Earnings Call Transcript - INSE Q1 2020

Operator, Operator

Good morning, everyone, and welcome to Inspired Entertainment First Quarter 2020 Conference Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note that this 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 first quarter 2020 earnings press release, which is also available in the Investors section of the company's website at www.inseinc.com. 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 included in the earnings press release. With that completed, I would like to now 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, everybody, and thank you for joining our first quarter conference call. With me virtually are Brooks Pierce, Stewart Baker and Dan Silvers. I'll begin my remarks by briefly discussing the first quarter and the context of the plan that we have been implementing since COVID-19 hit. Then I'll discuss the positive revenue and cost trends that we've been seeing in the last eight weeks or so, and the impact they have had on our liquidity and our outlook going forward. And finally, I'll talk a little bit about how we see our retail business coming back. At that point, I'll turn it over to Brooks to discuss some of these revenue and cost developments in more detail. And in departure from our usual conference call format, Stewart will not do a detailed review of the financials. All of the necessary details are in the press release and 10-K, and Stewart is of course available this morning to answer your questions. When we last spoke in early March during our fourth quarter earnings call, we were tracking ahead of our internal budget for the first quarter of 2020, and nicely on plan relative to the 2020 full-year consensus estimates of EBITDA, which would have been in the mid-70 million range. Because of the significant seasonality in the acquired Novomatic business, EBITDA, what would have been the seasonally weakest first quarter, would then have sharply increased to EBITDA well into the 20s in the second and third quarters, and then leveling out in the fourth. But of course, the entire scenario changed dramatically during March, when nearly 100% of our retail business at all geographies was shut down. As expected and previously discussed, first-quarter EBITDA was impacted by a number of concurrent factors: the residual impact of the triennial review, which did not go into effect until April 2019, but fortunately as of the end of March has now finally been lapped; deliberately increased spending levels during the first quarter in anticipation of very significant revenue increases that had been expected in the second quarter; the seasonality of the acquired holiday park business, where the fixed cost structure erased significant EBITDA contributed by other parks of the acquired Novomatic business; and finally, the non-occurrence of certain one-time revenue items in the fourth quarter last year. But of course, what was not expected and which completed in effect the perfect storm was the impact of COVID-19, which eliminated a huge portion of retail revenue in betting shops, pubs, arcades, etc. before any attempted cost reductions could be realized. In mid-March, as this was unfolding, it would have been difficult, if not impossible, to believe that we would have ended April with positive EBITDA for the month, as well as positive cash flow. Week-by-week as we moved from mid-March to the end of April, and now into mid-May, we've been able to steadily and dramatically lower our operating costs, aided significantly by the UK furlough reimbursement plan, which very critically was just extended from June through the end of October. At the same time, as almost a mirror image of our declining costs, our online revenue started accelerating week-by-week, so that by the end of April our EBITDA was positive for the month and continues on a week-to-week growth trajectory. As a consequence of these two positive trends, we ended the month of April with slightly more than $49 million in cash, considerably more than we might have expected a couple of months ago. Given our current liquidity, along with where EBITDA and cash flow are, we believe we're nicely positioned to wait for the retail world to reopen. Our retail networks in the UK, Europe and the U.S. consist primarily of physically small, geographically widely dispersed predominantly local facilities that will have a relatively short response time to turn back on, and are highly likely to quickly recover their player base. Reinforcing this view, I think it's important to mention, in conclusion, that just last week, it all started last Monday, more than 3,500 OPAP shops in Greece were reopened for both lottery and live virtual sports betting, though not yet for VLTs. And in just the very first week, notwithstanding the enforcement of significant customer limits and social distancing to deal with the COVID issue, the daily level of our virtual sports business for the entire week returned to about 80% to 85% of where it was before COVID-19. The fact that we were able to achieve this clearly supports both the thesis on the resilience of the wide area locals market in general. And of course, it further accelerates our month-to-month EBITDA and cash flow. So that going forward we will hopefully continue to see the benefits of Greece as well. And of course, we're looking forward to restarting the VLTs not just in Greece, but in our other geographies as well. And so with that, I'll hand the program over to Brooks.

