Jumbo Interactive (ASX:JIN) is a wonderful business that we’ve liked for a long time. But with its share price doubling over the past six months to an all-time high, is it wise for would-be buyers to step aside for now?

Back in May 2012 we reviewed lottery ticket reseller Jumbo Interactive and as we were owners of the shares, felt somewhat obliged to point out the risks as well as why it was an obvious value opportunity for The Montgomery [Private] Fund.

Back then our model for valuing a company’s shares suggested a valuation of $2.15-$2.32. And the shares did indeed exceed our stated target of delivering a 50 per cent return in less than a year, rising from circa $0.90 to just shy of $3.00 in February the following year.

Jumbo’s flagship product is its Oz Lotteries website, through which it resells tickets on commission to lotteries including OzLotto, Saturday Lotto and Powerball. The platform now also distributes lotteries on behalf of Australian charities including Surf Lifesaving and the RSPCA.

Some background

The company generates some of the highest Customer-Lifetime-Value to Customer-Acquisition-Costs (LTV/CAC) in the world, which is also reflected in marginal gross margins of near 100 per cent. Both of these metrics have the declining customer churn (customers leaving the platform) to thank, which in turn is due to what can only be described as a very competent marketing and sales team.

Back in 2012, the company had 75 staff and its customer database held 1.38 million accounts (in June 2012). Jumbo claimed 50,000 and 100,000active regular customers, spending on average about $20 per week. Total Transaction Volume (the amount all of the company’s customers spent on lottery tickets through the platform) was $99.7 million for the year ending June 30, 2012 up from $75.9 million in 2011. Revenue was $24 million and reported NPAT was $6.7 million.

In 2012, expansion into the US was being touted as a major source of growth, as there are 43 state lotteries and a population that spends US$60 billion a year on lotteries (compared to $3.6 billion in Australia). ‘Internet’ lottery sales were permitted in January of that year with Illinois becoming the first state online on March 24. Jumbo had just commenced social media marketing.

In 2012, Jumbo’s shares were trading at just ten times forecast earnings and the CEO and founder Mike Veverka – then owner of 9.2 million shares or 22 per cent of the company, was worth just over $10 million – included both his direct phone number and email address in investor presentations.

Since then, the company has grown.

Fast forward

As at December 31, 2018 the company has 576,000 active customers spending an annualised $300 million on tickets. Revenue is at an annual run rate of $61 million, including charity lotteries, while NPAT is running at an annualised $25 million.

And the runway for growth remains very long with the company able to license its platform to lottery operators globally. The company will also grow revenues from the online migration of charity lotteries. Think of all of those chances to win a car, a holiday or a house, with tickets sold door-to-door, at supermarket entrances, shopping malls and over the phone by the police, rural fire service, boys homes, and hospitals. Now imagine all of those tickets sold online through a platform such as that provided by Jumbo. And finally consider how many charities exist globally.

At Montgomery, our clients have benefitted from the migration online of advertisements for jobs, cars, classifieds and houses through SEEK, Carsales, TradeMe and Realestate.com respectively. Jumbo may just facilitate the same trend in lottery ticket sales.

Today, the average customer spend is $419.78 per year, and while this is pleasingly higher than the $321.89 per year of two years earlier, it equates to just $10 per week, which is less than the $20 per week of 2012.

Offsetting this of course is the growing customer database, which can have a material impact on sales revenue. This is especially true when jackpots reach higher levels and the company’s promotion machine kicks into gear. One wonders however whether the low hanging fruit – the regular and big lottery player – was picked earlier in the company’s history and whether the more recently-acquired active customers spend less per week.

The bigger issue however is perhaps the current price.

Let’s talk price

Back in 2012, Jumbo’s market capitalisation was about $51 million. This represented roughly two times historic revenue and materially less than ten times net profit after tax.

Today, Jumbo’s market capitalisation is just under $1.1 billion or 16 times revenue and 40 times earnings.

Back in 2012 if we ran the company’s full year financials through an excess return valuation model, adopting a 10 per cent discount rate, an assumed payout ratio of 50 per cent, 42 million shares on issue and beginning equity of $10 million, and if we also decided to discount the 65 per cent return on equity that year and instead adopted 45 per cent, we would arrive at a valuation of $2.32, which was above the then traded price and which represents an earnings multiple of about 22 times.

Of course, we’d normally use the estimated shareholders equity for the following year and if we did that that valuation would rise to more than $4.00.

Back in August of 2012 the shares traded at $2.10, a discount to both of these valuations.

Fast forward to 2019 and Jumbo’s return on equity is expected to be about 53 per cent. After seven years of equity growth through retaining profits and through capital raisings – a not insignificant amount from executives exercising low-strike-price options – shareholders equity has risen to $47 million. There are 60 million shares on issue and the payout ratio, excluding special dividends, is about 48 per cent. Adopting these numbers, and the same discount rate of 10 per cent for comparison purposes, we arrive at a valuation of $10.17, which is equivalent to about 24 times earnings.

Not only was the price lower in 2012 but it was also at a discount to our estimate of the company’s intrinsic value. With today’s share price over $18, a fall of more than 40 per cent is required to bring the company within reach of our current estimate of ‘value’.

Clearly the price reflects the fact that interest rates have dropped significantly since 2012 and consequently it may be reasonable to lower the discount rate in the calculation for intrinsic value. The outcome of such a move would be an increase in the estimated intrinsic value. The discount rate would need to be reduced to just 7 per cent to raise the estimated intrinsic value to the current share price. And remember, the share price also reflects enthusiasm about and opportunity to expand the company’s lottery sales platform globally.

One thing your author knows however is that business growth is never smooth. Growth takes longer to materialise, costs blow out and from time to time material reinvestment needs to be undertaken. And on top of all of that, there are economic bumps that remain out of management’s control.

Time for patience

Investors must remember that business success takes longer than anticipated and so patience is required. Jumbo has been talking about US expansion for many, many years. Patience must also be applied to the selection of the appropriate price to pay for even high-quality business such as Jumbo.

On the subject of buying shares, we are mindful of the fact that since the start of 2018, the founder and CEO has exercised 1.9 million options to purchase the same number of shares at an average price of $3.57. However, he has almost matched these purchases with the sale of 1.6 million shares at an average price of $9.84, netting $10.5 million since September 2018.

Jumbo does appear to be a very high-quality business with bright prospects. But the CEO has not been increasing his ownership at current prices and perhaps, given the lack of a margin of safety between the value and the price, neither should outside investors.