How Gambling Companies Are Faring in Social Gaming

How Gambling Companies Are Faring in Social Gaming
[img courtesy of bloomberg]
In the first few months of 2013, the biggest fireworks in gambling stocks have come from online gambling, most notably the legalization of iGaming in New Jersey in late February. The passage of the New Jersey bill led shares of Caesars Entertainment (CZR) to nearly double, while other companies including Boyd Gaming (BYD) and Zynga (ZNGA) saw large boosts in their stock prices as well.

Of course, as I’ve noted in the past, these stock price gains are purely speculative; indeed, as of yet, not a single dollar of revenue has been created by a legalized, fully regulated iGaming operator in the United States. And iGaming isn’t the only area where gambling operators and suppliers are attempting to create online profits. Social gaming – in many ways pioneered by Zynga – has become a key focus for many major companies in the gambling industry, among them Caesars, International Game Technology (IGT), Bally Technologies (BYI), and bwin.Party Digital Entertainment (BPTY.L). Notably, executives at these companies – including IGT CEO Patti Hart and bwin.Party head Norbert Teufelberger – have repeatedly asserted that social gaming is a targeted profit center in and of itself, not simply a means of creating new potential customers for real-money gambling in Europe and, eventually, the U.S.

The attraction of social gaming, from the perspective of these companies, is easy to see. As Arooga CEO Karl Jeffery told our own Becky Liggero last month, social gaming has a customer base that is estimated to be twenty times that of online gambling. Meanwhile, the business offers high gross margins; as Jeffery pointed out, if a company can reclaim its development costs, either through in-game advertising or through the “freemium” model, the cost for each additional user is essentially zero. As such, popular, well-designed games with a long shelf life can create significant profits once the initial costs have been fully repaid.

Of course, there are some concerns as well. Competition in the space is seemingly infinite, as the barriers to entry are limited to a developer’s kit and a decent computer. Indeed, many extremely popular apps have been designed by small, independent developers, who have managed to create user bases in the millions with minimal marketing budgets. Of course, many of those apps have also had a short shelf life; witness Draw Something, designed by OMGPop. Zynga purchased the company for $180 million in early 2012, in an acquisition that Forbes would later point out occurred “literally the day” that Draw Something peaked in terms of users. (Zynga would write off more than half of its investment just six months later). For all the hype about social gaming, it’s worth pointing out that not even Zynga has yet to turn a profit in the space. Both Zynga and smaller competitor Glu Mobile (GLUU) have seen their share prices tumble in response, from $11-$14 last year to barely $3 per share at present levels. For the larger players, social gaming so far has been much more interesting – and lucrative – in theory than in practice.

Still, the space represents an opportunity for growth for the gambling sector, an industry that has struggled to create any revenue improvement in the US for some years now. This is why so many companies are entering the space, whether through acquisitions – most notably IGT’s $500 million purchase of Double Down Interactive last year – or through in-house development, a tack that bwin.Party has taken. As such, it’s worth reviewing the recent financials for social gaming among the gambling industry’s leaders, and an attempt to figure out whether social gaming can, in the future, become a significant contributor to profits and boost share prices.

For Zynga, the purest-play social operator, the space has been a struggle. 2012 revenue grew 12 percent year-over-year, driven in large part by advertising growth. But pre-tax profits fell 30 percent from 2011; even worse, the company guided for adjusted pre-tax profits for 2013 to be, at best, barely half of the 2012 figure, or roughly one-third of the company’s 2011 profits. This comes despite a series of cost-cutting measures undertaken late in 2012. Part of the issue is a switch to mobile, which has raised serious questions for companies throughout the online industry – including leaders such as Facebook (FB) and Google (GOOG). With mobile ad rates significantly lower, and mobile users less lucrative (at least in the fourth quarter, the first quarter Zynga broke out mobile numbers), Zynga may see more users but less revenue, and lower profits.

For its part, Glu Mobile – as its name suggests – has focused solely on the mobile space, designing games for smartphone and tablet users. Its 2012 results showed decent growth – sales rose 20 percent on an adjusted basis – but it too expects a slowdown in 2013. The company guided for non-GAAP revenue of $84 million to $92 million, compared to $87.5 million last year. Like Zynga, it too, expects to be unprofitable.

For gambling companies entering the space, the question is whether the struggles of pure social operators Zynga and Glu is reflective of endemic struggles facing the industry, or whether the lack of growth at those companies is due, at least in part, to the entry of so many well-financed competitors. In bwin.Party’s case, the company simply hasn’t had enough time to develop revenues in the space. bwin.Party’s social unit is relatively new – it began its foray into the sector by acquiring Orneon in May 2012 and creating a new game studio called “Win.” The division has not created much, if any, revenue so far, but CEO Teufelberger said in an interview posted on the company’s investor relations website in March that “we are making good progress…I am quite confident that we will hit all our targets for the year,” though he also admitted, “We have come a bit late to the game.”