Brooks Pierce, President & COO

Okay, thanks, Lorne. I'll keep my comments brief as well to allow more time for Q&A at the end of the call. As Lorne mentioned, our virtual sports and Interactive businesses were growing prior to COVID-19, but the shelter-in-place restrictions have really accelerated that growth. We're seeing significant growth in our current Virtuals and Interactive customers, organically with their existing customers, adding additional customers in the quarter in both segments, and importantly, a number of contract executions this quarter that we'll be launching soon, and an incredibly robust pipeline of opportunities across both segments. The Virtual Grand National and the Kentucky Derby: Triple Crown Showdown showcased our product to new audiences with viewership in the UK of almost 5 million people and in the U.S. of almost 2 million people. We're enthusiastic about the announcement of our deal with the Oregon Lottery and SBTech. We've been steadfast in our belief that the lottery channel will be a significant driver of growth for us, given the wide distribution and vast number of retailers in their networks. This channel, along with the expansion of sports betting across North America in both retail and online, are key to our long-term strategy. The combination of all of this, and importantly, the lack of live sports has been a tremendous lift to our Virtuals business, and experience from around the world shows us that these products are sticky with players and will be a core offering to our customers on a worldwide basis. Moving to the Interactive slot side, our slot portfolio showed all the same characteristics as we mentioned about the Virtuals business, with substantial growth in play from existing customers, a number of new customers added, and importantly, record numbers out of our North American business in New Jersey, and with Loto-Quebec and BCLC in Canada. We'll be adding customers in New Jersey as we currently only provide to four of the top 10 customers that have announced agreements, as you all have seen for both Virtuals and slot content with DraftKings, FanDuel and the GVC licenses in New Jersey. And these will be going live in the second quarter. We've also noticed that other states like Michigan will be coming online, and we are hopeful that more states will be added. We're also thrilled to see how our omni-channel strategy is working, as many of our core retail titles like Centurion and Super Hot Fruits are also the leading titles online. We're expecting growth out of some key international markets like Greece and Spain as they launch this year, and our success in Greece retail should serve us well as the products go online with customers like OPAP. Finally, we're very excited from a product standpoint with two Megaways titles we're launching this summer with the Centurion Megaways game, as well as a title we acquired as part of the NTG acquisition, a Reel King Megaways game. So, these are very exciting for our customers. Moving on to the VLT side of the business, we discussed last quarter about our early success in Illinois with the launch of our Valor cabinet into the market starting in the fourth quarter of 2019 and the sales we saw in the first two months of 2020. We had sold 161 terminals over the first two months and were expecting a robust third month to end the quarter, which was obviously interrupted with the shutting down of gaming in Illinois. We believe that there will be strong demand for our products when Illinois opens back up, as our games are consistently leading performers in the venues we serve. Additionally, we believe that distributed gaming in Illinois and other markets we are targeting will be much easier to manage, as Lorne mentioned before, with social distancing practices. We also anticipate that the social distancing requirements will be easier to manage in our venues worldwide, just as Lorne discussed about Greece, but also in the UK and Italy. Let me move to the cost side of the business and talk a little bit about some of the cost initiatives we've undertaken since the closure of our retail business, and I wanted to add some color to that. Along with all the measures previously mentioned, we've been able to execute on the synergy plans as part of the NTG acquisition that we’ve covered in the past and are confident of our updated synergy projections of $15 million. We'll be in a stronger financial position when our retail businesses reopen, and we will have right-sized the organization to service our customers when their businesses do reopen. We couldn't have achieved this without the extraordinary efforts of our employees working under extremely difficult circumstances for reduced pay, but they've really stepped up, and we're looking forward to bringing back our employees that are on furlough as soon as the retail businesses return. These have been difficult times for all, but we feel very good about the growth we're seeing in our online businesses, the early results in Greece from our first retail market coming back, the difficult measures we've taken to align our cost structure with the new realities going forward, and our strong belief that we're in the market segments that have the chance to recover the fastest and will be the easiest for our customers to manage in this new operating world. So, with that, those are my remarks. I'll turn it back over to Lorne.

Lorne Weil, Executive Chairman

Thanks, Brooks. Okay, operator, I think at this time, we can open the program up to Q&A please.

Operator, Operator

We will now begin the question-and-answer session. Our first question is from Chad Beynon from Macquarie. Go ahead.

Chad Beynon, Analyst

I wanted to start with just kind of the business model and the margin ramp recovery. I believe the majority of your revenues are recurring. So, as the locations open back up, I'm assuming your margins can ramp quite quickly, obviously dependent on the amount of revenues going into the machines. But could you just help us think about what maybe a fixed versus variable in your cost structure and as the business kind of gets back to close to a normal state what the margin profile could look like across the company?

