Down but not out: gambling stocks have a bright future
The British gambling sector has been hit by taxes and tighter regulation. But the depressed share prices have yet to factor in the compelling long-term growth outlook, says Stephen Connolly.
Britain's £14.5bn gambling industry was dealt a double whammy last year. First, the government slashed the maximum stake on highly profitable fixed-odds betting terminals (FOBTs), electronic slot machines containing a range of games, from £100 to £2. Second, to make up for the lost tax revenue, it hiked duties on online and mobile casino-style games from 15% to 21%. On balance, this is likely to be neutral or maybe slightly positive for the public finances, but it certainly tears a hole in the industry's profits; many highstreet betting shops will disappear.
Nevertheless, despite the gloomy backdrop and sinking share prices, the sector is hardly a write-off. It is in a state of flux, gradually adapting to the tough conditions and eyeing up future growth in online and mobile gambling. It is also investing in sustainable growth overseas, especially in the US where stringent gambling regulations are being relaxed.
What's more, low stock valuations now reflect the British regulatory shock and subsequent downgrading of profit expectations. What they don't reflect, however, is the scope for future growth. This could therefore be an opportunity to place your bets on the gambling sector on the cheap.
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Looking beyond Britain
Profitability is set to trough in the next year owing to the combination of lost UK profits and investment in US expansion. After that, however, the industry could be generating robust earnings growth. Of course, the UK high-street betting shop business which houses the FOBTs needs attention, with some companies having to do more than others.
For William Hill and GVC (which owns Ladbrokes Coral) in particular, as operators of the bulk of the UK's 8,400 high-street betting shops, a top priority will be adapting their retail operations to fit a markedly less profitable market after the stake cut takes effect in April.
According to the Gambling Commission, people betting in shops, or physical betting, currently adds up to £3.2bn. That represents 22.5% of the UK's total gross gambling yield (GGY), a standard measure of all the money wagered by punters minus the winnings paid out. But this includes 33,000 FOBTs which brought in £1.7bn last year, more than half the total. It's impossible to gauge exactly how customers will adapt to the £2 stake, but the initial hit could be mitigated slightly by upgrading products and overhauling shops to maintain and attract customers. More significantly for the bottom line, leasing arrangements will be optimised and shops shut.
The sector itself is upbeat beyond UK regulatory difficulties. William Hill, for instance, still has ambitious profit targets over the next four to five years despite heavy reliance on FOBTs. The general optimism is based on two imperatives. First, the industry knows that more and more people will bet remotely, whether on the internet or their mobile phones, and there are betting markets around the world where remote gambling has barely penetrated. Second, to avoid significant regulatory obstacles, it must re-balance business by diversifying geographically. These overlapping strategies offer considerable scope for tapping new revenues.
Going online
Remote gambling has been around for more than 20 years, with punters initially placing bets on the internet through their computers at home. Mobile gambling, however, is a more recent phenomenon. It started to gain traction from 2010 as smartphones spread; nowadays it is the fastest-growing part of the market. In the UK it was not really until about 2000 and beyond that leading bookies such as William Hill and Ladbrokes launched and started growing online businesses, benefiting from strong domestic brand recognition which they could leverage for marketing, particularly through their high-street shop presence.
Of course the internet helped lower barriers to entry and the incumbents lost some ground, but they have worked hard to cement their presence. UK customers are wagering more than £5bn a year online, more than half of which goes on casino-type games and nearly two-fifths on betting. The top online operators are Bet365, Paddy Power Betfair, Sky, GVC/Ladbrokes Coral and William Hill. There are still many small operators, too, with 888 remote-gambling licences in issue, according to the Gambling Commission.
Beyond the UK, however, remote gambling is in its infancy. While global remote gambling was reckoned to be worth £35bn in 2017, that's still only about 11% of the total global gambling market, estimates market researcher H2 Gambling Capital despite year-on-year growth of 9% over the past decade. Remote is expected to grow by a further 40% to reach £49bn by 2022. Globally, remote penetration is only about a quarter of the UK figure of 43% of the overall gambling market.
