Investing The Hard Way: Remember Europe?

It’s got to be somewhat frustrating for European iGaming operators. Despite the Continent providing basically the world’s only regulated, open online gambling markets; despite the expertise flowing from the providers of platforms, software, and support across Europe; and despite the fact that the only way for individual investors to access real, concrete iGaming profits is through European companies; all anybody seems to want to talk about is the US market, which hasn’t created a single dollar in revenue for a publicly traded company since 2006.

Investing The Hard Way: Remember Europe?

Yet investors in those publicly traded companies are bidding up shares of companies such as Zynga (ZNGA) and Caesars Entertainment (CZR), creating millions of dollars in market value based solely on still-unrealized revenues from still-undefined potentially regulated markets that, so far, total less than 13 million people. That total is less than the population of the Netherlands, and barely more than Portugal or Greece, neither of which offer the extensive land-based operations seen in Nevada, New Jersey, and Delaware, the three US states that have instituted online gambling regimes. Indeed, Europe’s total population – even excluding Russia, which remains closed to publicly traded iGaming companies – is roughly double that of the US, while the Continent has a historically more liberated attitude toward gambling than does its ally across the pond.

So while the focus has been on the US, Europe has offered a number of opportunities for savvy investors. The most compelling has been 888 Holdings (888.L), which has tripled over the past year and trades at five times its levels from just eighteen months ago. I’ve noted in the past that 888 simply continues to out-execute its peers; it remains one of the few companies on the Continent to see growth in the stagnating online poker market, with poker revenues jumping 44 percent in 2012 over 2011. According to a company presentation designed for analysts in conjunction with 2012 results, even the re-launch of Full Tilt Poker did little to dent liquidity on the 888 platform; a chart in the presentation showed that 888 liquidity growth outpaced that of its five major competitors. Overall, a 13 percent increase in revenue turned into a massive increase in after-tax profit, which rose from $2 million in 2011 to $35 million in 2012. The company remained optimistic on 2013, noting that year-to-date revenue was up over a record first quarter of 2012. Chairman Richard Kilsby wrote that “we have the right strategy and are executing it well…we look forward to an exciting future.” CEO Brian Mattingley concurred, calling 2012 the company’s “strongest performance to date” and calling 2013 “a year of tremendous opportunity.” Mattingley also pointed out that regulated markets – often considered a detriment to publicly traded operators – have actually helped boost 888’s business, with poker revenue more than double it was in the pre-regulated period, even when accounting for gaming duties. The company also posted a marked increase in mobile penetration, with mobile usage moving to 18 percent in sports betting and poker and 14 percent in casino from a standing start at the beginning of 2012.

888’s recent success has been matched by another European iGaming provider, albeit in a vastly different manner: Paddy Power (PAP.L). Like 888, Paddy Power has used innovation and a effective, albeit controversial, marketing strategy to run circles around its competitors. Unlike 888, Paddy’s growth has not come from poker, but from mobile, a segment that in the long run looks likely to show far more growth. (In addition, mobile gambling, particularly in sport, doesn’t face the shadow of an industry-dominating – and privately-held – behemoth, as poker does with the presence of PokerStars.)

Paddy saw revenue grow 25 percent year-over-year (excluding the effect of currency fluctuations), though profits did not see the same level of growth. The reason, as Paddy demonstrated in its own earnings presentation, was an investment in the company’s physical presence (47 new shops were opened) and its digital offering. The company invested €26 million in upgrading its infrastructure, developing new mobile and online products, and creating new events and markets for sports betting. Online profits excluding Australia actually fell, due solely to losses taken on new start-up ventures. (Most of the losses came from the company’s expansion into Italy, which has turned revenue-positive so far in 2013.) But revenue in that group rose 27 percent, showing that Paddy’s past investments in marketing and expansion were taking hold, and giving hope that the investments made in 2012 would pay off in the future. Mobile usage soared, with mobile revenues increasing to fully a quarter of total revenues (outside of Australia) by the end of 2012. Notably, the stakes wagered on mobile were 41% of totals, a figure that dominates competitors such as Ladbrokes and William Hill. There are some concerns, most notably the proposed UK point-of-consumption tax, which Paddy estimated could cost it as much as €31 million a year, nearly a quarter of its current operating profit. But this is a company that has continued to innovate, is a clear leader in mobile, and has, as it noted in its presentation, grown earnings per share at a stunning 30 percent annual average since going public in 2000. That earnings growth could be dented by the UK tax, but with the company’s innovative marketing and mobile strategies continue to succeed, it should be able to mitigate the bottom-line hit.

