JOHN M. DUTTON WAS ALSO HIGH ON STARNET BESIDES WILLIAM DONALDSON'S EASYLINK
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PUBLIC ANALYSIS & REVIEW (PAR)
Starnet Communications International, Inc. (SNMM)
John M. Dutton, Analyst
Date of Report: March 8, 1999 Shares Outstanding : 22,638,262
Stock Price: $4.93 Estimated Float: 9,000,000
Latest 12 mos. Price Range: $6.03 - $ 3/8 Recommendation: Buy
Industry Sector: Internet Gaming and
Entertainment Target Price (12 mos.): $14 - $20
10 Day Avg. Volume 335,320
Starnet is fast becoming the leader in the multi billion dollar worldwide internet gaming markets.
Starnet’s gaming revenues are growing rapidly from Licensing of its Technology and its operation of five internet gaming areas, including casino games, live sports books, horse racing simulcast and paramutual betting, international lottery, and bingo/keno.
Gaming represented 56% of revenues in Q2 of fiscal 1999 as compared to 8% for fiscal year 1998.
A fast expanding licensing program targets specific high revenue gaming markets. Starnet expects to add over 20 internet gaming license operators in the next 12 months. It has 17 currently.
Earnings expansion comes from its own operations, and from ongoing participation in a licensee’s revenue stream.
The substantial potential common share price appreciation derives from E.P.S. projected within two years of $.75 - $.80 with a target P/E of 20x — 40x.
Starnet Communications International, Inc. (BB: SNMM) was formed by the 1997 acquisition of Starnet Communications Canada Inc. It is a SEC full reporting Delaware corporation operating from Vancouver. Starnet Canada was a pioneer in the use of internet technology, internet site development and EFT transaction processing. Management’s business model was to use the acquired Starnet technology and capabilities to grow a large worldwide market via the internet. Today, this model has grown SNMM into one of the three leading international licensors of on-line gaming. Starnet is the only licensor that also operates its own on-line gaming site.
Starnet Communications International, Inc.
In thousands of US dollars except per share
Selected Operating and Per Share Statistics
Fiscal year end 4/30:
Revenues
Net Income
EPS (2)
EBITDA
FY 2001 Est.
$ 37,375
$22,725
$ .78
$27,935
FY 2000 Est. (1)
25,828
16,322
$ .69
12,819
FY 1999 Est.
9,658
2,413
$ .10
3,898
FY 1999 — 6 months
3,319
309.5
$.01
967
FY 1998 — 6 months
1,430
(296.9)
$(.02)
65
FY 1998
3,370
(1,038)
$(.05)
(167)
(1) Includes $4 mm gain from sale of On-line Interactive subsidiary.
(2) Currently outstanding shares plus dilutive effect of stock options
and warrants estimated to be 4,219 in FY 00 and 6,500 in FY 01.
During its software development stage, management planned for a total gaming experience. SNMM developed five gaming venues including 22 casino games, brokerage of international lottery tickets, operation of live sports book wagering, and twenty-four hour live simulcast and paramutual betting on horse and dog racing. A bingo game soon will be operational. Until the development of gaming, the Company’s operations consisted of several leading internet adult sites and an adult search engine. The adult revenue is reported under Online interactive.
Revenues from operation of its own internet gaming site, along with initial and participation fees from the turnkey licensing of its gaming systems, accounted for 8% of revenues in fiscal 1998. In 1999’s Q2, gaming revenues accounted for 56% of sales. With the profitable Online interactive rapidly declining as a percentage of sales, we expect that adult operations will be sold by early fiscal 2000. Management intends to concentrate entirely on growth of gaming.
The Company invested the profits and technology from its Online interactive business, estimated fiscal 1999 revenues of $3.5 million, to build a worldwide internet gaming business. By growing a gaming licensee network along with its own site operations, Starnet is rapidly building market share in this new internet industry. The Company offers a turnkey software gaming package, along with fee based use of its certified EFT internet transaction system. Its first license sale closed in Q4 of FY 1998, an additional seven were concluded through Q2 of FY 1999. Three more were added in Q3 and six so far in Q4 for 17 licensees total. This growth produces no expansion of inventories, while license receivables are highly controlled and total credit risk is rapidly reduced by increased diversification as new licensees are added. SNMM receives its license payments monthly.
