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Investing The Hard Way: A Long Year For iGaming

TAGs: 32Red, 888 Gaming, Betsson, European Commission, greece, Groupon, investing the hard way, Net Entertainment, Norbert Teufelberger, Paddy Power, roller casino, Unibet, Vince Martin, Zynga

It’s almost depressing, in a way, to cover the online gambling world. For all the optimism; for all the potential; and, for all the insatiable consumer demand, the industry continually sees roadblocks put in its path. Back in February, I noted the  immense regulatory and tax challenges facing iGaming companies in Europe, arguing that “ownership in online gambling stocks now seems to require a master’s degree in European politics, with an accompanying law degree focusing on the Treaty of Lisbon and its interpretation by the modern CJEU.”

Investing The Hard Way, A Long Year For iGamingNearly ten months later, it seems little has changed. The gambling industry is again claiming that an EU member has violated continental rules; this time it’s Greece, but little is being done about it beyond the release of bureaucratic reports. Onerous taxation – long a bane of the gambling industry worldwide – has recently been  maintained or instituted in countries like Bulgaria, Hungary, and the Czech Republic. Bulgaria maintains a 15% tax on turnover, while the Czechs have tacked on a 20% tax on gross win to a 19% corporate tax for iGaming firms.

In the US, the euphoria following the late 2011 Department of Justice opinion re-interpreting the Wire Act quickly faded, as stocks boosted by the move gave back their gains within days. The industry’s chief proponent, Nevada Senate Majority Leader Harry Reid (D-NV), has seen his online poker bill stall time and time again. With a so-called “lame duck” session of Congress now underway, Reid has said he has zero support for a bill from the GOP, damaging hopes for federal legalization of state poker. At the state level, potential initiatives in New Jersey, Colorado, and California – among others – have died in committee, leaving tiny Nevada and Delaware as the only two states with online gambling. Those two states hold just over 1% of the US population, showing just how little headway iGaming advocates have made this year. And of course Asia, as always, remains closed off to publicly traded operators.

Despite the headwinds facing the industry, and the economic turmoil gripping Europe, 2012 has been a modest success for iGaming stocks. The best performer has been 888 Holdings (888.L), which has better than tripled over the last twelve months, reaching an all-time high in November. The reason for the stock’s success is, quite simply, the company’s success; 888 is en route to a record year in terms of both revenue and profits. The company has even seen strong success in poker, with segment revenues up 21% in the third quarter, while many of its competitors see declines. Indeed, according to pokerhistory.eu, 888’s market share in poker is up around 60% year-over-year.

Another big performer this year has been Paddy Power (PAP.L), up nearly 40 percent for the year. Again, the company’s success is driving the stock; like 888, Paddy posted a strong third quarter, with revenue up 23 percent, continuing a strong track record of top- and bottom-line growth. Paddy is executing in its legacy markets; operating profit at its retail locations in Ireland and the UK rose 85 and 48 percent, respectively, in the first half of the year, according to a company presentation. Online profit has actually been flat for the year’s first nine months, but that is in part because the company is investing effectively, through increased marketing, expansion in Italy, and additional promotional spending.

For both 888 and Paddy, the question going forward is twofold. First, can the company maintain their recent run of success; and second, is that potential success already priced in? Looking at the first question, there’s no reason why both companies cannot continue to outperform. 888’s poker strength has only moved its market share up to fifth worldwide; with a bit over five percent, continued strength could push it past bwin.Party Digital Entertainment (BPTY.L) and iPoker into the number two spot behind PokerStars. In 2011, according to the company’s annual report, the company received less than 40% of its revenue from Europe (excluding the UK), perhaps limiting some of the regulatory risk associated with the Continent. As and as still a relatively small player – market share in Italy, for example, was less than 5% according to that annual report – there is plenty of growth. For Paddy Power, its retail base in the UK and Ireland benefits from stable regulation and reasonable taxation (Ireland’s turnover tax is just one percent). The company has invested in a consistent, albeit controversial, marketing campaign that sets the Paddy Power brand apart from its competitors. There seems to be little reason the company cannot continue its revenue growth, which could exceed 20% in 2012 after growth in the high teens the year before.

But the difference between the two stocks is the movement in the stock price. As noted, 888 has tripled over the past year, with the stock’s run continuing over the last six months. For Paddy Power, in contrast, most of the stock’s gains came in early 2012, in the wake of the DOJ opinion and the company’s reporting strong 2011 annual results. It’s not necessarily true that a run like that enjoyed by 888 necessarily makes a stock “expensive” any more than a steep fall makes a stock cheap. (Just look at Groupon (GRPN) and Zynga (ZNGA).) But the fact that Paddy has basically treaded water over the past six months, while 888 has zoomed up another 65 percent would lend credence to the idea that Paddy is cheaper on a relative basis.

