I-Gaming: Profitability, Regulation, and Capital Markets

Why the U.S. will sit this one Out

      Woe is the U.S. investment banker. Obstreperously high in the 90s on the vaporous profits of virtual businesses, he awoke in 2000 to a splitting headache and stacks of valueless stock certificates. And if public castigation, legal reprisal, and regulatory strong-arming were not punishment enough for his profligate transgressions, he now finds himself uninvited to the next big party : igaming IPOs.

      Until very recently, the public finance markets were generally considered off limits for Internet gaming operators : they had been a vehicle mainly for software companies that have serviced the industry since the mid- 1990s. Since that time, most operators have shied away from the public markets as a means of capital funding – until now. A gray regulatory environment, combined with relatively illiquid capital markets for igaming in the United States, made it extremely difficult for firms to go public.
      Due to the incredibly profitable nature of the business, many operators who had first mover advantage – that is, they had opened their doors at the early stages of the Internet – did not need access to the capital markets. For that matter, there was also no desire to release their financial results and corporate governance to the rest of the world.
      But great – not good – ideas that work and start in someone’s basement or in a small office complex need capital for expansion, acquisitions, and business development. These funds can be sourced from either the private or public markets; whichever is most liquid. This is where the capital markets come in handy. The capital markets do just that – they supply much needed capital to the marketplace of businesses. They are a lifeline for growth.
      It all starts with an investor looking to park his money in a business with the potential to generate  the greatest returns on their invested capital. The capital markets are therefore faced with a difficult dilemma: How to connect investors, searching for those returns, with the best businesses generating such returns. And herein lies the problem:
      Investors want to participate in what has been an incredible trend in Internet gaming: the IPO. And, they are getting that chance. Just not in the United States. And we will tell you why.

Tantalizing Profits

The painful irony of the position of U.S. bankers evokes the myth of Tantalus, who stood eternally starving and parched, surrounded by fruit that was just out of reach, in a lake with water that would recede each time he dipped to drink.
      The United States comprises on average  50% of the customer base for igaming operators, comprising a whopping 75% of the online poker market. While the dotcom profits proved evanescent, we estimate that companies catering to gamers ’ unabated avarice will realize profits north of 60% on $9.7 billion in revenues in 2005. We estimate – and our estimates are always a conservative view of the industry – the business will grow to $148 billion in revenues in 2010, a 10 year 16% annual growth rate. I challenge any market expert to present an industry with such tremendous, long term growth potential, and uncharacteristically high customer retention rates to boot.

Until very recently, the public finance markets were generally considered off limits for Internet gaming operators.

      PartyGaming, the global igaming leader with 54% of the market, recently floated its IPO at £ 4,86 billion, and 888.com at £ 700 million. The businesses are virtual, but the numbers behind them are very real. There are more listings yet to come, and U.S. bankers will have to sit this round out.
      According to the London Stock Exchange’s (LSE) Alternative Investment Market (AIM )  statistics, as of November 2005, the largest company on the AIM had a market capitalization of more than $2.1 billion, a whopping 31% higher than the next largest listed company. Neteller, an commerce firm servicing – what else?  - the online gaming industry among several business segments, is the fifth largest firm on the AIM with a market capitalization of $1.3 billion. As more igaming companies find the ability to list on the AIM, and on the main LSE share market, investors will have more of an opportunity to participate in the tremendous growth in this industry – just not in the United States.

It’s the Law. Well, Sort of

The primary reason that American bankers must longingly sit out the bonanza across the pond is the ambiguous legality of online gambling. While the U.K. has gone the road of regulation, the U.S. has stood firm in its rich history of Puritanical prohibition. The U.S Justice.

Betting on legislative stagnation or a move towards regulation could reap them windfall profits.