Lorne Weil, Executive Chairman

I'll take a shot at least a high level on that, and then Brooks or Stewart can certainly add more detail. But I think there's no question. I think there are three things going on. As our retail business comes back, the margins on the legacy business overall should recover to at least the levels where they were before COVID. So, EBITDA margins that I think we’re comfortably on average in the 30s. It's obviously an average of a few different businesses that have different margin characteristics; the online business has a higher margin. But assuming it comes back in roughly the same mix, we would expect to see margins comfortably in the 30s for us. The overall margin of the acquired businesses, as we've pointed out a few times, was considerably lower than ours at the time of acquisition. But the digitization is moving fairly quickly. We have, I think, a terrific plan for taking much of the business cashless, which will have a tremendous impact on margins. So, I don't know on a standalone basis if we could expect the acquired businesses’ overall EBITDA margins without taking into account the synergies to get up into the 30s where ours are, but certainly, let's say 10 points higher than they were at the time we acquired the business, and then there are the synergies as Brooks pointed out. Once everything settles down, and ironically, the COVID experience has actually accelerated the implementation of the synergies, that will add another $15 million on top of everything else. So if you combine those three pieces: our legacy margins pretty much going back to where they were, an increase in the Novomatic margins due to digitization and going cashless, and then finally, the realization of the synergies; I feel pretty good that whenever our revenues get back to where they were prior to COVID, the overall margin of the company should be considerably higher.

Chad Beynon, Analyst

Okay, that makes sense. And on the analog to digital transformation on the acquired businesses, given what's going on right now and the cash situation or your view of preserving cash, should that take a little bit longer than I guess what you’re talking about before? I know you're already at a pretty high percentage on the digitization. But can you walk through the timeline there?

Lorne Weil, Executive Chairman

Well, the payback on the investments in the digital machines is so quick that even in an environment where obviously we're being as stingy as we possibly can with CapEx, I think the one thing we probably won't necessarily slow down is that because it takes maybe not even a year to get our investment back. And so it would be maybe penny-wise and foolish not to stay with that investment.

Brooks Pierce, President & COO

Yes, and Lorne, let me just add one more point to that, and Chad. The other part about digitization is the business model in the pubs market is on a rental rate. So, even though it may take some time for pub traffic to come back and cash boxes to come back, the way it's structured is we get paid a daily rental fee. So, to Lorne’s point, the payback is, A, very quick; and B, there's not a risk that the play won't come back at the pace that we'd like it to come back.

Chad Beynon, Analyst

Okay, that sounds great. Moving on to the United States, particularly Illinois, you mentioned your successes that began in the fourth quarter and continued into the first quarter. Brooks, you noted that nearly every operator in Illinois has trialed your machines and placed orders. Could you provide us with an updated view of the total addressable market? What are your medium-term expectations once the market recovers? We understand that operators will face constraints in the next few quarters. However, given your achievements, do you have an updated perspective on what the total addressable market could be in Illinois or overall expectations for North America? Thank you.

Lorne Weil, Executive Chairman

Yes, yes. So in Illinois, obviously, it will depend on when it comes back. It will also depend on when people go to the sixth machine. We think they will. And obviously, with the larger stakes and prizes, we think the Illinois market will come back fairly quickly, and we would expect just based on our performance, right now as you know, Chad, it's basically been two vendors in the market. Novomatic has had a little bit of success, but frankly we would expect to be a core offering based on the results we've seen in all the locations. It appears to us that there's going to be demand from a customer standpoint for our machines. So we feel that that's a market that will support us. And then in terms of the other markets, I think we've talked about this before. Certainly, we're targeting the G2S markets like Oregon and the Canadian provinces. And again, pre-COVID we were seeing some real positive feedback from those customers, and felt like we would be making some announcements this year about that. We'll have to see how that plays out, but we're no less bullish on those markets. And I think as we've discussed before, we think that distributed gaming has a much better chance of expanding than building large casinos.

Operator, Operator

Next question is from David Bain from ROTH Capital. Go ahead.

David Bain, Analyst

I was hoping we could start with Interactive, actually, and congratulations on the expansion there. Could you walk us through maybe a bifurcation of online revenue versus the rest of the business? I mean, in essence, when you say Interactive has increased 30% and 100% over March and February, can you give us an actual baseline revenue number for either January or February?

Stewart Baker, CFO

Yes. Dave, it’s Stu here. The way I think about it is in terms of where we were beforehand, we would have expected overall Interactive revenues to be just under 10% of the overall group. So that's a combination of online Virtuals and online slots. So hopefully that gives you a size of where we were before and where we're trading at now.

