guess where I would start since most of mine have been asked, the Virtual Sports online mix, are there some data points that you can offer to give us a sense as to how penetration is progressing in the U.S. relative to the mix that we see in Europe? And if that's varying by skin, are there certain data points you can take from those that are maybe promoting the product differently and use within your captive customer base to kind of help move that segment forward?

Brooks Pierce, CEO

Yes, it's probably too early to share details. In a quarter or two, we may be able to provide some insights. Right now, our focus in the U.S. is on ensuring that we have the product perfected, as I mentioned in my prepared remarks. BetMGM has been a valuable partner in this effort. We will not expand this product to additional markets or customers in New Jersey until we are completely confident that we have it right and that we understand what North American players are seeking. This is a new product for them, and the sports betting landscape in the U.S. is still quite new. Most of the growth you're observing comes from outside of North America, but this gives us optimism as we recognize that we are just at the very beginning stages in the U.S.

Lorne Weil, Executive Chairman

Dave, this is Lorne. I apologize for interjecting, but I wanted to bring up something related to Brooks' comments about the iLottery business. We see a significant opportunity to adapt the content we've created in iGaming for the iLottery sector. The potential here is clearly vast. Additionally, we believe there's a strong chance to incorporate our Virtual Sports content into lottery offerings. While the Virtual Sports games are typically shorter, we think we can creatively use the graphics, similar to the home run hitting competition Brooks just mentioned, to develop outstanding lottery products. Ultimately, I believe that a major part of how our Virtual Sports technology generates revenue in the U.S. will increasingly stem from the iLottery business than we had previously anticipated.

David Bain, Analyst

As a follow-up to that, I know this has been asked before, but could you provide insight into the EBITDA margins for iLottery? Considering what you mentioned earlier about content already being available, can we expect margins similar to those in Interactive or online virtual in the intermediate term? Is there a possibility of achieving those margins quicker than we did during the launch of Interactive? It would be helpful to understand what profitability looks like in iLottery and the expected progression there.

Lorne Weil, Executive Chairman

Yes, I think it’s reasonable to expect that the margins will be at least as high as those in Interactive, if not higher. In the B2B sector we operate in, unlike the B2C sector, we can already see significant scalability in our business. For instance, when we develop a new game, having 50 customers to sell to results in much higher margins compared to having just one customer. The key factor for us is how well we can scale our content development. The advantage we have in iLottery is that we can leverage the content we've already created for the iGaming business. Assuming everything else remains constant, I would expect our iLottery margins to be at least as favorable as those in Interactive, if not better.

Operator, Operator

This concludes our question-and-answer session. I'd like to turn the conference back over to Lorne Weil for any closing remarks.

Lorne Weil, Executive Chairman

Thank you, operator. I don't really have anything to add to what we've talked about so far this morning. Obviously, we're feeling pretty good about where we are. But by the same token, we're not taking anything for granted. We understand that to maintain the leadership that we have in the businesses we're in that we have to continue to invest in all of the parts of the business that determine our competitive position, and we have every intention of doing that. And therefore, we're pretty optimistic in terms of where we think the future is. Thank you for joining this morning, and we look forward to speaking to you in another quarter. Goodbye.

Operator, Operator

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.