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Investing The Hard Way: Europe, iGaming, and Shuffle Master’s Retreat

TAGs: bwin party digital entertainment, Caesars Entertainment, Calvin Ayre, Department of Justice, Gary Loveman, iGaming North America, international game technology, investing the hard way, Norbert Teufelberger, Ongame Network, Shuffle Master

The main program of the 2012 iGaming North America conference opened on March 5th with optimism in the air. A little over two months after the Department of Justice appeared to legalize online gambling in the United States, attendees listened to speakers who boasted of the billion-dollar revenue potential for the US iGaming market, and made bold predictions for the pace and scope of online gambling legislation in the US. As if to punctuate the bullish mood, one of the conference’s few exhibitors, Ongame Network, was acquired by Shuffle Master (SHFL) less than an hour before the conference’s session on mergers and acquisitions was to be held.

Investing The Hard Way: Europe, iGaming, and Shuffle Master's RetreatFour months later, the mood in the iGaming industry is far less ebullient. Just two states have moved toward legalization, industry insiders have mocked the valuations paid by iGaming acquirers, and, now, Shuffle Master has backed out of its Ongame purchase. Ongame remains owned by Bwin.party Digital Entertainment (BPTY.L), whose co-CEO Norbert Teufelberger is, ironically, one of the insiders who has criticized the inflated price tags in the iGaming sector. Teufelberger’s firm, which stood to earn as much as €30 million from the sale, will seemingly now have to settle for a less-inflated – ie, cheaper – sale price, as he tries to boost a stock that is trading near an all-time low.

Of more interest to investors, however, is Shuffle Master’s reasoning behind the deal’s cancellation. In a press release announcing its decision, CEO Gavin Isaacs opened by emphasizing that “we remain ardent believers in the growth opportunities for online gaming.” But Isaacs went on to detail the reasons for Shuffle Master’s abrupt change of heart, reasons that show an insider’s caution toward issues that may hit gambling stocks worldwide over the next twelve months:

“Business conditions in Europe have deteriorated since February.”

This should not be news to anyone who even casually follows the global economy; the drama in Greece has faded from the front pages, but Italy and Spain have moved to the front of the line in the ongoing European debt crisis. Germany continues to oppose a full bailout for its southern neighbors, who edge closer and closer to outright default and, in the long term, a potential collapse of the Euro itself.

Amid the political infighting, economic activity on the Continent continues to contract, and European stock markets continue to fall. But surprisingly, European iGaming leaders such as 888 Holdings (888.L), Paddy Power (PAP.L), and Betsson AB (BETS-B.ST) have defied economic fears and performed well so far in 2012. Shuffle Master’s decision to back away from Ongame, and its clear belief that the European weakness will eat away at profits for gambling operators, may be an omen of more difficult times for those stocks in the year’s second half. Shuffle Master no doubt had the opportunity to look at Ongame’s books, and the fact that they concluded that an Ongame purchase would no longer be neutral on an EBITDA (earnings before interest, taxes, depreciation, and amortization) basis – as they did when announcing the purchase in March – means that Europe’s economic weakness may finally have struck the continent’s gambling providers. If so, that likely means that as-yet unreleased results for the second and third quarters will disappoint the market; and investors should avoid – or sell short – iGaming stocks.

Investors in Las Vegas Sands (LVS) will also see a major effect from the Eurozone’s direction. Last week the company announced that it would postpone until September its decision on where in Spain it would build its proposed “EuroVegas” resort casino – if it goes forward with the project at all. For LVS investors, the disarray in Spain – where the unemployment rate is around 25% – is beginning to create a “heads, I win, tails you lose” scenario. As Spain craters, Sands should be able to extract concessions from a government desperate for tax revenues, from banks seeking any type of return on their capital, and from a construction industry in equally dire need of customers. For long-term investors, LVS’ potential project looks to be a bet on Europe’s eventual rebound at a lower near-term cost.

Even if Sands walks away from Europe, it seems likely that the news alone might help, rather than hurt, the stock, particularly in the short term. LVS has been driven down by fears of slowing growth in Macau, despite the fact that  analysts are calling those fears overblown. (Goldman Sachs made a similar case on Thursday.) But, clearly, the marked change in the broad market – from a high-flying, risk-taking first quarter to a risk-averse sell-off in the second quarter – has taken its toll on LVS,  which has fallen 31% since early April, soon after the broad market turned negative.

