Take a gamble on the vice sector

It's probably not too much of an exaggeration to say that only the proverbial trip to the moon would have insulated you from the recent hysteria surrounding the granting of a Super Casino' licence to the city of Manchester.

This whole episode must surely have been driven by the headline-grabbing interests of certain newspapers, because even when this licence is combined with the other 17 new smaller regional casino licences that are also due to be issued this year (following the introduction of the long-awaited new Gambling Act this September) the impact on overall gambling activity in the UK is still likely to be only marginal.

Big developments in UK gambling

We base this on a market fact uncovered by researchers Mintel. The 140 odd existing UK casinos accounted for only 8% of the £715m total net expenditure (stakes minus prizes) in the UK gambling market in 2005.

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In contrast betting' - in high street bookmaking shops and over the internet - is the flutter' of choice for UK adults and accounts for 38% of the market with a value of around £3.6bn. What's more, it has enjoyed phenomenal growth. Betting business was up 113% between 2001 and 2005 increasing market share from only 24% at the start of this period.

After this sector comes The National Lottery. This accounts for another 25% of gambling expenditure, although its influence is waning as it has experienced a 5.6% fall in value since 2001. But this decline cannot detract from the influence the Lottery has had in kick-starting mainstream interest in gambling in the UK.

It has contributed greatly to the 36% growth the overall gambling market has enjoyed between 2001 and 2005, seeing net expenditure rise from £6.9bn to £9.4bn. And the predictions are there's more to come. It is forecast to break through the £10bn barrier for the first time this year - with net expenditure hitting £10.4bn.

During this period and in addition to the impact of the Lottery, the gambling market has benefited from other developments too. These include lower betting shop taxation, the introduction of Fixed Odds Betting Terminals (FOBTs) into these shops, the gradual expansion of the casinos market and the relaxation of restrictions on advertising of gambling services. The latter has certainly proved beneficial to the UK's bingo halls which have enjoyed a 52% growth rate in net expenditure over the 2001 to 2005 period.

However, dark clouds loom over the bingo industry as the smoking bans to be introduced in England and Wales later this year, are predicted to hit it hard. Early evidence of this was the recent decision by Rank to close nine of its Mecca Bingo clubs, which will leave it with 103 outlets, the second largest operator in the market after Gala Coral with 175 clubs.

Much more positive to the gambling industry has been the major broadening of the channels through which gambling services are now accessible. This includes the nascent channels of TV and the mobile phone but it is the internet that is having by far the greatest impact on UK gambling - significantly more than the impact a few additional casinos are likely to have.

The growth of online gambling

Mintel found the proportion of UK adults gambling online has doubled over the past four years and this trend looks unlikely to slow down judging by the most recent trends. When you consider these gamblers represent only 2% of the adult population (equating to one million people) and that only 4.5% of the population has access to the internet then the opportunity for future growth looks to be very impressive.

The future looks even rosier when you consider that online gambling is heavily-skewed towards younger consumers - with levels peaking among men aged 25 to 34-years-old. As these customers mature they represent a sizeable market that the online operators can target on which to grow their businesses.

The one downside of betting online - and in bookmaking shops - is that it provides the lowest level of margin compared with other forms of gambling when using the calculation of prizes distributed versus stakes received.

This would show that a hefty 92% of the stakes received by betting operators are returned as prizes. This compares with an average of 80% for gaming machines, 83% for casinos, 75% for bingo operators, 50% for the National Lottery, and a miserly 25% for football pools providers.

The latter's poor return to punters might be a contributory factor of its continued deterioration in popularity, with net expenditure having fallen by almost 28% between 2001 and 2005, giving it a market share of only 1%.

However, when this margin calculation is applied to online gambling it overlooks the fact that the internet benefits massively from its significantly lower operating costs, when compared with pretty much all the other forms of gambling, especially costly bookmaking shops.

But even this superior business model could not protect it from the bombshell that hit it last October. An unexpected vote in the US Senate passed the Unlawful Internet Gambling Enforcement Act' and in one fell swoop outlawed online gambling in the US.

This caused mayhem in the markets and the shares of the online operators have fallen dramatically since this shock announcement. All the major players now have valuations of a fraction of those they enjoyed at their peak: Sportingbet has been among the hardest hit and its shares are currently 90% off their 12-month high; PartyGaming are over 70% lower; and 888 are nearly 60% below their peak.

For these quoted operators it was imperative that they offloaded their US divisions and unshackled themselves from all their business connections in the country, which must have been particularly hard since all of them received by far the majority of their revenues from US punters.