The Starnet Gaming Business. The use of the internet to deliver a gaming product has opened a substantial, worldwide market. Frost & Sullivan estimate that wagering via the internet for casino games and sports events was approximately $1 billion in 1998. A recent report quotes gaming industry consultants Christinansen/Cummings Associates estimating internet wagering to reach $2.3 billion by 2001. For United States residents, the market for internet gaming is clouded. The cloud results from a debatable Federal prohibition under the 1961 Interstate Wireline Act. This 1961 act makes it illegal to take bets via the telephone lines unless otherwise authorized by a particular state. To plug ambiguities or loopholes existing in the 1961 Act, Sen. Kyl (R-AZ) introduced the Internet Gambling Prohibition Act of 1997 that specifically bans online gambling. Passed 90-10 by the Senate in July 1998, the Kyl bill is held up in the House. Numerous, broad internet commerce issues are raised by bill opponents, while US gambling interests are reported to support passage of the bill. Proponents of the Kyl bill primarily base their arguments on inability to regulate the internet.
With substantial future gaming tax revenues at stake, we expect that Federal and state governments will develop U.S. internet gaming legislation and regulations addressing U.S. residents. Further, the possible legality of Indian reservation based internet gaming is a companion issue to regulators. Starnet licenses and operates its gaming subsidiary in Antigua, where most of its licensees co-locate. Predominantly, the licensees house their sites on the Company’s Antigua based server. Because of the North American cloud, Starnet does not knowingly accept wagers from either a US or Canadian resident. With per capita wagering substantially higher in many countries as compared to the United States, Starnet markets its own and licensees gaming sites to specific target markets throughout the world. It uses licensing to build its penetration of the world’s segmented gaming markets.
Starnet’s Antigua subsidiary World Gaming Service, Inc. ("World Gaming" at www.worldgaming.net) offers full service wagering, and its website receives monthly over 500 thousand hits. The Starnet website includes 22 casino style games of chance (www.worldcasino.net) including slot machines, roulette, twenty-one, craps, and a "slots" bingo game. A second site features a live sports book (www.worldsportsbook.net), a third offers horseracing simulcasts and paramutual wagering (www.worldracetracks.net), while a fourth site will provide international lottery ticket brokerage (www.worldlotteries.net). A fifth site for bingo will be relaunched shortly. For its racetrack website, World Gaming has 15 simulcast agreements with world racetracks to offer live simulcast viewing and paramutual wagering including horse, harness, and dog racing. Starnet will initiate shortly its 24 hour live racing simulcasts with paramutual betting through its own and its licensees’ sites.
The Starnet gaming software is owned by its Antigua licensing subsidiary Softec Systems Caribbean Inc. ("Softec", www.softecsystems.com). Softec licenses World Gaming and a growing list of licensees. A $100,000 license fee provides an installed turnkey operation of the five gaming venues. Starnet receives a continuing percentage of the licensee’s revenues. The licensee must obtain a gaming license from Antigua (US $100,000) or if necessary from the jurisdiction where domiciled. Softec modifies the new licensee’s site to more reflect its intended market segment. This change can reflect a particular motif or ethnic market e.g., Asian, Japanese, Indonesia, or Latin America. Management wants a licensee knowledgeable of the target market in order to maximize its sales potential. Licensees generally establish their marketing efforts from within their target market. Management notes that its gaming sites are now available in eight languages with additional planned. Starnet will launch WorldGaming 2000 this summer, which contains the Company’s (and it states the industry’s) most advanced gaming programming. It will include 3D and many other advanced programming features to foster a realistic gaming experience. Several of the Company’s licensee sites are: www.clubriocasino.com; www.i-casino.com; web.archive.org www.gemcasino.com; web.archive.org; www.aztecgaming.com; www.superbet.com; www.lasvegascasino.com; www.casinoonair.com; and www.classiccasino.com.
Growth in License Sales and Continuing Fees. Starnet’s future earnings growth will come from its ongoing participation in the licensees’ revenue stream, not from initial license fees. Softec receives a sliding scale from 15%-40% of a licensee’s gross revenue (wagers less payouts), as well as fees for operating the licensee’s site. For all customers, it converts available credit on credit card to gaming funds through its offshore EFS Group subsidiary. Management expects that for each license, the continuing annual payments to Starnet should average between $1 and $2 million. Its primary cost against continuing license income is software amortization and site direct costs. Gross margins should exceed 85% in fy 2000, while S, G & A should totaling 27%.
Management emphasizes that the licenses are structured operationally and financially so that a licensee’s prime responsibility is to market their gaming site to their market. Management notes that its monthly license fees, which it believes are lower than competition, should make more monies available for marketing, which increases site utilization and revenues. In addition to the 17 licenses sold fiscal 1999 year-to-date, our earnings model projects the sale of 22 in fiscal 2000, and 25 in fiscal 2001. We expect the 1999 number may end higher as management reports a backlog of current applications in processing.
