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I've been a long-time reader of these boards and have really enjoyed the content; but haven't posted much. I thought this was worthy of a post, though.

I noticed a line in the MD&A (Management's Discussion & Analysis) of the CRYP annual report that I'll quote below.

"Management estimates that the enactment of UIGEA would have reduced revenue by $31 million and earnings by $24 million if the act had been in force for all of 2006."

This sentence just about jumped off of the page and hit me.

Keep in mind that total net earnings for 2006 were $24.8 million, and operating earnings were $22.4 million. UIGEA was the US legislation enacted on October 13, 2006 that made it illegal to process gaming-related financial transactions for US-based players.

The company is saying that absent is its US operations (30% of sales), it would not have made an operating profit. Meaning, that on their own, the European and other businesses lost money in 2006.

I think the reason for this may simply be the leverage issue. 30% of their sales generated more than 100% of their profits because they came at the point when the fixed costs were all covered. But perhaps some of the final payments from Betfair or other one-time items are adding pure profit to the US pile of revenue? Or, perhaps they have lower costs on their US business? At any rate, it isn't important now that all that revenue (and profit) has gone away.

So, if it is simply a question of maximizing volume to leveraging their fixed costs, then the key would be how fast CRYP can replace the $31 million lost from the US.

They did $19.6M in sales in Q1...(ex jackpot reserve), annualizing this equates to $78.4M, but Q1 is a seasonally strong quarter, so perhaps $75M is a better estimate for the year. This would be $29M less than last year, equating to almost flat growth in the European operations. Maybe reflective of their poker activity slowing down, as some have posted?

Management goes on to say that " the latter part of 2008, we should start to trend toward quarterly revenue run rates similar to those realized prior to the UIGEA enactment..."

Well, Q1 2007 is the first full quarter without US revenue, so like-for-like comparisons (ie. for the Europe business) will begin in 2008... why the "latter part of 2008"? Slow market perhaps? Or a cushion for management? :-) (see comment at the end)

For balance, here is a third, IR department-esque, quote later in the report: "Since 2002, Cryptologic has been...shifting its business to Europe, and our record revenue and earnings in 2006 arise from our success in these markets and others that embrace internet gaming. Our thriving European customers, strong balance sheet, and new business in Asia enable us to to face the future with confindence." I'm taking this with a salt shaker, given the information above.

So, it seems to me that Europe wasn't profitable last year, and still isn't, hence the ugly Q1 results (again a loss without the jackpot reversal... which I wonder if CRYP will need to re-provide for jackpot winnings, given the two recent big payouts announced in a recent press release).

To sum up, it seems like CRYP is in a transition phase. Asia has a lot of promise, but their operations there aren't even off the ground yet (I'm referring to their JV... I don't know how many current customers they have there). Their core business, European gaming is unprofitable at the moment. Operating expenses are going to increase by $2.5-3.0M per year due to the new HQ in Ireland (although some have prediced cost savings eventually if they leave Canada).

On the plus side, they seem to have good technology, have signed some new customers recently, and could be well-placed to do business in Asia (although it is still early). And $102 million of their $374M market cap is in cash. And the model appears to be really scalable.

So, while I was really excited about the company in the $25-28 a share area prior to Q1 earnings... and given that I like the idea of buying out of favor companies, or those that are suffering a TEMPORARY drop in earnings... it is not clear to me that the lean times at CRYP will end within the next few quarters.

I feel that Q2 will be ugly again, with Q3 (seasonally the weakest quarter) being mediocre, and subsequent quarters into 2008 also mediocre. Investors will begin to lose patience (Europe hasn't turned around, slow Asia rollout), and the stock could be back to the $15-17 range by this time next year.

In analyst-speak, I see more issues than catalysts on the horizon, and while this could be fine if you buy and hold, at $25 a share you aren't being compensated for it. Wait until the sentiment turns more negative and the stock bottoms out... my guess in the $15-17 range.

Fool On!


PS- If you want a laugh, look at the "Scorecard 2006" and "Goals 2007" sections at the beginning of the annual report. All the specific Financial Performance metrics are dropped from Goals for 2007 (vs. 2006) and in fact, none of the categories by which they judged themselves in 2006 is repeated in 2007. Typical repainting the bulls-eye ahead of time to prepare for your wayward shot! (I realize UIGEA was outside of their control, but still...)

My view is that they should have at least owned up to the fact that 2007 will be ugly and explained why. If all your profits are going to disappear next year, it seems like a big enough issue to address in the annual report.
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