David Bain, Analyst

Got it. Okay. Can you provide an overview of the economics for Virtuals, such as FanDuels or DraftKings, in terms of revenue percentage or any other way that would help us model growth across the channels? Additionally, as you expand, I assume this is a high-margin business. Can you discuss the margins?

Brooks Pierce, President & COO

Yes, I can take the first part of it. So, David, how it works is we get paid a percentage of NGR, and mostly that, just to give you a range, it's in kind of double-digits, which is not way in double-digits but in double-digits. So for us, kind of like it is with our existing Virtuals customers, the whole idea is to be able to drive play with the customers. I think most of our customers like DraftKings and FanDuel, who have a large base of customers, will be trying to cross-pollinate the Virtuals product with what they're seeing in live sports and, frankly, with slots. So it's just another part of their portfolio that they'll be able to try and get their customers engaged. And obviously, we'll do everything we can to help them in that. But that's kind of the business model. I don't know, Stewart, if there's anything more or Lorne anything more you want to add about that?

Lorne Weil, Executive Chairman

Well, I think in terms of David’s question thinking about how to model the opportunity overall going forward, I think the best guidance you could get, David, is to look at the experience in Europe, where the customers all have almost unlimited live sports and some of them have 15 or 16 or more channels of our Virtuals. Generally, the Virtuals do surprisingly well—it could be 10% or 15%, it varies a little bit between online and the retail market—but something in that range is not an unrealistic estimate of what the volume of Virtuals betting handle could be. So if you start with whatever your projections are for the base sports betting business and then take a percentage of that as Virtuals, and then estimate what the GGR that is for the operator, that gives us, as Brooks said, in the low double-digits percent of that. And multiplying those three things together would give you some target of what that business can mean to us. Of course, from a profitability point of view, essentially the incremental profit on the incremental revenue is very high.

David Bain, Analyst

I guess the last question, if I could, would be back to retail. It looks like William Hill and others seem fairly healthy. When you look across the portfolio of those you work with, just any kind of thoughts on the health of their businesses and any sort of thoughts on the competitive landscape and how that may change if this accelerates closures by some competitors or anything as we come out the other side of COVID on the retail side from a share perspective?

Lorne Weil, Executive Chairman

Well, what I was going to say is that as you know, a large portion due to the impact of the triennial review taking the lower end of the shops and closing them has pretty much occurred. I think William Hill closed over 700 shops. My guess is that there will probably be some slight additions to the shop closure numbers because of COVID-19. But again, I think it will be on the kind of last link of the chain, so to speak. And as we've discussed before in a couple of other calls, what generally happens is a big chunk of that goes to other of our customers since we have William Hill, Paddy Power and Betfred. But now, I think we're encouraged by what we're seeing with online and expect that there's going to be a stickiness component to the online revenue that may not have existed before. So, we would hope to recapture what any additional store closures would be, or at least a big chunk of that, through either one of those channels.

Operator, Operator

Our next question is from Ryan Sigdahl from Craig Hallum. Go ahead.

Ryan Sigdahl, Analyst

So you guys talk a little bit about virtual sports in the U.S. But we've been hearing about a surge in betting on simulated Madden and e-sports in the U.S., while traditional sports are postponed, and kind of a big growth opportunity there. How do you think about the opportunity for virtual sports in the U.S. and maybe how it compares to e-sports and simulated sports such as Madden?

Lorne Weil, Executive Chairman

I'll share my thoughts, and then I'll ask Brooks to add his perspective. Starting with Europe, we've observed that the volume of virtual sports betting, both online and in retail, closely aligns with live sports betting. There's significant overlap in the player base and a consistent pattern in their betting behavior. Since the legalization of sports betting a few years ago with the repeal of PASPA, we have actively engaged with all the states planning to launch sports betting. Currently, 16 or 17 states have enacted laws. The feedback we received indicated that while our product seemed promising, many operators are overwhelmed with establishing their infrastructure, working with state governments, and recruiting players, which has made them unable to focus on us at this time. However, we've benefitted from this pause, as companies like GVC, DraftKings, and FanDuel, along with certain state lotteries, have expedited their discussions with us about adding virtual sports to their platforms due to limited betting options available now. By the time the sports world recovers from COVID, we anticipate a significant expansion of our U.S. customer base for virtual sports. European experiences suggest that the return of real sports is unlikely to cannibalize the business we will have built in the meantime, and it might actually enhance it by re-engaging players who have been inactive. The main point is that we have a considerable number of potential new customers ready for integration.

