Supply Side Investing - Evolution AB

Best lesson from Capital Returns and how it applies to the live casino industry

On November 2023 I started a position on Evolution AB. I never wrote here about it because it’s a very well known company and there are a ton of good write-ups out there and I had nothing to add.

Some days ago, while re-reading Chancellor’s book Capital Returns, I was reminded of the importance of focusing on an industry’s supply dynamics, instead of the demand dynamics. Most investors focus on the demand of the products or services that companies sell, but it is more important to focus on the supply dynamics of the industry.

The typical capital cycle of an industry (from Capital Returns by Chancellor)

For an industry where there is no limit to supply and anyone can start a business and compete, an industry with low barriers to entry: Once the participants see that profit margins and returns on investment are high, they will invest more money, they will bring in more supply. If demand then goes down, or the market is over-supplied, profit margins will fall as participants compete on price. Down cycles can be really long an aggressive if they have to clean up many years of over-investment, but then, the industry ends up with less supply, returns on capital and profit margins improve and share prices can recover.

Some times, the low part of the cycle can be postponed for many years if demand is strong and growing. For example, the IT outsourcing industry looked like an industry full of compounders, and it was for many years, but once there were some problems on demand, the fact that supply was not limited and increasing, created a hard market for all the participants.

Endava issued a profit warning as margins are falling due to lower demand and higher competition

What kind of industries can escape the capital cycle portrayed above? Industries in which supply is limited for some reason. Look for example, at the social media industry. If someone wanted to start a company to compete with Meta Platforms, they would have a really hard time. Who would join a new social media, where none of their friends are there and there is not much content? The network effect makes it hard to compete and naturally limits supply, there will only be a handful of social media companies, and winner will take most. If demand for ads drops, Meta will have a bad time, however, it will be very hard to take market share away from them.

Evolution AB and the live casino industry

Players of online casinos expect the best possible experience, since there is a high element of trust involved. Digital casino providers usually do not have the scale and expertise necessary to live-stream games by themselves. Since Evolution’s customers lack the scale and expertise to in-house their games, they go to Evolution who charges them a fee as a percentage of their profits. For a new entrant in the industry, they will find it almost impossible to make a profit, since they will need enough scale through contracts with several online casinos who are all already working with Evolution or another player. Evolution’s customers will not change to another supplier if there is not a good reputation and high element of trust. Supply is very limited.

The live casino industry is a winner takes most industry. It is very hard to start a company from scratch and compete with Evolution, so there are only a handful of competitors such as Playtech. As with social media, the best (Evolution) takes a big chunk of market share, and experiences excellent economics and profit margins. The fact that supply is limited is great for the industry in the long-term.

I am not sure if Evolution will be able to maintain it’s crazy-high margins, and there are some risks such as regulation, however, I think the industry has excellent prospects and I am long. It was also at a bargain price back in November, but I do not think it’s expensive now.

I could write a lot more about Evolution, but I think it is best to refer you to the best writeup out there from my friend Fundasy:

Evolution Gaming: A Moat Analysis

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