That game is indeed crowded, with many big players. IGT initiated its social strategy with its Double Down purchase, which followed the 2011 acquisition of poker network Entraction (that platform would be shut down barely a year later). The combined purchase price of the companies – over $600 million – and the change of focus at IGT from its traditional role as a slot machine manufacturer for land-based casinos would lead to a nasty proxy fight that nearly cost Hart her job. But Double Down has shown some signs of progress for the company, and though it still seems unlikely to justify its half-billion dollar price tag, IGT has repeatedly said it expects the social gaming division to be “GAAP accretive” in fiscal 2014 (ending in September). In other words, it will boost the company’s bottom line even after accounting for millions in earn-out bonuses and other acquisition costs.

To justify that price tag, Double Down still has a long way to go, but it is showing impressive growth. Revenue grew 15% sequentially in the December quarter, after growing 20% in the September quarter from the previous three months. And while its user base is dwarfed by Zynga – monthly      average users were about 5 million in the most recent quarter – its monetization ability is significantly better than its larger competitor. Bookings per daily active user were 31 cents, compared to single-digit figures for most Zynga apps. Social gaming alone created $41 million in revenue in the quarter, and gross profit of nearly $25 million. Unfortunately, the company’s operating expenses increased by $39 million year-over-year; CFO John Vandemore said on the post-earnings conference call that “the vast majority of that is attributable” to increased spending in the social gaming unit. So it would appear that social gaming is still dragging IGT earnings down; but if it can continue double-digit sequential growth quarterly, revenues will double in short order, and gross profit will eventually outstrip the increased operating expenses needed to support the division.

The question to be answered is whether that growth can continue for multiple years or if IGT will, as Zynga appears to, hit a ceiling that minimizes growth. It’s worth pointing out that, excluding the retention and earn-out payments made to Double Down employees and investors, gross profit for social gaming appears to have been higher than operating expenses in the December quarter. So IGT may still have a chance for the Double Down acquisition – which was widely criticized by many, myself included – to become, as Hart once claimed to the Las Vegas Review-Journal, “the best investment [IGT] ever made.”

Another large company that used acquisitions to enter the social gaming space is Caesars, which continues to spend on new on- and off-line projects despite a crushing $20 billion debt load. Caesars built its interactive division through a nearly $200 million purchase of Playtika in 2011 and added to it earlier this year with the acquisition of social gaming developer Buffalo Studios. However, unlike IGT management, who staked their very jobs on their interactive strategy and trumpet its growth at any chance, Caesars continues to refuse to break out numbers on either its online gambling or social gaming initiatives. This despite the fact that the company is dangling the prospect of spinning off its interactive division, which Caesars has somehow managed to keep unstained by the company’s debt. Caesars’ success in social gaming is thus hard to read, and two key pieces of information among the little publicly available data paints a contradictory picture. In 2012, revenue in the company’s “other” division – which includes Caesars Interactive along with corporate costs and income from certain minority ventures – more than doubled, rising $140 million year-over-year. CIE includes not only social gaming, but the company’s real-money partnership with 888 Holdings (888.L) in the UK and the World Series of Poker franchise. Given 888’s recent success, it seems likely the real-money segment saw a revenue boost. But given that is just an 888 skin, in a UK market that has never reached the heights seen in the US pre-Black Friday, it seems highly unlikely that the real-money operations account for more than a fraction of the revenue gains. Similarly, the WSOP may have shown a nice year-over-year increase, but it appears highly unlikely that WSOP revenues would have increased by $50 or $70 million given the relatively stagnant interest in poker and the lack of real-money operators (and potential television sponsors) in the US. As such, it would seem highly likely that social gaming did account for much of that revenue boost.

But how much? And, more importantly, at what cost? The success of social gaming at Caesars is brought into question by one key fact. Rock Gaming, a joint venture partner of Caesars in its Ohio properties, bought shares of Caesars Interactive in early 2012. It also had an option to purchase more shares; that option expired in November with no evidence in SEC filings that Rock indeed added to its stake. As such, investors without access to Caesars Interactive numbers should wonder why one of the few companies that have seen those numbers elected to pass on what many are touting as such a lucrative business. Still, the revenue jump does appear to show that Caesars is at least competing in social gaming, though it’s worth pointing out that its user base for the Caesars Casino app on Facebook is a fraction of that of Double Down’s casino app.

Overall, the big movers in social gaming – Zynga, Glu, IGT, and Caesars – have not, as yet, gotten the bang for the buck that many were expecting. It’s why Zynga and Glu have seen their share prices crumble, and why CEO’s Hart and Caesars’ Gary Loveman have come in for criticism of their acquisition strategies and prices. But it doesn’t appear – at least not yet – that social gaming should be written off by investors. The space still requires a great deal of caution, and the cost-cutting measures at Zynga and the incremental, far cheaper process undertaken at bwin.Party reflect an industry coming to terms with a space that is simply not going to have the exponential growth many once predicted.

But the lack of hoped-for growth doesn’t necessarily mean social gaming can’t, or won’t, become a solid profit stream even for gambling companies new to the field. If those companies can execute, and can focus on costs and profits instead of merely eyeballs and revenues, there still appears to be hope for social gaming companies. The question that remains is who will execute the best; who will win; and if there will be enough for everyone to go around.