Given the more hesitant attitude toward risk, the removal of a potential $35 billion investment might ease some of the bearish sentiment toward LVS, and allow the struggling stock to resume the bull run from its lows in 2009. Either way, Spain’s worsening struggles should be Sands’ gain, which adds to the already-strong case that LVS is a  bargain stock at current levels.

“Although we believe in its eventuality, there is also uncertainty surrounding the timing of legalization and the rollout of online poker in the U.S. at both the state and federal levels.” 

In what might be the understatement of the year in the gambling industry, Isaacs – in standard CEO-speak – expressed his frustration at the slow pace of legalization. Only Delaware and Nevada have legalized iGaming, with neither state expecting actual gameplay until year’s end, at the earliest.

The setbacks faced by legalization advocates in key states such as California, Illinois and New Jersey, are not news, of course; nor, should they necessarily be surprising. After all, at the end of 2011 our own Calvin Ayre put the odds at just “50/50” that more than one state would have legalized online gambling by the end of 2012.

What is interesting is that Shuffle Master is bearish enough about US legalization to back out of a deal that, to be honest, really doesn’t cost the company very much. If Ongame had hit all of its targets, the total purchase price for Shuffle Master would have been about $36 million. Shuffle Master has a market capitalization over $800 million, and has generated nearly $90 million in cash flow the last two fiscal years. The price tag for Ongame, though substantial, is not high enough to threaten Shuffle Master’s existence; in fact, if Isaacs had put out a press release announcing that the company had taken the $36 million intended for the Ongame purchase and burned it on the front lawn of Shuffle Master headquarters, SHFL should only have fallen about 4.5%.

But, in the hours after the announcement, SHFL actually fell about 7%, as traders interpreted Shuffle Master’s exit from Ongame as an exit from the entire iGaming sector. By day’s end, however, SHFL had recovered most of its losses, and, after a strong two weeks, is actually up 16% from its low point on the 27th. What does this show? The short-term effect of the announcement was quickly negated by longer-term investors, who more correctly understood the ramifications of the decisions. This is the exact same effect (albeit in reverse) seen after the Department of Justice opinion in late December; then, short-term investors drove up gambling stocks across the board, only to see those stocks pull back when the market digested the issues facing US iGaming. Overall, the potential of online operations simply is not affecting share prices, putting a dent in the bull cases for companies like Zynga (ZNGA) that rely on investor hopes for substantial profits from a legalized US online gambling market.

The low price tag also shows the pessimism Isaacs and Shuffle Master have toward US legalization. Given the $36 million cost (at most) for Ongame, one would think Shuffle Master would show more patience given the billion-dollar estimates often given a potential US iGaming market. Yet the company showed no interest in tying up a relatively small amount of cash, or making an even more modest investment in keeping an unprofitable Ongame afloat for a few years. This attitude is in sharp contrast to the bullish tone taken by CEO’s Gary Loveman of Caesars Entertainment (CZR) and Dan Murren of MGM Resorts International (MGM). Both executives have repeatedly and optimistically touted the potential benefits of US Internet gambling. Yet Shuffle Master is backing away from an eight-figure investment in the sector, while Caesars and MGM boast debt balances of $20 billion and $13 billion, respectively. Shuffle Master’s cautiousness toward the sector belies the claims of bulls in CZR and MGM that online gambling will materially impact their stock price, given the billion-dollar interest costs both companies face on an annual basis.

“We will continue to pursue opportunities to achieve our growth objectives in the online space, including leveraging and protecting our strong intellectual property and brands, and will investigate all prospects – both organic and acquisitive – that make strategic and financial sense.” 

In other words, the party may be over, but the battle has only begun. International Game Technology (IGT)‘s $500 million purchase of Double Down Interactive, made less than three weeks after the DOJ opinion, looks more and more ridiculous by the week, as M&A activity in the sector cools.

But the battle for US iGaming profits will continue – Shuffle Master isn’t going anywhere, nor are any of its myriad partners, customers, and competitors in the gambling industry. In fact, the slower-than-expected pace of legalization may even the playing field in technology, as the interactive departments of various land-based giants have the ability to play catch-up with some of the European partners like 888 and Bwin.party.

The real battle looks likely to come in branding and marketing, as opposed to technical capability. Each company will have its own strength: Caesars’ World Series of Poker brand, IGT’s slot portfolio including Wheel of Fortune and Sex and the City, Shuffle Master’s proprietary table games such as Ultimate Hold ‘Em. With such a long road to legalization, success in the space is going to come down to execution, and which company creates the best marketing campaigns, the most secure technologies, and the most exciting user experience. The days of high-priced acquisitions and huge profit projections are over. For investors, and the industry at large, now the fun really begins.

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