Rolling into a mobile future, Roller Casino by Paddy PowerThere is another key reason to buy Paddy Power, even at a relatively high earnings multiple of about 21: its growth in mobile. While 888 has been boosted by success across segments, including poker, no iGaming company can match Paddy’s focus on innovation in the mobile sphere. I argued in September that mobile gambling had the potential to be far more lucrative than online poker, and Paddy’s recent strength is in no small part due to success in its mobile initiatives. The company’s new mobile app allows customers to point an iPhone at a TV and instantly bet on the match being televised. Mobile penetration continues to grow, with mobile turnover at 27% of total stakes in Australia and a stunning 45% at paddypower.com, according to the company’s third quarter update, with similarly strong growth being seen in the casino offerings as well. Paddy’s app also allows for physical interaction with the mobile device – with slot bonus rounds requiring the phone to be manipulated and the company’s “Roller Roulette” mobile game allowing players to control the speed of the roulette ball. These sound like minor innovations; but they can make a major difference. Allowing customers control (or, perhaps more accurately, the illusion of control) and an extra level of interaction creates more entertainment, and more customer loyalty. Paddy’s recent success in mobile – and the effect of that success on the company’s profits and stock price – shows these innovations matter to its shareholders. Gamblers are going to want to be a part of Paddy Power – and investors should too.

But beyond 888 and Paddy, there has been little news of notice in the iGaming world – and that lack of movement has been reflected in stock prices across the sector. Most online gambling stocks have risen to date, but a sizeable portion of the gains came in the first quarter, when stock prices rose across the gambling sector and around the world. A six-month chart of major iGaming stocks such as Net Entertainment (NET-B.ST), 32Red (TTR.L), and Unibet (UNIB.ST), shows the stocks stuck in a range of returns between three and six percent, with comparatively little movement in what is often a volatile industry.

There have been two laggards. The first is Betsson AB (BETS-B.ST), which has given back most of its gains after rising over 50% in the first four months of the year. I recommended Betsson back in February, given its strong dividend yield and exposure to the relatively stable Scandinavian economies and regulatory structures. The company does have risk in Turkey, where even Betsson itself admits on its investor relations page that “future revenues from Turkey continue to be more uncertain than those generated by its other markets.” (That risk comes from a similar problem: Turkey’s protection of its state-run monopoly appears to run afoul of EU and WTO rules, but it’s unclear as to who is willing to enforce the international standards.) But beyond Turkey, Betsson has a far more stable revenue base than its competitors, not to mention a dividend yield over 5 percent, higher than not only other iGaming companies but stocks in any industry. With the stock now down about 10% from its February levels, it remains an interesting play for long-term investors.

Zynga's Marc Pingus and Bwin.Party's Norbert TeufelbergerOf course, the other laggard is bwin.Party, which continues to struggle after its poorly-planned and poorly-executed 2011 merger. The stock had managed to rally some thirty percent after reaching an all-time low in August, with the run getting a nice boost from the announcement of the company’s partnership with Zynga (ZNGA). But as has been its history, the company – and the stock – tripped up again. This time, co-CEO Norbert Teufelberger was arrested in Belgium, setting off another decline in the share price. BPTY now has a market capitalization about one-third of the combined market values of PartyGaming and bwin when their merger was announced, and it’s not hard to see why. The company has consistently disappointed investors with its earnings reports, is rapidly losing poker market share to PokerStars, and has responded with little more than a cautious social gaming initiative and the aforementioned Zynga tie-up. The Zynga deal was well-structured by Teufelberger and fellow co-CEO Jim Ryan – although details have not been released, it appears that bwin.Party will be contributing little more than assets it has already developed. But Zynga’s real-money aspirations are unlikely at best, and it seems similarly unlikely that the combination of two struggling companies will somehow create a successful joint venture. BPTY may look cheap, but it has been – and likely will be – even cheaper in the not-too-distant future.

All told, investing in iGaming requires the same focus on execution and branding that investors need in other segments, such as the similarly competitive US regional segment. Investors should go where the gamblers are going. They are going to 888 for its growing poker liquidity; they are going to Paddy Power for its innovative mobile apps and its award-winning marketing campaigns. There’s a reason those stocks have been successful, and a reason they seem likely to continue that success.

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