The growth figures posted by 888 and Paddy Power would be impressive in any industry, let alone one so reliant on a European economy that continues to sputter. Any return of the fears about the European debt crisis – which flared a year ago but have largely quieted – would, on their own, likely bring down share prices of not only 888 and Paddy but their competitors as well. But it’s also worth noting that 888 and Paddy Power are delivering their growth not only in a depressed market, but in countries – notably 888’s exceptional performance in Spain – that are among the most troubled on the Continent. For long-term investors, this should give confidence that these two companies can survive a potential downturn if it comes, while an economic rebound will only magnify their leads over their competitors.

It’s simply imperative that investors choose companies that are leading the field, particularly in an industry as cutthroat as European iGaming. That’s why – despite a recent rebound in its stock price – bwin.Party Digital Entertainment (BPTY.L) remains a questionable buy. The company showed mobile growth of just 80 percent in 2012; while that sounds impressive, it came off a very low base, and represented less than six percent of total revenue for the company. The company repeatedly noted its intention to invest in and expand its mobile footprint, but clearly it will be lagging its competitors, notably in the sports betting segment. The company’s legacy poker operation continues to struggle; poker revenue fell 17 percent year-over-year, and trended down by double digits again in the first 10 weeks of 2013. The problem, according to CEO Norbert Teufelberger, was that players were lost as the company completed the integration of its bwin and PartyPoker platforms. The problem for investors is that the supposed benefits of “scale” created by the merger of bwin and PartyPoker are clearly not materialized on the revenue side. Indeed, the company has already warned that full-year revenues for 2013 will be below analyst expectations. Due to the fact that cost savings from the merger are progressing better than expected, the company still “remains confident about the full year (earnings) result.”

But which company do investors want? One that is creating booming revenue growth, and re-investing that growth into new initiatives and mobile development? Or one that is seeing revenue fall – as it did for bwin.Party in 2012, versus the separate entities in full-year 2011 – but saving money by firing programmers and outsourcing its web hosting? Analysts surveyed by Reuters are expecting modest earnings growth from bwin.Party – at best – in 2013 and 2014, which brings real risk to the stock. Given the company’s colorful history, and the extensive regulatory and taxation risk involved in investing in European iGaming, bwin.Party investors must accept the risk that, on any given day, a piece of bad news could send the stock down by ten or even twenty percent. There seems little point to accepting that risk if the upside is earnings growth of eight percent, based on cost-cutting and merger synergies. True, bwin.Party is hopeful about US penetration; but so is 888, and PokerStars, and Caesars, and IGT, and everybody else. And given that PartyPoker is clearly losing substantial liquidity in its current markets, betting on new markets as salvation for the company – and the stock –  seems a leap of faith.

For gambling industry insiders, understanding the relative strengths of the companies in the industry is a substantial edge in choosing stocks. The companies leading the iGaming industry – among them 888 and Paddy Power – have been doing so for some time, and look poised to continue their dominance. On the basis of earnings, those stocks are more expensive – but for good reason. They’re simply executing better right now, and positioning themselves better for the move to mobile, the move to dot-country, and, likely, the eventual opening of the US market. Too often, investors look too much at the numbers and forget the most important question of investing: which company do you want to own? For those investors looking to own a piece of a real business in Europe, as opposed to a hoped-for business in the US, 888 and Paddy Power remain two of the best choices on the Continent.