Steve Oh Value Investing

Optimal Group, Inc.

Steve Oh
Value Investing
4/10/2007

Company Background
Optimal Group (OPMR) is a payment processing company based out of Montreal, Canada with
operations in the United States and Europe. Its market capitalization is about $200M. In 2006,
its operations were separated into three segments:

Optimal Payments handles credit card payments for small and medium sized businesses
FireOne Group processes transactions for online gaming businesses
Optimal Services provides hardware maintenance and repairs services.

In September 2006, the company sold nearly all of the assets of Optimal Services and
discontinued the operation. In 2007, the company combined Optimal Payments and FireOne into
one payments services group.

Optimal Payments
Optimal Payments processes credit card payments for small and medium-sized Internet
businesses, mail-order merchants, and retail point of sale merchants. It processes credit card
payments for card-not-present and card-present transactions. The payments business generates
revenues primarily from fees charged to merchants for processing services, as well as from fees
charged to consumers who use electronic wallet services.

FireOne Group
FireOne processes online gaming transactions through the use of credit and debit cards,
electronic debit and electronic wallet. It charges fees to the end customer.

In June 2005, Optimal Group sold a 20% share of FireOne on the Alternative Investment Market
(AIM) of the London Stock Exchange. It sold 10 million shares for $44.1M, valuing the
segment at $220M.

With the growth and popularity of online gaming and online poker, EBITDA for the group grew
from $7.2M in June 2005 to $10.6M in the following year. Furthermore, EBITDA margins for
this line of business are above 42%. FireOne was drove much of the growth for Optimal Group
up to 2006. Many analysts saw the growth in the FireOne group as a good reason to invest in the
Optimal Group.

However, United States Congress passed the Unlawful Internet Gambling Enforcement Act of
2006 (UIGEA) in October 2006. This act prohibits businesses from accepting payments related
to betting or wagering over the Internet. Subsequently, FireOne stopped processing financial
payments originating from the United States. These transactions from the United States
represented approximately 81% of FireOne revenues.

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With the viability of FireOnes business in question, Optimal Group made an offer for all of the
issued shares in FireOne held by non-controlling shareholders, which represented approximately
24% of FireOnes capital. They completed this offer on February 23, 2007. The offer price was
0.60 per share, representing a cash consideration of approximately $16.4M. This gives
FireOne an implied valuation of $61.3M.

Stock Price
On March 28, 2007, Optimal Groups (OPMR) stock closed at $8.20.

Stock Price
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Stock Price $ 8.20
52 Week Low $ 7.45
52 Week High $ 16.90
Drop from 52 Week High (51.5%)
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Close on Mar. 28, 2007

A look at the stocks performance shows a downward trend since April 2005. Over a three day
span in early October after the announcement of the UIGEA, the stock price dropped 42%.

OMPR

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Ratio Analysis

Market And Book Values

Value Per Share
Market Value $ 195,596 $ 8.20
Book Value $ 219,382 $ 9.20
Cash $ 134,196 $ 5.63

Ratios
Price/ Book 0.89
Price/Sales 1.02
P/E (Trailing) 15.3
P/E (Forward) 12.3

On the surface, the company looks like a value investment with a Price to Book ratio below one
and a low Price to Earnings ratio of 12.3. Additionally, the company has large cash reserves on
the balance sheet equal to $5.63 per share.

Balance Sheet
In addition to the strong cash position (see Figure 1: Net Cash and Net Debt), the company
carries very little debt. There is no long term debt and $8.6M of short term debt. The Debt to
Equity ratio is 0.04.

The company carries $106M in goodwill and intangible assets which represents customer
relationships, proprietary technologies, and suppliers contracts. Being a payments processing
company, the company has very few hard assets outside of cash.

Reproduction Value
Adjustments are made to the book value of assets to estimate the reproduction value of the firm
(see Figure 2: Reproductin Value). Excluding cash, the firm does not have much in tangible
assets. It carries not inventory and has only $2M in PPE. It holds $22M in cash and short term
investment as reserves against fraudulent activities related to credit card payments. However, a
company entering the business would not have to carry these reserves so cash and short term
investments are adjusted almost to zero.

Optimal Group owns proprietary technologies and must continue to invest in research and
development to create and maintain technologies related to its business. A competitors ability
to recreate Optimal Groups assets would depend on their ability to create these technologies and
customer relationships. These values are represented in goodwill and intangible assets. A
competitors costs to recreate these intangibles would be closer to the gross intangible value, not
the value current on the book which the company has been amortizing. Intangibles were
adjusted up to include the amount amortized in the past three years.

