Stock Analysis - CEO Interview, Cryptologic from Stockhouse.com
Contributed by: Chaya Cooperberg, Stockhouse Columnist
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Cryptologic (TSE: CRY)
Cryptologic Leads Competition, And May Spin Off IPO
With a huge deal just inked, and more to come, gaming software developer Cryptologic may be a good bet. An upcoming Nasdaq listing, and the possibility of a spun-off IPO, give the profitable company good odds for further success.
In Mark Rivkin's windowed, corner office, the only visible clue to the gaming nature of his software development company, Cryptologic (TSE: CRY), is in the two framed posters of the king and queen of hearts decorating one wall. This small detail attests louder than words to the tasteful, and careful, manner in which Cryptologic conducts business in the flashy world of online gaming.
The profitable company recently sealed the biggest deal the industry has probably ever seen, and is in negotiations with a few more major players. With an upcoming Nasdaq listing, a new product the company thinks is leading the competition by more than a year, and serious talk of spinning off one division with an IPO, Cryptologic has the looks of a good bet in a growing, but risky, industry.
A glass Ernst & Young Entrepreneur of the Year trophy catches the light on a table across from Rivkin's desk. The COO and his CEO brother, Andrew, were this year's finalists in the Young Entrepreneurs category, for those aged thirty or younger. Now 28 and 30 respectively, they founded the business in their basement five years ago. "Basically two brothers starting up a software development company, developing Internet encryption technology," says Rivkin. Andrew was the more technical of the two, but in the summer of 1995 they hired top tech gun Anatoly Plotkin, a Russian ex-pat who had developed software for a Soviet military contractor. Now, Plotkin is the company's Senior VP of technology, and the Rivkins basically provide their vision of the structure.
The Rivkin's original business plan included an E-commerce product called Ecash, which uses the encryption technology and proprietary Internet language they had developed. Using 6,500 different algorithms and a unique messaging language, the program is extremely difficult to hack. Rivkin figures the company has processed more than $2.5 billion of transactions with no report of security loss. An upgraded version of the software is due out sometime in 2000, and a new product for micro transactions such as buying stocks online, is currently in development. This kind of software is a hot commodity as the E-commerce market blazes forward, but competition is fierce.
On the other hand, Cryptologic's gaming software is already counted among the market leaders. The gaming software was the first value-added application. In 1996, the company licensed its first casino, InterCasino, and beta-tested the product. The software is unique among its competition because it is client-server based, as opposed to Web-based, making the program much faster. However, the browser can link to the client server to deliver a running sidebar of information, such as news, stock quotes and ads. Cryptologic has since sold the software to the Cyprus Intertainet Overseas Licensing Limited (IOLL). This wholly owned subsidiary licenses the product to customers, in return for an upfront fee and revenue sharing on an ongoing basis. A license costs approximately US$250,000, but that's pocket change compared with the revenue gained from user fees. There are about 30 different brands of casinos using Cryptologic's technology right now, and the software is available in several languages. The program reaps accolades from those in the know, and after a simple demo, it's easy to see why. Lush color and graphic detail define 3-D panoramic views of the game rooms, through which the realistic plinking of chips echoes. A new version of the software is due out this month, which will add more interactivity. "Version 4.0 will keep us a year or a year and a half ahead of the competition," Rivkin says confidently.
Leaving the virtual realm, a tour through the office maze reveals the many faces of the company. The central Toronto location is home to management and administrative employees, the 24/7 tech support people, the artsy guys tucked away in the graphic design room, the techies in gaming software development, and the editorial staff for Gamesmania Internet Magazine, a video game e-zine. Rivkin glows with youthful enthusiasm as he enters the Gamesmania office, with its shelves to the ceiling overloaded with titles such as Tomb Raider and Age of Empires 2. The acquisition of the e-zine was a strategic one. Bought from a subsidiary of Microforum in January 1999, the site gives the Rivkins a better idea of how to create Web content. "My brother and I are very interested in that industry as well as the PC industry," Rivkin says. More importantly, the site can serve as the perfect vehicle for the Ecash software. "The idea was…they would use our Ecash software to sell PC games, Nintendo games, through their site."