A licensee’s site is generally operational within 90 days of signing. On signing, fifty percent of the $100,000 license fee is due with the balance paid and booked on site operational delivery. Our earnings model assumes an increasing average dollar amount paid to Starnet for the continuing license fees. This increase through fy 2001 reflects primarily revenue growth from sales efforts and a more mature site. For fiscal 2001, our model projects license fees paid to Starnet plus its own gaming revenues will averages less than $900 thousand for each of the projected forty-four "full-year equivalent" operating licenses. By the end of fy 2001, over 60 licenses should have been sold. A preponderance of the licensee sites will be new in 2001. For fiscal 2002, therefore, total continuing license fees should greatly benefit from earnings growth of the over 60 licensees operating for a full year.
Live paramutual betting operations will commence with real time gaming (Win and Place) and simulcast broadcasting. Toronto’s Woodbine Racetrack owned by the Ontario Jockey Club ("OJC" at www.ojc.com) and the Hialeah (FL) Park racecourse will be the first live track simulcast. Starnet plans to develop with the OJC a "state of the art" internet paramutual betting system. Woodbine and Auto Tote have previously announced intention to jointly develop an automated internet paramutual wagering system. When Starnet launches paramutual, we expect revenues from wagering to increase quarterly revenues by $600,000 at attractive margins.
Competitive Internet Gaming Companies. There are three main internet gaming companies offering turnkey software. The largest is CryptoLogic (TSE: CRY) with 1998 U.S. dollar revenues of $23 million, Starnet and privately held Micro Gaming of South Africa. All three license casino turnkey systems, but only Starnet provides the four additional gaming venues and operates its own gaming site. CryptoLogic is the largest licensor of internet casinos (14 licensees). Starnet’s management believes they can surpass CRY in number of operating licensees during fiscal 2000. With World 2000 this summer, management expects to lead technologically its competitors, who have also recently made new releases of gaming software.
Within its gaming venues, Starnet both competes and works with several companies. In paramutual racing, Ubet (OTC: UBET) provides paramutual technical systems in conjunction with the Ladbrook Race Track. Unlike SNMM, UBET does not hold wagers. UBET recently concluded agreements with Suffolk Downs (MA) and Santa Anita (CA). ODS, a United Video (NASDAQ: UVSGA) subsidiary, provides a set top box in conjunction with satellite TV and a telephone line that ties into 10 tracks including the U.S.’s Churchill Downs. By using the internet with current state of the art, management expects to provide a much more cost effective and realistic paramutual and racing product than its competitors. In sports book wagering, the major company is American Wagering Inc. (NASDAQ: BETM), with whom the Company both competes and ventures.
World Gaming is re-launching its lottery sales site. Here, world lottery tickets of 13 countries are sold through supplier agreements with lottery ticket distributors. Purchasers buy a package of tickets for multiple drawings that are purchased at a premium to ticket face cost. Tickets remain with the contracting distributor from whom winnings are paid through World Gaming.
Marketing of its cyber casinos and other venues is key to Starnet’s future financial performance, as Starnet has substantial operating financial leverage. A new marketing "Partners" program was introduced that tracks the source of a customer and cumulates their gaming activities. Websites that carry Company or licensee banners are paid quarterly for a referred customer’s aggregate and continued gaming activities. Management believes payments to referring websites from tracked customers will be substantially more profitable for that website than their standard web advertising rates.
Starnet Future. While US gaming companies have supported the Kyle bill, a February 10, 1999 MSNBC news article discussed the internet efforts of major U.S. casino companies via Australia. These companies, including Harrah’s, Park Place, and others including possibly Microsoft, have made substantial casino investments in Australia. These investments position companies for worldwide internet gaming based in Australia. In 1997, an Australian "national framework" approved legalized internet gaming as approved by the States. Legislation to allow web gambling is likely to pass shortly in the State of Victoria noted the MSNBC article. New South Wales is also likely to approve internet gambling legislation. Arguing that Australian oversight regulation would "surpass that of existing Caribbean countries", the Australian government is preparing to give Australian based companies entrance into the world internet gaming markets. It could be lucrative for both Australian governments and their domestic companies. They too must exclude U.S. and Canadian customers.