Finally, the Other Asset line item represents FireOne. Since the companys recent offering
valued the company at $61.3M, this item was adjusted up to reflect its current market value.

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The Reproduction Value of the enterprise is $114.0M and the equity is worth $239.6M after
adding in net debt or $10.0 per share. Because Optimal Group does not rely on hard assets to
generate earnings, a reproduction value calculation is less reliable compared to a similar
calculation for a company with lots of physical assets.

Income Statement
The income statement of Optimal Group is difficult to evaluate because only one financial
quarter has passed since FireOne stopped taking payments from customers in the United States.
Those revenue sources accounted from 81% of FireOnes revenues and approximately 34% of
the entire companys revenues. Analysts were very pessimistic about the companys ability to
generate earnings after the passing of the Unlawful Internet Gambling Enforcement Act. They
estimated EPS of $0.03 for 2006 Q4 when the company reported $0.15. Optimal Payments,
unaffected by UIGEA, had no problems generating earnings.

Earnings Power Valuation

Again, it is very difficult to normalize Optimal Groups earnings because their ability to generate
revenue changed dramatically very recently. With that in mind, the company was valuated with
three Earnings Power Valuation calculations:
I. Based on 2006 full year earnings. The EPV for full year 2006 is much too high so this
will serve as an upper bound for EPV.
II. Based on Q4 earnings (reflecting the impact of the UIGEA) prorated. The EPV based on
2006 Q4 earnings prorated reflects the recent drop in FireOne revenue but also includes a
seasonality basis since the company has historically recorded better earnings in Q4.
III. Based on 2006 full year earnings generated by the Optimal Payments group. Earnings
for just the Payments group, which should be unaffected by FireOne, will serve as the
lower bound.

A summary of three valuations (see Figure 3: Earnings Power Valuation) is below:

Earnings Power Value

Enterprise/S
Enterprise hare Equity Equity/Share
I. 2006 Full Year Earnings 259,381 10.87 384,996 16.14
II. 2006 Q4 Prorated 204,823 8.59 330,438 13.85
III. 2006 Full Year Optimal Payments 81,479 3.42 207,094 8.68

The third earnings power valuation which is the most conservative valuation will be used going
forward. This value assigns zero earnings power to the FireOne group even though it generated
EBIT of $7.0M in the fourth quarter. FireOne is has viable business opportunities outside the
United States but the group is still very difficult to valuate.

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Finally, a check on the enterprise valuation of Optimal Payments derived with EPV is compared
to comparables shown below:

Optimal Payments Comps

Optimal RDM Heartland
TEV/Revenue 0.8x 2.5x 0.8x
TEV/EBITDA 8.7x 18.6x 10.0x

Growth Opportunities
The EPV calculation is based on Optimal Payments 2006 earnings and does not give the entire
firm any credit for any growth opportunities. Optimal Payments can expect healthy organic
growth given the reasonable expectation that more small and medium sized businesses will
conduct more transactions over the internet and with credit cards.

However, the major source of growth unaccounted for in the valuation is FireOne. First, it can
be run as a viable business if it concentrates it efforts on customers in Asia and Europe.
Secondly, it is possible that Congress will reverse the Unlawful Internet Gambling Act. In
March 2007, Representative Barney Frank, the chair of the House Financial Services Committee,
stated that he may introduce a bill to reverse the Internet gambling law. Also, the World Trade
Organization ruled in favor of Antigua in a complaint that the United States ban on internet
gambling violates free-trade rules. The United States will choose to ignore this ruling but other
countries may use this disregard of the WTO against the country in future free trade negotiations.
In that case, the debate over the Unlawful Internet Gambling Act will resurface.

Summary of Valuations
A summary of the various valuations discussed are presented below:

Summary of Valuations
Enterprise Equity Equity/Share
Market Value 69,981 195,596 8.2
Book Value 93,767 219,382 9.2
Reproduction Value 113,993 239,608 10.0
EPV (Full Year; Payments Only) 81,479 207,094 8.7
EPV (Q4 Prorated) 204,823 330,438 13.9
EPV (Full Year) 384,996 510,611 21.4

If the company is valuated by $5.28 in cash plus $3.42 in EPV for Optimal Payments then the
equity is worth $8.7. It currently trades at $8.22. For that price, the investor is paid $0.50 to take
the following elements of the company:

Growth in earnings of Optimal Payments

Current earnings of FireOne
Growth in earning of FireOne w/o a reversal of UIGEA
Growth in earning of FireOne w/ a reversal of UIGEA

These elements are very difficult to measure but surely have some value.