Tellingly, the development base for the Ecash product is in another office a few blocks away. This is because the company sees the Ecash and the gaming software as entirely separate entities, and hopes to create a more palpable distance between them. "There has been some talk of separating the two companies completely," Rivkin says. "Separate the divisions and actually spin it off as another company." He feels the E-commerce software is now being overshadowed by its more glamorous offspring, and deserves a management and investor base of its own. Rivkin says management intends to take that newly independent company public, but would first raise funds for the enterprise through existing shareholders.
There is no question, though, that the lion's share of Cryptologic's revenue comes from the gaming software, and its continued success largely depends on it. According to Nesbitt Burns research, the online gaming industry will be worth $10 billion in 2002, up from $650 million in 1999. Rivkin estimates that Cryptologic's licensees make up about 50% of the industry from the perspective of the number of customers it attracts. "Other companies have 50 to 100 different licensees, whereas we only have 15," he says. "It's small, but our licensees are more successful than any of the other companies." He attributes that to the quality of the gaming software, and in larger part, to the marketing efforts of the licensees.
The company's market share just got a huge boost through a recently inked deal with one of the UK's largest bookmakers, William Hill Ltd. IOLL will add its Internet gaming software and support services to William Hill's impressive gambling offerings. William Hill owns about 23% of the sport betting shops in the UK, controls an estimated 42% of the telephone wager market, and offers sports betting online, as well. Rivkin can't say exactly how much the deal is worth to Cryptologic, but is glad to comment on the scale and potential. "This is the biggest deal that anybody in the industry has, by far," he says. "I think it's going to be a very large deal. How large? The sky is the limit."
The company envisions its future as one aligned with many icons and titans of the industry. "I think that there are a lot of other opportunities with companies as reputable as William Hill," Rivkin says. Cryptologic is now working on several deals with major industry names in Australia, where online gaming is regulated. The company is aggressively pushing to get its software certified in the country that is already being hailed as the next major hub for the booming market.
The online gaming industry, though, still lags behind its land-based cousin in terms of respectability. In a business that is commonly viewed as sinful by the moral right and uptight, online gaming is the devil in the fabled playpen. It is young, fresh and quite possibly out of control. When done right, it's beyond the long arm of the law. Why is online gaming the 1990s version of modern rock and roll?
According to Rivkin, it boils down to a lack of understanding. "People see how well we are doing, but I think that because it's such a young industry, people just don't understand," he says. "They don't understand the business. Yet. It's going to take some time for us to convince people that this industry is here to stay. Because it is. It's not going away."
A sting operation taking down one of the industry's most recognised names surely did not help legitimate the business. The Vancouver office of Starnet Communications was raided in August by a team of police officers after an 18-month investigation into the company's operations. While no charges were laid, Starnet's stock immediately plummeted and enough negative rhetoric erupted to compel Cryptologic to release a statement saying it had absolutely no connection to the busted company.
But are investors scared off? Cryptologic is a profitable Internet play trading at a modest seven times trailing earnings. Rivkin doesn't think fear is an issue but he, like many analysts, does believe CRY is getting short-changed. "I think the stock is extremely undervalued," he says emphatically. "If you look at our multiples and multiples that other Internet companies get, it's something that we really don't understand. We work hard to try and get our message out there and communicate with the public and tell them what we are doing and how different we are from other companies."
But are investors scared off? Cryptologic is a profitable Internet play trading at a modest seven times trailing earnings. Rivkin doesn't think fear is an issue but he, like many analysts, does believe CRY is getting short-changed. "I think the stock is extremely undervalued," he says emphatically. "If you look at our multiples and multiples that other Internet companies get, it's something that we really don't understand. We work hard to try and get our message out there and communicate with the public and tell them what we are doing and how different we are from other companies."
Cryptologic only profits indirectly from the transaction through the licensing fee, and not specifically from the winning or losing hand. Rivkin justly points out that negotiations with William Hill would have fallen flat if there were a hint of illegalities. "The people here in management are honest people," he says earnestly. "When people look at us I think they see that. I hope they do anyway."