Brooks Pierce, President & COO

Yes, I won’t comment on the specific numbers, but yes, the pipeline is huge. I think Lorne's points are spot on. I guess probably the only other thing I would add to that is the idea that when the NBA comes back, I don't think anybody is going to be watching two NBA players playing each other in NBA 2K. But I do think people will be betting on virtual sports as an event that goes off every four or five minutes, just like they would be betting on live NBA basketball. So, we feel very good about how our product actually sits alongside live sports and some launch points that are improving over the years in Europe. Remember, most of our customers here got their start in Europe and are familiar with this market's potential in the States as well.

Ryan Sigdahl, Analyst

Good. Thanks. That's helpful. You mentioned Greece and Illinois along with other regions, but what are you specifically hearing from retail in the UK? What is your expectation for the timeline and pace of reopenings there?

Brooks Pierce, President & COO

Yes, the current situation in the UK suggests a phased return. It appears that most of our business will fall under phase three of the retail relaunch, which includes motorway services, pubs, holiday parks, and licensed betting shops. Although there is considerable political activity in the background, we anticipate that UK retail will reopen in the first week of July. There may be some positive developments sooner, as there is support for non-essential retail to open earlier. However, from a planning perspective, we are counting on the first week of July. Stewart, do you have anything to add?

Stewart Baker, CFO

No, you've got the latest position; as you say, that we’re working towards. I guess like everywhere it's subject to change.

Ryan Sigdahl, Analyst

Good. Last question from me. So assuming retail opens kind of on those timelines along with the cost cuts you guys have done, do you think you can inflect the positive free cash exiting this calendar year?

Lorne Weil, Executive Chairman

I'm sorry, could you repeat the last part of the question? I just didn't hear it.

Ryan Sigdahl, Analyst

Can you share any insights on free cash flow as we approach the second half of this year? With retail starting to reopen and the cost reductions you've implemented, do you think it's possible to turn free cash flow positive by the end of this year or early 2021? Any thoughts on the timeline?

Lorne Weil, Executive Chairman

Yes, Stewart, do you want to start? I have my thoughts, but it would be best for our CFO, who is more familiar with the details, to address that first.

Stewart Baker, CFO

No, no. I'll be happy, unless you want to give your opinion, Lorne, and then I’ll follow up.

Lorne Weil, Executive Chairman

No, because I don't want the people on the call to think I'm influencing your answer. So, I'd rather have you take your best shot.

Stewart Baker, CFO

So Ryan, there are a few points to consider. As you mentioned, revenue is expected to start coming back and since it’s recurring, we anticipate it will return relatively quickly. We will only increase costs when the revenue justifies it. We should not create a situation where we take on more customers than we can support with our revenue. Initially, there may be a slight outflow in working capital due to the need to pay people more quickly than we receive cash, which means we’ll need to invoice sooner. Additionally, as you mentioned, we will not increase our capital expenditures to the same extent as we did previously. As Lorne pointed out earlier, we plan to be cautious. Some of our capital expenditures relate to capitalization, and while we have elements still working on the Interactive side, the retail side will ramp up once it is operational. However, you should assume that in the short to medium term, our capital expenditures will decrease, leading to positive free cash flow.

Operator, Operator

At this time, we have no more questions. This concludes our question-and-answer session. I would now like to turn the conference back over to Mr. Lorne Weil for any closing remarks.

Lorne Weil, Executive Chairman

Thank you, operator. I don't really have much to conclude with, except thank you all for calling in from wherever you're hopefully safely hunkered down. I think you can tell by the tenor of our call today that we're feeling pretty good about where we are considering the predicament that everybody in the world is in. I think we’ve played our hand as well as we possibly could. Our businesses are doing, as we've said, in the online world and now with Greece back, considerably better than we might have expected. Consequently, our liquidity is very strong, our month-to-month performance is surprisingly good, and we're just going to have to wait this out until more of the other markets like Greece come back and each of our markets, most of whom are remarkably similar in style to our customers in Greece. Therefore, things respond as quickly as Greece has, I think by the time we get to the end of this year, we should be really up and running pretty close to where we might have been, had it not been for this whole unfortunate incident. So, thanks again, and we'll talk to you in another quarter. Bye, bye.

Operator, Operator

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