Department has declared i-gaming illegal, a position formed from an amalgamation of laws : start with the Wire Act (18 U.S.C. 1084 ), which prohibits the electronic tr4ansmission of wagers on sports, throw in a bit of RICO racketeering law (Travel Act), which makes it a “crime to use interstate or foreign facilities in aid of unlawful activity. ” and mix that with a few other broad ranging United States Codes.
      To the small problem of the federal government impinging on states righ5s (steadfastly respected in the case of casino gambling), the DOJ cries moral indignation. Deputy Assistant Attorney General A John G. Malcolm, in speech in 2002 , enumerates the many threats he sees to public order: from the time-honored call to protect the children, to the government’s maternal concern for the plight of Internet-enabled, homebound gambling addicts, to the more serious concerns over money laundering.
      The call by senators for further legislation of this sector, the need for which again raises the question of the firmness of the DOJ’s current position, is motivated by factors far more wide ranging than saving sinners. For one, online gambling puts in peril the massive revenues generated by state lotteries. With frequent and exorbitant jacpot payouts, gambling websites present people with an enticing and alternate destination for their dollars – one that doesn’t even require them to leave the house. Even better. Many states are also committed to legal agreements that give Indian tribes exclusive gambling rights, worth billions of dollars. In the future, any new legislation proposed would have to include a carve-out for Indian   tribes – and even the outlook for those legislative efforts is bleak.

      Yet, the legal gray area is the crux of the problem for the U.S. capital markets. And the House Financial Services Committee, the committee exerting some very powerful influence over them, is not making things better.
      The risks go beyond any potential monetary penalty. The DOJ has raised the specter of 18 United States Code 2: aiding and abetting. Applying the statute would facilitate the prosecution of otherwise completely legal activities when they are done to assist online gaming businesses. Services covered under the statute are comprehensive, and include banks, broadcasters, consultants, ISPs, advertisers, and many more. Media companies such as Clear Channel communications. Infinity Broadcasting. Discovery Networks as well as Internet titans Yahoo! And Google have stopped  running ads for online gambling as a result of legislative uncertainty and governmental pressure. Citigroup and PayPal have refused to process payments to online gambling companies.
      ISPs and other related firms are not alone. The Lawyer.com has reported that top New York based law firm Skadden Arps Slate meagher & Flom has advised its Wall Street clients not to participate in the underwriting of online gambling floats. That’s pretty clear message. I would say.


Internationally, the U.S. faces similar regulatory challenges. In a case brought by Antigua in 2003, the tiny island challenged the legality of U.S. restrictions on the cross-border supply of gambling and betting services. The World Trade organization (WTO) ruled largely against the U.S. The WTO  found the restrictions to be contrary to the obligations of the United States under the General Agreement on Trade in Services (GATS). With a conciliatory nod to the necessity of U.S. laws to “protect public morals or to maintain public order,” the Panel concluded that the U.S. had made a commitment to grant full market access to gambling and betting services under GATS. Hence, the application of the Wire Act, Travel Act, and Illegal Gambling Business Act to online gambling constitutes a “total prohibition ” on the service, in violation of this commitment.

      There are two complications with this. I’m no lawyer, but legal experts with whom I have worked have made it very clear that the WTO neglected to take into account key. U.S an out. In addition, the United States government does not intend to allow an international body or individual country set its own domestic legal precedent. Just as the United States cannot prosecute citizens operating “illegal” i-gaming sites abroad, so they should not have to accept the legal precedents set by foreign entities through international bodies. That’s the theory, at least.
Selling traffic will be the next big trend in the U.S. capital markets.

Extreme Volatility Potential Doesn’t Help

If fears of prosecution, steep fines, and the possibility of a 40% market share loss at the whim of legislators aren’t enough to scare U.S. investors out of the gambling sector, there are also significant risks inherent in the business itself. For one, the barriers to entry into the market are fairly low. Although a few first movers have thus far dominated the market, the costs to consumers to switching from one service to another are almost zero. As new competitors arise and offer better software or other enticements, such as smaller rake backs (the poker saite’s take of the pot), it is difficult to gauge how customers will respond. PartyGaming , a leading online poker site, saw its stock price cut in half in September  as a result of increased competition. Sites such as www.bonuswhores.com have recently sprung up, catering to players who are not loyal to any particular site, but to the best deal. Affiliate sites are also gaining traction as traffic drivers to online gaming sites. Affiliates take a cut of the rake in return, and work with whichever site will give them the best deal.