As honest as management may be, the nature of the industry is one that attracts seedy characters--criminals even. Mob infiltration is of particular concern to the trade's regulated companies. To help combat that, Cryptologic has hired Norm Inkster, the ex-commissioner of the RCMP, as an advisor to its board. The company also uses the KPMG investigation and security division to check up on all the people it deals with, including licensees and some employees. In addition, the auditing firm has examined Cryptologic from a legal perspective, with respect to the laws surrounding money laundering, and been satisfied that Cryptologic is safe. "From our point of view, we do not want to do business with anybody who's iffy," says Rivkin. "We want to operate like a regular big company."
Right now, Cryptologic is waiting approval for its 40-F filing with Nasdaq, a move that would almost certainly propel growth. The company filed the form on August 26, and according to Rivkin, it's coming along well, but the exchange is pretty backed up. "It's just a matter of whoever is next in line," he says. In anticipation of the listing, a stock split has been considered, but only if shares hit the $30 range. "There is nothing planned in the near future," Rivkin stresses. "It's something we talked about."
By all accounts, Cryptologic is a healthy, growing, productive company. Not only is it profitable, with net income for the second quarter totaling $4.9 million, or $0.57 EPS, but it has a whack of cash at its disposal. In its last reported statement, the company had US$36 million in the bank, and Rivkin says that there is "quite a bit more than that now." Third quarter results are due out by the end of this month, but Rivkin warns against too-high expectations. "There is seasonality in this business, so in the summer months we flatten out quite a bit," he says. "I think we are seeing some growth now. In the fall and the winter our business starts to pick up again."
For a guy who doesn't even enjoy gambling, Rivkin, along with his brother and a staff of 70, have managed to create a leading software gaming company that apparently exists, according to Rivkin, within the borders of the law. Big deals, great products and strong initiatives to create shareholder value, suggest it has the capacity to deliver on its market potential. But as fast as the online gaming industry is growing, Cryptologic may remain underplayed until its reputation as a good bet in a risky business is firmly established.
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StockHouse: You and Andrew founded this company in 1995 in your basement. How did you get from there to the business we see today?
Mark Rivkin: We put out a business plan together, took it out to the financial community to try and raise some capital for further development of our product. In January of 1996, we were successful in raising some $400,000 in seed capital. In March of 1996 we did a reverse takeover on the CDN, of an old mining company. Then we did another, followed that up with another private placement in June of 1996, and raised $870,000 to continue developing our product.
We had three products that we were developing from the business plan. One was an Internet encryption product and our own Internet language that fits on top of the standard Internet language. It sends secured messages back and forth. The other project was an Ecash application that uses security. Then on top of that, our first value added application was the gaming application, so that people could play casino games over the Internet.
Cryptologic is basically a software development company. We don't operate any of the casinos ourselves. What we do is license the technology to third parties to have Internet gaming licenses, to accept wagers, internationally from customers. We commercially licensed our first casino in November of 1996.
StockHouse: And that was InterCasino?
Mark Rivkin: Yes, InterCasino. Basically, through that summer of '96 we beta tested that casino so it was operating for free on the Internet. Customers could come in and play it. That's how we tested our software initially.
StockHouse: How many games did you have at that point?
Mark Rivkin: Good question. Five maybe. Blackjack, roulette, slots, video poker, there was probably one more. So we do concentrate on development. We got a TSE listing in September of 1998. Our new version of the software, Version 3.0 was released in October of '98. Now we are due for Version 4.0 to come out in October of '99. Hopefully. And we acquired a company called Gamesmania in January of 1999 and that's just covering the PC gaming industry. As I said before, we are a software supplier to the Internet gaming industry. We license our software to third parties to operate through our subsidiary. We sold the software a couple of years ago to the Cyprus Intertainet Overseas Licensing Limited (IOLL). They license the technology that we develop and in exchange for that they get an upfront fee. The standard agreement is an upfront fee and revenue sharing on an ongoing basis, as a licensing fee.
StockHouse: How much is the license initially?
Mark Rivkin: If you compare it to the revenue generated, it's small. It's around $250,000 US, somewhere around there. That's a standard licensing fee but it's negotiable.
StockHouse: How many licensees do you have at this point?
Mark Rivkin: With William Hill we are at 15.
StockHouse: Are there more licensee announcements coming up?