For example, at the time of its float PartyGaming generated a massive 88% of its revenues from its US customer base and Sportingbet had hardly been quiet about its focus on targeting the large and lucrative US market. Regardless of the magnitude of its former revenues Sportingtbet was forced to sell off its entire US business for the nominal sum of $1.

It was possibly because Sportingbet's chief executive had been particularly critical about the US legislation on gambling that the company's chairman last year found himself under arrest when briefly setting foot on US soil.

He represents one of a growing number of senior online gambling executives to be arrested by the US authorities including the ex-chief executive of BetonSports - and it is the high likelihood of further arrests that makes for great uncertainty in the sector.

Should you invest in the online gambling sector?

The big question for investors is whether to reconsider the online gaming sector or whether it is still a no-go zone?

For sure, some of the dust has settled as the quoted companies have extricated themselves from their US businesses but it is the potential for arrests that remains the big issue. The recent detention of two of the founders of online payments firm NETeller has prompted a new worry for the sector because they are being charged under a combination of the new Gaming Act and on money laundering charges.

Unlike the previous arrests the latter could have a material impact on the gaming companies because if found guilty of the new charges, then the US Justice Department would be able to claim back all the money (from the company as well as the individuals involved) that had been raised when these companies floated on the stock market. In the case of NETeller the US prosecutors have also seized £28m of cash.

If it wasn't for this negative overhang then the sector would look reasonably rosy for the major operators, according to Warwick Bartlett, founder of Global Betting and Gaming Consultants, who travels the world advising countries on implementing gambling legislation.

He says Asia represents a "huge" opportunity once the penetration of broadband and internet access increases. Vietnam for instance has a population the size of Germany (albeit less affluent) and then there are other territories such as Indonesia, China and Hong Kong where much opportunity lies.

But even in these new areas there are still some risks as evidenced by the recent detention of a representative of online gambling firm Victor Chandler in Israel, when promoting the company's online gambling sites in the Middle East.

Thankfully Europe remains both a safe bet and a still largely untapped market that is growing at a healthy clip. Proof of this came from quoted operator 888, which recently issued a trading statement highlighting that net gaming revenues (from outside the US) was up a healthy 28%.

PartyGaming has also made its intentions clear about attacking non-US markets with the recent release of early French, Spanish, Russian and Portuguese language versions of its poker software before it embarks on a full launch later in the year. The company is also cranking up its marketing activity in Europe with TV ads appearing in September, alongside increased online promotions via viral campaigns on YouTube.

Both Party Gaming and Sportingbet remain serious online players even now with their smaller ex-US business models and their shares have moved up from 12-month lows, in spite of continued selling pressure on their stock. Bartlett suggests this is partly down to their founders and senior management's still holding sizeable stakes and that this overhang continues to act as a dampener on their progress.

Their weakened balance sheets are also likely to have put paid on their earlier aspirations of acting as consolidators in the gaming market. This is now being left to stronger established operators such as Ladbrokes and William Hill, plus potentially big US gaming groups like MGM and Harrah's.

These players now consider purified' online operators, including 888, Sportech and Betinternet, as targets now they are rid of US revenues and run clean' businesses. Early evidence of this development is the ongoing talks between 888 and Ladbrokes about a sale of 888's assets.

The combined advantages of avoiding the US and balance sheet strength derived from their domestic betting shop businesses puts both Ladbrokes and William Hill in strong positions to act as consolidators.

And not having the US Justice Department breathing down their necks, and looking to arrest their executives whenever they pass through America, will undoubtedly provide a serious level of comfort to investors. This will also have acted as a support for their share prices after the shock October announcement. At Friday's share price of 441.5p Ladbrokes stands close to its high for the year of 462p, while William Hill's share price of 658p is also not far off its 12-month peak of 681p.

Their well known brand names also act greatly in their favour, according to Mintel, which found that although online gamblers frequently use a wide range of websites for browsing and checking out odds, ultimately they do their actual betting with a recognised name.

And this trusted brand recognition is not restricted to the UK, suggests Bartlett, who reckons they are equally well known overseas. When this is supplemented with the additional credibility of the British Kitemark featured on their websites and UK regulation he reckons this makes them very attractive to overseas gamblers.

What investors in such companies as Ladbrokes and William Hill - and any other quoted gambling company - will be hoping for is that their pick at least maintains its existing share of the gambling industry pie. The gambling market is forecast to grow by an impressive 31% by 2011 when it will account for a chunky £13.6bn of net expenditure. What nobody will want is to see another US Congress shocker.

By Glynn Davis for The Daily Reckoning. You can read more from Glynn and many others at www.dailyreckoning.co.uk