BUSINESS

Morgan Stanley Research: conclusions from trip to Gibraltar

TAGs: Gibraltar, morgan stanley

We hosted an interesting online gambling field trip to Gibraltar, that gave us cause for optimism on US and European regulation and casino growth, although poker remains a concern. Overall, our visit was a positive one with the reasons for optimism for the industry from US and European regulation, possible consolidation and growth in casino more than outweighing concerns over the current weak trading in poker. We think structural growth prospects in the industry are high, and are not well reflected in the share prices. We rate bwin, PartyGaming and 888 Overweight, and see these companies as best positioned to take advantage of significant long-term growth potential in the industry. There were a number of consistent themes in the meetings:

1) US liberalization preparations are well underway.
2) The French market opening has strong potential, and other markets in Europe are likely to follow.
3) Online consolidation seems to have taken a back-seat, while developments in new markets are so fast.
4) Rising fraud levels have been brought under control.
5) Poker trading remains challenging against the US-facing sites.
6) Trading in casino, sports and bingo remains strong.
7) Sports is a differentiated and high quality product.

1) Operators are gearing up for US liberalisation.
All operators were optimistic about prospects for liberalization here, and are all positioning themselves to be involved in any opening in the market. Bwin said it had seen a substantial rise in interest from US organisations looking to make sure they are ready for these changes over the last eight weeks. Bwin and PartyGaming are negotiating with potential partners in California and elsewhere, and are considering both B2B deals and joint ventures with land based casinos, current gambling licence holders and other parties. Both said that any deal could involve a US partner taking a strategic stake in the company. What is perhaps most encouraging is that the European operators seem to be in strong demand from potential US partners, allowing them plenty of choice both as to who the partners are and the structure of any deals. This also shows that liberalisation is increasing being seen as the future within the US.

2) Significant potential from liberalization in Europe.
Bwin remains hopeful of getting a licence to offer sports betting in France before the World Cup starts at the end of next week, and poker licences should follow a month or so later. The Italian experience shows that regulating online gambling, and allowing mass-media marketing, generates significant growth in the total market. Italy also shows that it is key to get into emerging regulated markets early. France looks like it will be a very competitive market initially, and Bwin and PartyGaming both appear well-prepared to make rapid inroads. Estimates of reaching break-even vary widely between the operators- bwin expects to make a profit after nine months, PartyGaming some time next year, Ladbrokes after three years, and the Barriere group think it could take four, despite its expectation of being a top five operator. The economics in France will depend on whether or not the government follows Italy in lowering tax rates and how long it takes to do so, and whether French consumers choose licensed operators over untaxed offshore sites. On the latter point, Arjel is hiring 150 operatives to police the new regulations, and licence holders are also likely to be looking to help here. The operators were also optimistic about progress in Spain, Germany, Greece and Denmark, all of which are in the process of liberalizing their online markets. In newly-regulating countries the operators expect that tax rises will be more than offset by market growth as advertising becomes legal, although there is likely to be volatility in profits as new territories make the transition.

Exhibit 1
Legal online gambling in Italy is now much bigger than offshore gambling was before regulation – we expect other countries to follow

Source: H2 Gambling Capital, Morgan Stanley Research

3) Online to online consolidation looks unlikely in the very near-term, although operators recognise that the rationale remains compelling.
Given the advantages of scale in the online gambling industry and the strong overlaps between major operators, we continue to think industry consolidation is desirable, would be beneficial for participating companies, and will happen in the medium term. We think both cost and revenue synergies are readily achievable, that technological integration is feasible and we estimate that a Party/bwin merger would enhancing earnings by 20-40%. The operators are aware of this potential, but large scale consolidation in the near-term looks less likely than it did a few months ago. While the shape of US regulation looks unclear, and the operators are examining the potential from partnerships of various types in the US, there is likely to be less focus on consolidation amongst the European operators in their current form. On top of this founder shareholdings seem to remain an obstacle. We continue to think that the rationale for consolidation is compelling, and that large-scale M&A activity is inevitable in the medium to long term.

4) Fraud costs are under control.
Operators saw a sharp rise in chargebacks in H2 2009. However this is a result of deliberate risk management decision-making to maximize revenues rather than minimize chargebacks. Tighter controls prevent access by some legitimate revenue-generating players, so operators have to manage the trade off between chargeback costs and curtailing their own revenues. They do this by regularly tweaking their procedures, which can result in volatility in fraud costs, but a rise in chargeback costs should not be a cause for concern per se because as long as the risks are being managed well the costs should be outweighed by extra revenues. Despite a rise in H2 2009, fraud levels have been brought under control.

5) Poker remains challenging.
The market is concerned about weakness in poker trading after 888’s profit warning last week and lacklustre figures from other operators. Part of the decline is seasonal, part of the decline is FX driven, and poker activity tends to be volatile, with weather one of many factors having an impact. However, all of the listed operators continue to struggle to compete with the high liquidity and marketing resources of the US facing operators. Even these have seen some stagnation in volumes recently, so poker increasingly appears to be becoming a mature product in the some of the established geographies. We see decent growth potential in newly regulating markets like France and Denmark, and being positioned to benefit from this (as Party is through its B2B deals with PMU and Danske Spil) will be essential we think.

Exhibit 1
Although April and May have been weak relative to Q1, PartyGaming and bwin both had more players in May 2010 than they did in May 2009

6) Casino and bingo trading remains solid.
Despite weakness in poker, which is the main player acquisition tool for operators like PartyGaming, the performance in casino sounded strong throughout the industry. New slots are continuing to be a key driver of growth here, and in particular the use of brands from film and television to bring in new players. Growth at PartyGaming from new and improved content is being augmented by better and more focused marketing and new jackpot strategies, and its strong development capability is increasingly a strength here. 888 said that while reported revenues were coming under pressure here, all the weakness is due to currency, with underlying player dynamics remaining strong. We think operators with proprietary casino technology (888 and PartyGaming) will have a significant advantage here as the market develops.

7) Sports an area of real differentiation.
Sports players are the cheapest to recruit, and have the longest average lives (although casino players have higher lifetime values on average). Unique content and live streaming is providing a real point of differentiation, and with bwin securing a wide range of exclusive content deals, we think it is best positioned to dominate the sports betting market across Europe. Sports trading remains extremely strong for William Hill, and its rejuvenated product range and risk system has driven ongoing market share gains here.

Source: Morgan Stanley Research

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