Can the online gambling sector pay out?

For investors in online gambling firms, the last few months have been the stuff of nightmares. Many knew the sector was a risky bet, but few knew how risky. They found out in July when BetonSports' former chief executive, David Carruthers, was arrested in the US. The move was seen initially as a one-off, but it soon became clear that it wasn't: instead, Republican senators had decided to find a way to make online gambling illegal and landed on the 1961 Interstate Wire Act as a way to do so.

Until then, the Act, which bans gambling by phone, had blocked US business start-ups in the online gambling sector, but not prevented "US punters from shipping their billions abroad". By 2005, some 12 million Americans placed about $6bn in bets online, about half of the industry's revenue worldwide, suggesting that the US had to take some action either to open up internet gambling to its firms, or to forbid it to its citizens, says the FT. Unfortunately for investors, the House of Representatives, led by presidential hopeful Bill Frist, chose the latter course, adding online gambling to the Act, hence criminalising electronic payments to online betting firms.

Given America's tolerance of other forms of gambling, the clampdown reeks of hypocrisy, says The Economist, which cited politics as the real motivation. There may be a case to be made "that online gambling is worse than the real-world sort", but even so the arguments all pointed to regulating online gambling, not banning it. The effect on sector share prices was devastating, particularly for PartyGaming, operator of the world's largest poker site. As news broke of the US move, PartyGaming dived from 107p to 45p. It has since fallen further, and has been ejected from the FTSE 100. Merger hopefuls Sportingbet and World Gaming suffered even steeper falls and groups providing online payment services were hammered on the prospect of losing a major source of revenue.

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One month on, the dust is settling. Many operators have withdrawn from the US to look elsewhere, review cost-cutting measures, or consider bid approaches. Sportingbet and Leisure & Gaming have offloaded their US operations to private investors for $1. The latter intends to relocate in Curacao and gamble on being left alone by US law enforcers, says The Daily Telegraph. Sportingbet says it plans to keep its Paradise Poker business, but will focus on punters in Europe and Australia. PartyGaming believes it can circumvent the clampdown by offering lotteries and fantasy sports betting both exempt from the ban. Many of its US customers may carry on playing by transferring their custom to operators such as Isle of Man-based PokerStars, which is owned by Israeli investors.

So, is it all over for the sector? You might think so; it's bad for business to be linked with "such spectacular failures", says the International Herald Tribune and many fund managers flatly refuse to discuss online gambling stocks. But there's much to play for if investors "accept some important new rules" and short-term pain, says Breakingviews.com. First, the investment story has changed. The bet is now on non-US growth, which looks steady enough at 17% per year. Second, the shareholder base is due to alter. While risk-hungry hedge funds lose interest and look elsewhere, institutions after a lower-risk growth story may take a look, something that could reduce the volatility of the sector's share prices.

Online gambling: four potential recovery plays

Online gambling companies clearly aren't for risk-averse investors, but the anticipated sector consolidation may offer a buying opportunity. Some analysts think PartyGaming's rivals 888 Holdings (888.L, 96.5p) and Sportingbet (SBT:Aim, 43p) are cheap at their new, much-reduced, valuations. Both have already started to lessen their reliance on the US and use cash piles to develop the potential of Asia and Europe's relatively untapped market.

But a better option could be to opt for firms with little or no US exposure. Gibraltar-based 32Red (TTR:Aim, 87p) has mostly UK customers and recently bought sports betting group BetDirect, which has never taken bets in the US. The shares suffered over the summer as the World Cup hit gaming revenues and are currently near an all-time low, trading on a forward p/e of 25.

Firms providing services to gambling sites, such as payment services firm Neteller (NLR, 147p), are another recovery play. As noted above, Neteller has been battered by the US clampdown, with the share price diving from more than 850p, but markets may have over-reacted. The shares now trade on a forward p/e of around three. The majority of revenue still comes from America, but the firm is growing rapidly in Europe and Asia.