Mark Rivkin: Cryptologic is a little bit different from other companies in the same industry. People come to us all the time and want to license technology. We take the approach that we select the licensees that we want to do business with based on their marketing plan, their brand name. We like to be more selective because even the smallest licensee requires the same amount of time as one of the larger licensees to develop software and maintain and support them. We want our family of licensees to be successful large organizations, well capitalized.
StockHouse: How long does it take to set up a licensee?
Mark Rivkin: It usually takes between two and three months. From start to finish. It depends on how long the negotiations go.
StockHouse: How many casinos out there are using Cryptologic technology?
Mark Rivkin: There are about 30 different brands of casinos, using the same platform. They all use the same technology. But they have the ability to re-brand the casino to attract different customers, to attract a different demographic. For example, a Japanese language casino, which is in the Japanese language, with Japanese dealers. We have a couple and we're working on more. The Japanese language has been out for about two years now. They market to Japanese customers only. Not to the North American market, but the Japanese clients. They are focussing in on a particular demographic.
StockHouse: Who would you say are your main competitors on the gaming, not the E-commerce, side?
Mark Rivkin: We have tons of competitors for the E-commerce offering, be it Microsoft or other companies. Concentrating on the gaming portion, it's difficult to make a comparison because companies like BossMedia and Starnet operate their own casinos. They are not just licensing the technology. From a licensing point of view, those two companies are probably the competition.
StockHouse: What about other companies, such as Chartwell [A.CWH] and Tropika [TPIL]? Or don't they pose much of a competitive threat?
Mark Rivkin: It's hard to say. We try to follow the industry, but we're a development company focussed on developing the best software and hopefully the rest will take care of itself.
StockHouse: What about the software makes it stand out from other technologies?
Mark Rivkin: It's client server. On the web-based version every time you select a card or initiate an event, graphics and sound are transmitted over the Internet, in most cases. In 1995, we looked at that web base, and decided that its better to have graphics and sound stored on the customer's computer because really what you are doing is you're playing a video game and video games don't work very well over the Internet using a web base system. They are not fast enough. So we decided to develop a client server type of environment.
StockHouse: Are there any developments with the Ecash software?
Mark Rivkin: What we have done with the Ecash company is actually separate development. We now have this office which basically develops the core technology for encryption for gaming and for the Ecash that is embedded in the gaming product. But we have another Ecash product that we are working on which is for small micro transactions -- buying stock from the Internet, and offering services like a Bid.com, couponing, all kinds of different services. It's going to be sort of an all-in-one commerce product. But what we have done is separate the development team so we have an office that's about two or three blocks away and that's where we are doing the development for the Ecash product.
StockHouse: When will the upgraded version be out?
Mark Rivkin: It will be sometime in 2000.
StockHouse: How are you planning to market the product?
Mark Rivkin: First, we have to raise money for that product. There has been some talk of separating the two companies completely. The same basic shareholders but separating the companies. Separate the divisions and actually spin it off as another company.
StockHouse: Would you take it public?
Mark Rivkin: We would, yes. It should be on its own. This business right here is doing very well, but it's overshadowing the Ecash product that we have. It should have a home of its own. They're completely different products, different management. They really require different management.
StockHouse: How secure is the Ecash software in terms of encryption?
Mark Rivkin: It's a proprietary encryption application. Basically we use our 6500 different algorithms to encrypt and decrypt data. We have also developed a proprietary messaging language. You have to understand how a message is developed if you want to look at it or understand what it is and what it is for and what it is doing. So we encrypted the message and wrote our own language so that our servers will only accept messages written in their own language. Makes it difficult to hack. We processed over $2.5 billion dollars of E-commerce transactions so far. Probably more than that, and there has been no report of security loss or hackers or anything like that. We've been pretty successful managing that, as well as a key managing system which mainly is the encryption keys going back and forth. So each session as you go through it, transmitting information through servers from here, servers in Antigua, servers wherever the operator is based, is all managed by us and that's a pretty elaborate system. We also change, as I said, the keys between sessions. Because we change the key every time, you actually have to re-hack each time a new session started.
StockHouse: What will be different about the Version 4.0 of the gaming software?
Mark Rivkin: I can't really say at this time what is going to be different in 4.0.
StockHouse: Is it going to blow us away?