UK operators' strong advantage
Low penetration online is an opportunity UK-listed operators should be able to grasp thanks to a very strong advantage: they have already created and significantly grown their digital offerings in the world's biggest regulated online gaming market. This high level of complex know-how and experience forms a solid foundation for expansion.
Many markets have yet to develop a full regulatory framework for digital. But they are catching up, propelled by social campaigning to safeguard gamblers and formalise online's legal status, which will then allow them to monitor and secure gambling-tax revenues. Brazil, Russia and India, for example, are all large gambling markets developing their online regulation. Whether entering directly into new markets, offering IT and platform support or forming alliances with local partners, the UK businesses have a solid offering.
Moreover, a good online or mobile platform that is efficiently managed should in itself fuel growth. The data that can be collected and analysed should provide the gambling businesses with a comprehensive picture of tens of thousands of individual users. This gives unique insight into what they like, which can be used for further product development and innovation, tailoring offerings to what customers want and winning their loyalty and thus repeat business.
As the database grows, the user experience should feel increasingly personal; if the analysis is effective punters should be receiving offers and services which quickly engage and motivate them. This is how Netflix or Amazon, for example, try to understand and predict what will work best with users. Remote gambling is growing faster than shop betting, and it makes intuitive sense that in a world where people increasingly interact via social media and mobiles, it will continue to do so.
Innovations that have already demonstrated the appeal of online include services that allow live gambling, "cashing-out" of bets (getting money back on your bet before the event is over, with the amount based on the odds at the time you cash out), and tempting offers timed to coincide with major events. State-of-the-art platforms that can engage and entertain customers on a personalised basis in a timely way must surely succeed.
Going west
The second source of growth momentum is the shift to the US, which is a complex market. Surprisingly, sports betting was outlawed around 25 years ago, except in four states (Delaware, Montana, Nevada and Oregon). Then last spring the Supreme Court ruled six to three that the Professional and Amateur Sports Protection Act (known as "PASPA") was unconstitutional, paving the way for individual states to legalise sports betting. Of course a ban on sports betting didn't mean it didn't happen. With the underground market said to be worth $150bn, according to the American Gambling Association, many think the industry is about to gain from a "cannabis" effect, whereby an illicit but common activity becomes legitimised.
UK-listed gambling groups consider the market rife with opportunity: GVC's CEO Kenny Alexander said last year that the US "could become the world's largest regulated sports betting market". They already have operations in the US. William Hill, for example, controls 57% of the sports betting market in Nevada, operating 108 of the state's 190 outlets, and is the exclusive bookmaker in Delaware for sports betting, where it is run by the state lottery.
Not only do the British gambling groups believe their existing presence and brand recognition give them the base from which to grow, but they also emphasise their longstanding expertise and technical, often proprietary, betting know-how whether Premier League football or the names of royal babies gained in more mature markets like the UK.
According to researchers Eilers and Krejcik Gaming, seven US states are expected to permit sports betting this year, which could produce revenue of nearly $1.5bn from a mix of physical and online betting. This is expected to be followed by more than 20 more states, adding a further £7.5bn of revenue over the next few years. William Hill has access to 17 of these states already, including three-quarters of those set to clear the way for gambling this year, so it is in line for a potential $5.2bn of revenue. It has already taken bets in the first states to pass legislation, including New Jersey. It operates in a tie-up with Eldorado Resorts, under which it can exclusively provide off- and online betting to Eldorado's 23 million customers across 21 sites (a figure set to rise to 26) in 13 states.
GVC, meanwhile, has a joint venture with MGM Resorts International, a deal that gives it access to operations in 15 states and what it hopes will be "meaningful early-mover advantages". Paddy Power Betfair, which already runs an online casino in New Jersey, has taken a majority stake in US fantasy sports site FanDuel, creating a formidable US online business with a large sports-focused customer base.
