The index during 04 (September – November) has been dominated by five factors : pricing uncertainty after the PartyGaming debacle, increasing acrimony between Empire and Party, reassurance from sportingbet, weakness in UK sportsbook margins and the listing of 888. Both 888 and 32 Red have been added to the index, Yoomedia and Stanley Leisure have been removed from the Gaming Top -30.

PartyGaming continues to dominate the index, representing 34% of the value. Over the period, it gained 22% and is now ‘above water’ from its issue price. Broadly speaking, this is good news for the sector and should improve the outlook for IPOs in 2006. However, we remain concerned about certain aspects of the reporting and interpretation of PartyGaming’s news flow. First, since the sector is both high growth and comparatively young from an equity market perspective, trend analysis is difficult. It is for this reason that Party’s share price got slammed on the news that growth  slowed dramatically in the normally quiet July – August period. Equally, news that November  was strong was the most significant driver of recovery. The problem with this approach is that month – on - month snapshots can be highly misleading. For example, Party’s November figures were flattered  by the launch of blackjack . Given the maturity of the product, it is unsurprising that it had rapid take-up, on a site with the player volumes of Party. Therefore, ‘growth’ is front end loaded. The danger is that when month –on-month growth figures normalize faster than expected, the market could once again be disappointed. The management consistently being ‘surprised’ by the companies performance is also not conducive to stabilizing expectations.

      Another reason why Party recovered was that it became clear that it would not buy Empire Online. News of this meant that Empire has now had two potential suitors jilt it, which we do not find surprising. The company is a proven marketer but since it does not own its customers there is little residual value. The threatened court case against Party for breach of contract is an interesting piece of theatre, but we doubt a case can be proved given the wooliness of the contract and the news that party informed Empire of the risk of changing platform back in May. Substantive recovery relies upon Empire building upon the Noble / Club Dice acquisitions. Empire is a proven customer acquisition and Playtech is a proven backend, the untested aspect of the new model is customer retention.

Substantive recovery relies upon Empire
building upon the Noble / Club Dice acquisitions.

Sportingbet’s Q1 was highly encouraging, though since the stock is trading at a c.30% premium to the sector, this was largely in the price. In anticipation of a positive update, the stock gained 8% and now represents 15.4% of the index. Sportingbet has benefited from three key drivers. First, the organic performance of Paradise  continues to outperform expectations and this has been accelerated by a marketing push. Second, early indications are that US-facing shared purse technology is generating incremental win and should lead to earnings upgrades (c. £ 10m). Finally, US sports margins were strong, albeit weakeing into Q2. Given Sportingbet’s waterfront product offer, cross-selling opportunities are strong. This should underpin growth expectations, assuming there are no detrimental changes to the Us media-buying environment. Sportningbet   is also demonstrating to the market that spend per customer is more important than spend per product, which should improve interpretation of KPIs.
      888 had a difficult debut to the market but has now recovered strongly. The stock ended the period at a 9% premium to its listing price, which, at 12.5x forward earnings, puts it broadly in line with the sector. The company represents 7.5% of the index 888 continues to operate the largest casino on the internet and has made significant headway in Poker . Complete control of the value chain (software and retention) as well as experienced management means that the stock should add some much needed visibility and stability to the sector. We believe that the key to driving value from here remains two foold. First, by focusing upon customer retention. 888 should be able to improve lifetime value, thereby generating growth in a slowing casino market. Second, by outsourcing more of its development chain, as well as continuing with in-house programmes, new products should enhance targeted marketing opportunities as well as cross-selling.

      32Red is the other major listing during the period. The company was ‘introduced’, meaning that no money was raised and so there is no free-float. This means that the stock doesn’t trade and so the price doesn’t move. Nevertheless, valued at £ 60m, the company now represents 1% of the index. The company is a successful operator of MicroGaming software and has won many awards for feel and customer service. However, by not taking US bets, profitability is limited. Growth prospects rely upon penetrating new markets, which is usually a difficult and empirical process.
      Bet and Win   were among the best performers in the mid-cap arena, gaining 20% to become 15.4% of the index. This was driven by two factors. First, the company has swung into profit and the management is extremely bullish on growth prospects. Second, the company is also looking to buy ongame, which would significantly improve its poker reach and cross-selling potential. Moreover, with the stock trading on such a premium, it is easy to sue paper and make acquisitions earnings enhancing.

FUN Technologies was the top gainer of the index, adding 35.4%, to become 3%. FUN’s price was driven by Liberty  Media taking a 51% stake through a newco. Liberty sees FUN as a route into a comparatively ‘legal’ gambling environment (skill games) to push though its media channels. The strategc partnership will be a useful test as to whether well distributed skill gaming can gain critical mass. Most operators are still considering their options in this market, since ‘traditional’ online CPAs are too expensive  for the value of skill player to be economic. Equally, cross-selling between hard gambling and soft gambling has thus far been of limited success.
Another significant gainer in the UK small-cap arena was Sportech, which increased by 29.7%. This was due to the combination of two things. First, the stock has recovered from a profit warning, which was largely down to betting margins rather than ‘ structural’ issues. Second, and more importantly, the appointment of a new CEO (Ian Penrose, ex-Arena) has given some investors hope that a combination of cost cutting and clear strategic direction will torn the company around. On 7x forward earnings, fairly simple measures should have a positive influence on the share price.

Sportingbet has benefited from three key drivers.

Of the terrestrial operators, Hilton Group gained 11%, though this was due to news that the Hotels division could be sold to Us operator Hilton Corp. Equally, Rant gained 45% due to hopes of a takeover. The betting businesses of both reported difficult markets, however. Of the pure – plays William Hill lost 13.3% of its value, while Paddy Power lost 23.8%. Both were due to lower earnings guidance because of weak sports betting results. Significantly, the online channels have proved the most resilient due to the product speread and ‘ring – fenced’ client money, which encourages recycling and, cross-selling. UKbetting also warned that profits would be toward the bottom of the range due to weak sports margins. The stock fell 9% during the period, largely because of this. Nevertheless, gaming, content and integration plans are performing well and should begin to demonstrate profitable growth from 2006.
      The software providers have ‘decoupled’ in terms of stock performance, with CryptoLogic gaining 17.2%, but BOSS losing 6% and Chartwell off 17%. The rise in CryptoLogic was largely due to the closing of short positions and buying on the back of lengthened contract terms for Betfair. However, we remain concerned that the fact that Betfair has bought its own poker platform demonstrates a clear intent to leave when in –house technology is ready. The other software providers have suffered from poor market sentiment, coming off from highly expensive earnings rations in illiquid markets.

      Gaming VC fell 30% during the period, albeit staging a rally toward the end. The fall was because management realized that by cutting  marketing spend, profitability goes up, but then revenues start to decline. The rally was driven by news that a marketing campaign has started to generate customers again. We believe that Gaming VC has three issues of concern that it must demonstrate its capacity to deliver. First, that it is capable of generating solid and growing cash flows from its core German business. Second, that it shows sufficient flexibility to compete in a market place that is rapidly becoming competitive. Finally, that the ‘magazine model’ works in other jurisdictions.

Gaming Corp fell 13%, despite moving from an onerous BOSS contract and making headway in mobile. Profitability seems assured in 2006, but the company needs to deliver very strong growth to meet market expectations.
      World Gaming was suspended for much of the period while it raised funds for the acquisition sportsbetting.com. The site is World Gaming’s largest licensee (though the company also provides backend services to Sportingbet), which means that the company is becoming an ‘operator’. Given that the deal is being done on c.6x 2005E PBT, the deal marks an important value transformation at an attractive price.