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Finally, another sign of validation that the stock is undervalued comes from the companys
Board of Directors. On November 6, 2006, they approved a stock buyback program which
authorizes the company to purchase up to $1.1M of its common shares. This represents almost
5% of outstanding shares.

Value Investment Themes

The Optimal Group valuation reinforces several important Value Investing themes.
The company is small and relatively obscure. Several analysts tracked the company
when it was growth stock driven by FireOne but coverage has mostly stopped since
UIGEA was passed.
Investors were disappointed after UIGEA and the market overreacted in sending the price
of the stock down 52%.
Investors failed to find the hidden value of the company, namely Optimal Payments, by
evaluating the business on a per segment basis.
The cash position of the company provides limited downside risk.
Investors should not overpay for growth but should take it when it comes for free.
When a line of business is difficult to valuate like FireOne, it makes sense to subtract the
valuation of business that can be valued from the market cap to see how much that
business trades for. In this case, the value was negative.

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Exhibits

Figure 1: Net Cash and Net Debt

Net Cash and Net Debt
Cash:
Cash and cash equivalents 103,922
Cash held as reserves 18,960
Short-term investments 71,621
Short-term investments held as reserves 3,110
Settlement assets 7,061
Total 204,674
Less:
Bank indebtedness (8,581)
Customer reserves and security deposits (61,897)
Net Cash 134,196

Net Cash 134,196

Less Short Term Debt (8,581)
Net Debt 125,615

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Figure 2: Reproduction Value

Adjusted Asset Value
Book Value Adjustment Reproduction
Assets
Current Assets
Cash And Cash Equivalents 122,882 (110,594) 12,288
Short Term Investments 81,792 (81,792) 0
Net Receivables 8,817 0 8,817
Inventory 0 0 0
Other Current Assets 2,625 (656) 1,969

Total Current Assets 216,116 23,074

Long Term Investments 3,144 0 3,144
Property Plant and Equipment 1 2,121 1,576 3,697
Goodwill 49,243 0 49,243
Intangible Assets2 56,798 21,753 78,551
Accumulated Amortization 0 0 0
Other Assets3 10,423 50,877 61,300
Deferred Long Term Asset Charges 2,692 (2,692) 0

Total Assets 340,537 219,009

Net Reproduction Value

Adjusted Asset Value 219,009
R&D Past Three Years 7,558
Minus Non-Interst Bearing Liabilities (112,574)
Net Reproduction Value 113,993
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PPE is adjusted to gross value
2
Intangible assets are adjusted to gross value
3
Other Assets primarily represent FireOne and it is adjusted to the current market value of FireOne

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Figure 3: Earnings Power Value

I. Earnings Power Value
Based on 2006 Earnings

Sales 191,893
EBIT (before one-time charges) 27,282
Less adjustments (1,581)
EBIT adjusted 25,701
Tax rate 32%
EBIT after tax 17,477
Depreciation and amortization 13,649
Maintenance capex 0
EBIT after tax adjusted 31,126

Adjusted EPV
Per Share
Earnings Power (Enterprise) 259,381 10.87
Minus Net Debt 125,615 5.27
Adjusted EPV (Equity Value) 384,996 16.14

Calculated with WACC = 12%

II. Earnings Power Value

Based on Q4 2006 Earnings Prorated

Sales 33,932
EBIT (before one-time charges) 4,126
Less adjustments 0
EBIT adjusted 4,126
Tax rate 32%
EBIT after tax 2,806
Depreciation and amortization 3,339
Maintenance capex 0
EBIT after tax adjusted 6,145

Adjusted EPV
Per Share
Earnings Power (Enterprise) 204,823 8.59
Minus Net Debt 125,615 5.27
Adjusted EPV (Equity Value) 330,438 13.85

Calculated with WACC = 12%

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III. Earnings Power Value

Optimal Payments Group Only

Sales 107,742
EBIT (before one-time charges) (4,046)
Less adjustments (365)
EBIT adjusted (4,411)
Tax rate 32%
EBIT after tax (2,999)
Depreciation and amortization 12,777
Maintenance capex 0
EBIT after tax adjusted 9,778

Adjusted EPV
Per Share
Earnings Power (Enterprise) 81,479 3.42
Minus Net Debt 125,615 5.27
Adjusted EPV (Equity Value) 207,094 8.68

Calculated with WACC = 12%

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