The MSNBC article notes the potentially largest factor is Publishing & Broadcasting Ltd. ("PBL"), who is acquiring Melbourne’s only casino operator, Crown Ltd. MSNBC noted that PBL operates the Australian Nine-television network, and in a partnership with Microsoft, operates the popular Australian internet portal NineMSN. Crown will become the basis for PBL’s website gaming and is to be promoted prominently (with referral compensation) on the NineMSN portal. PBL has retained Goldman Sachs & Co. to evaluate spinning off a minority stake in PBL’s internet holdings to the public. Harrah’s, while publicly campaigning in the U.S. for a ban on internet gaming, controls and operates Sydney’s Star City casino. Star City has announced it intends to launch internet gaming within eighteen months assuming enabling legislation in New South Wales. The article points out that Park Place holds a 20% interest in Queensland’s Jupiters, Ltd., operator of four casinos and a recently acquired web sports betting company, Centrebet (www.centrebet.com.au). American Wagering, operator of sports betting books for 48 U.S. hotels and casinos, opens its Australian based sports betting site in March at www.megasports.com.au. Starnet notes that Australian legislation to date has only legalized sports book betting via the internet. Recently, the Company opened a benched in Australia with establishment of its EFT subsidiary.
The U.S. opposition to internet gaming mostly rests on the quandary of how to impose regulation. The MSNBC article quotes the Chairman of Nevada’s Gaming Commission stating that serious violations of U.S. law by Australian gaming operators with American gaming company investors could lead to revocation of their investor’s Nevada gaming licenses. Starnet points out that the Nevada legislature passed internet gaming but has not yet written implementation regulations. The potential loss of large future tax revenues from the regulation of internet gaming will probably determine policy in the U.S. This would capture the increasing tax revenues beginning to stream to the Caribbean, and other gaming centers including Australia.
Taxes: Starnet has no operations in the U.S., and after the sale of its adult sites, it would have only software development activities located in Canada. An installment sale of its adult sites could provide annual income to offset its Canadian expenses. All gaming and license income is now booked through Antigua where SNMM was granted a five year tax holiday. To minimize overall taxation, we expect the Company to announce shortly it will re-domicile outside of the US and Canada, probably to the Isle of Man. Management notes the Isle of Man tax structure is appropriate. Several British gaming entities have recently relocated to the Isle of Man. Our projected effective tax rate through 2001 is 15%.
Listing of its Shares. If the Company is redomiciled, the Starnet shares would trade as either ADRs or as a foreign listed corporation. With its April 1999 financial results near completion, its shares should qualify for a move to a NASDAQ or AMEX listing from the over the counter market..
Valuation. We expect during the next several years, Starnet gaming operations will grow rapidly. Its current growing base, together with its concentration on product improvement, sales, and marketing should give strong probability of achieving our projections through FY 2001. A P/E of 20x to 40x during these next two years, reflective of its growth rate and cash earnings, applied to average FY 2000-2001 earnings per share of $.70 - $.75, suggests a target of $14 to $30, or a one-year target of $14 to $20. We also believe its business may be an attractive acquisition to a worldwide gaming company willing to pay for a bench head in internet gaming. The Company’s balance sheet, with $1.7 million of equity at Q2 end and minimal working capital, should rapidly strengthen. Softec’s cash balances also increase from its own and licensee customers maintaining deposits between site visits.
John M. Dutton, 801 South Figueroa, Suite 1400, Los Angeles, CA 90017, Phone 213-630-4401, Fax 213-623-4590. Email: jmdutton@ix.netcom.com .
Investors Research Institute, Inc., P.O. 750471, Forest Hills, NY 11375-0471, Phone 212-484-4747, Fax 718-523-2137. Email: parprogram@usa.net , investorsresearch.org .
Starnet Communications, Inc., 425 Carrall Street, MezzanineLevel, Vancouver, B.C. V6B 6E3, Canada, Phone 604-685-7619, Fax 604-684-0391. Email: ir@starnetinternational.com , starnetcommunications.com .
M&A West, Scott Kelly, Phone 650-588-2678, Fax, 650-827-9508. Email: scott@mawest.com , mawest.com .
John M. Dutton, a member of both the Boston and Los Angeles Security Analyst Societies, has been an analyst and director of research at several firms including Moseley, Hallgarten, Estabrook & Weedon and LH Friend, Weinress, Frankson & Presson. He was president of Corsair Asset Management, an asset management firm, for over 11 years. For seven years he was a senior executive at the international hospital company American Medical International. Mr. Dutton's present work includes development and execution of strategic and financial planning for small cap companies.
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