      Another concern is the unpredictability of poof popularity and growth of gambling in general, and in particular that of poker playing. The recent mass public interest in poker has been a major growth driver for online gambling websites. Should this interest abate, so could much of the revenue of these sites.
      One element of business that always remains true is that growth means growing competition. One effect of this is the increased marketing costs that firms must incur to break into new geographies and even keep existing customers. PartyGaming is now targeting the UK market, where they are competing with established operators with sizeable market shares, even while attracting a larger customer base. This is why operators are increasingly investing in technology that helps build customer retention.
      It is unrealistic to expect the explosive growth rates that we have seen in poker to continue (30- fold increase in the last three years). But, even as important, lack of investor understanding of the industry and business model is one of the root causes of such volatility. One benefit for investors is the increased potential for arbitrage, which does provide added incentive to get involved in this market. Sorry, except the U.S. capital markets.

Place Your Bets

So stand our hapless U.S bankers, in a position not far from that of the customers of the online gambling sites in which they wish to invest. Betting on legislative stagnation or a move towards regulation could reap them windfall profits. But the morass of risk factors leaves the sector closed to all but the most dauntless. With a wealth of recent images of the – mighty-fallen corporate perp walks fresh in their heads, most bankers will stay far away from the sector.
      Some recent events could portend a roster picture for online gambling. Several states   (including North Dakota, Illinois and Georgia) have begun to enact local legislation that would legalize various forms of online gambling. Furthermore, the regulatory stance of the U.K., reflecting its belief in the infeasibility of the prohibition of such a widely demanded service, has emboldened some gambling sites to revisit their policies blocking U.S. customers.
      However, federal legislators and domestic casinos present a pronounced force in opposition to legalization. Until someone makes a first move, or a resolution is reached,  U.S. investors can watch in the audience, dreaming of playing with the big money, but will not have a seat at the table.

The Capital Call

These days, operators have found these funds through the public markets – in the United Kingdom, not the United States. The financial markets are more liquid, the regulatory environment is more favorable, and London providers perfect access to the global capital markets.
      Although U.S investors have to sit this one out, they are not going to miss the next major boom in Internet investment. The hottest and fastest growing segment of the the latest dotcom boom is Internet content and the fight for eyeballs. Some recent deals have been astounding. DowJones $ 519 million acquisition of Market Watch giving DowJones, the parent company of The Wall Street Journal, new fresh eyeballs. The New York Times Co. paid $410 million for About.com. Newscorp bought the parent company of My Space for $ 580 million.
      Even more incredible, the newer deals in the market place are closing even as some businesses do not have a revenue model. Why?  Many factors are guiding this trend but one in particular leads the charge. The most significant factor, according to a Standford University study, is that U.S. consumers now spend 1.7 hours per day watching television but a whopping  3 hours online. Several new studies that have been released suggest that number is progressing at a rapid pace.

      To all of you i-gamers and entrepreneurs out there, selling traffic will be the next big trend in the U.S. capital markets. There’s still plenty of capital to go around so take advantage of it.


MICHAEL TEW BIO  www.capitalhq.com

Michael Tew is a founder and principal of CapitalHQ. LLC,  a privately held stragic consulting firm. He has spent his career working closely with major investment banks, hedge funds, mutual funds, private eq1uity funds, publicly –traded corporations, government organizations, non-profit organizations, and think-tanks. Prior to founding CapitalHQ, Mr. Tew worked as a leading hospitality, gaming and leisure securities analyst at Bear, Stearns & Co., Inc. As a Vice President in the top-ranked research team three years in a row, Mr. Tew was the youngest officer in Bear, Stearns history. Prior to joining Bear Stearns. Mr. Tew served as a global public relations consultant for Price water house Cooper ‘ Hospitality and Leisure consulting group.

      Mr. Tew has provided advisory services to the Federal Bureau of investigation, the U.S General Accounting Office. He was a primary source in the GAO’s December 2002 report to congress, entitled “Internet Gambling: An Overview of the Issues. ” Mr. Tew is on the Editorial Board of Casino Enterprise management and the Gaming Law Review, both resources for gaming professionals.
      Mr. Tew  holds B.S in Finance and International Business form New York University’s Stern School of Business. He has also studied at Group HEC (Paris), SDA  Bocconi (Milan), and Wirtschaftsuniversitat (Vienna). Michael can be reached at mtew@captialhq.com