Mark Rivkin: I don't know if 3.0 blew you away, so it's hard to say. I think that we're still a year or year and a half ahead of the competition. Version 4.0 will keep us a year or a year and a half ahead of the competition. It's got some good functionalities. More interactive between people who are playing. If you want to make it the type of environment where people come to do more than just gamble. In that case they will spend more and more time in that environment.
StockHouse: How do you get around the legalities of Canadian law surrounding the gaming industry? You've said that only the Ecash software is run on Canadian servers. How does that circumvent the rules?
Mark Rivkin: The customer is making an Ecash purchase from here. When the customer wants to gamble, they make a purchase of let's say $100. So the end user will come to the Ecash systems and then make the purchase of $100. They want to play a game, blackjack for example. Your computer is going to connect directly to the computer in Antigua, without coming through here. The Ecash server is going to send the game server in Antigua a $100. The customer, the end user, now has $100 on the game server. They are going to play on that game server and then a result is going to be sent back, either plus or minus, to the Ecash server. There is actually, physically, no game that happens here. It's just a financial transaction. We are a transaction processor. We're just a settlement facility, no different than Visa or MasterCard would be when you walk into a store and you purchase a shirt. You are not actually buying it from Visa or MasterCard but the money is going through Visa or MasterCard at some point in the transaction, like through their banking system.
StockHouse: But at some point, Cryptologic profits from that transaction?
Mark Rivkin: Indirectly, through a licensing fee. The entire company, on a consolidated basis, profits as a result of licensing fees we can take through IOLL, but not specifically from this transaction. It is a software licensing fee. Like most software that is developed that people license, the better the software does, the higher the licensing fee can be. So there is a relationship but it's not a direct relationship, that if somebody loses a $100 in gambling we profit. It's a licensing fee.
StockHouse: I have a copy here of the criminal code on the gaming laws in Canada. I'd like to know how the company responds to each of these items.
Mark Rivkin: I can't. First of all I'm not a lawyer, and I can't comment on the legal aspects of gaming.
StockHouse: I understand, but as the co-founder and COO of this company, how do you respond to the section that states "Every one commits an offence who has under his control any money or property relating to a transaction"?
Mark Rivkin: But this is only related to cash transaction. It's not relating to a gaming transaction. It's not a gaming transaction.
StockHouse: There are many lawyers employed by the company. What do they say about the legal aspects of the business?
Mark Rivkin: It's not like that. We started in 1995. We've been doing it since then. We know that we are not in the gaming business. We know that when customers gamble they are playing on servers in Antigua, there's no gaming information that hits this company, aside from Ecash transactions. What you have to recognise also, is with the Internet it's very difficult to say where the transaction actually happened. If a customer is playing with cash in Antigua, that to us is where the gambling is taking place. That's where the customer wins or loses money. It happens in Antigua. That's where the gaming laws are stored. The customer communicates directly with those servers.
StockHouse: How does Cryptologic deal with licensees if they circumvent laws? Is that the sole jurisdiction of the licensees?
Mark Rivkin: That's the job of the licensee. The licensee is the operator. They do the marketing. They operate the casino. It is their customer.
StockHouse: You don't even market the games?
Mark Rivkin: We don't market any game to anybody. We are not in the gaming business aside from being a software development company. That's what separates us from people like Starnet [SNMM], people like BossMedia.
StockHouse: I'm asking these questions because they come up often on our message boards. Investors seem worried, in the aftermath of the Starnet scandal, to hold a piece of a gaming company. Do you find that fallout from Starnet's bust is affecting shareholder's faith in Cryptologic?
Mark Rivkin: I don't think so. We're two completely different companies with completely two different situations. I don't think, when you compare us to Starnet, is like comparing apples to apples. Cryptologic is a well-recognised company. Everybody knows what we do. We're a TSE listed company. We just completed a deal with William Hill. They did a tremendous amount of due diligence. They are a very large company. They wouldn't get involved with a company that was in a grey area or on the line. They looked at our business. They liked what we do. I don't think you can compare us to Starnet in any way. From a management point of view, our directors are very well known individuals in Toronto in the financial community. They are well respected. The people here in management are honest people. Honest and hardworking people. When people look at us I think they see that. I hope they do anyway. |