William Hill helps give some sense of the shifting business dynamics: even before PASPA was struck down, it had produced around $40m in US profits by last year. These are henceforth expected to be more than offset by costs of investing in further US growth, though some forecasters have suggested the company's US operations could potentially break even in 2020-20211 and be producing materially higher profits by 2022.
Value is stoking takeover talk
Gambling businesses are also seeking to expand their operations and customer bases through takeovers, especially when there are substantial synergies across online platforms and technical skills. The online businesses are highly scalable: each new customer requires little or no additional investment, so profitability compounds quickly.
Paddy Power merged with Betfair in 2015. Ladbrokes joined up with Coral in 2016, and this merged group was then taken over last year by GVC. Only recently there have been rumours of a merger (and confirmation of initial talks) between Paddy Power Betfair and Star Group, a Canadian company whose brands include SkyBet. The regulatory backdrop in the UK has depressed share prices and triggered talk of further consolidation.
But while mergers and acquisitions can provide an additional fillip for the share price, the key elements of the bullish case remain the international take-up of remote gambling and the considerable opportunities emerging from loosening regulation in the US. While the demand for remote gambling in the UK may be showing signs of maturity, that is not the case overseas and the experience and know-how of UK-listed businesses will stand them in good stead.
In the US, the outlook is exciting. The pace of growth will to some degree be affected by how quickly individual states authorise betting, and there are still arguments concerning interpretation of related laws. But UK businesses have been adept at getting in position and should ultimately gain from their early-mover status. Their experience from the largest regulated online gambling market together with good brand recognition in overseas markets makes them a strong contender for partnerships with emerging US operators.
No wonder, then, forecasts show a return to earnings growth beyond the next year or so. This has yet to be reflected in share prices depressed by the one-off regulatory hit in the UK. The opportunities both online and in the US, by contrast, should prove enduring. As news of online developments and US expansion in particular starts to proliferate in the next few years, stock prices should start reflecting the opportunities that lie ahead. Below, we look at the main likely beneficiaries.
Where to place your bets
GVC (LSE: GVC) is still digesting Ladbrokes Coral. Indications are that the synergies between the two businesses are better than originally thought. The group, which is valued at about £3.9bn and is a FTSE 100 constituent, has a good foothold in the US and more deals are likely, increasing exposure to this newly growing market. GVC has also been diversifying its international exposure. It has a big UK betting-shop estate which will have to be rationalised, but the potential upside considerably outweighs this downside and the shares are attractive.
About half the size of GVC in market size, William Hill (LSE: WMH) has a similar task at hand with its large retail portfolio. It has had some regulatory problems in Australia, which are now settled, and the shares have performed poorly in line with the rest of the sector. On latest estimates, however, the consensus 12-month price target is 243p, 40% above current levels.
The group was an early mover in the US and is perhaps among the best positioned for the growth story there, with its Eldorado tie-up looking promising. It has a strong brand and is determined to expand its online business, which has been delivering decent returns.
It would be remiss when looking at bookmakers not to include a stock that represents a gamble. For those who like a punt, consider Sportech (LSE: SPO), a £70m minnow with a focus on gambling technology and platforms. It has large exposure to the liberalising US market and this could pay off. It has been cutting costs and is debt-free. There have been some contract delays which should be rectified this year, and the only broker covering it sees good upside from current levels.
Another way to play the US theme is via a local business. Boyd Gaming (NYSE: BYD) has forecast long-term earnings growth of more than 20% a year, and brokers think the shares could climb 33% from current levels over the next 12 months. Again, it is well-positioned for gambling relaxation and the surge in sports betting, and it has strong management. It also boasts a promising joint venture with MGM Resorts International.
Finally, an option for those keener on funds. Gambling is a very narrow industry but the VanEck Vectors Gaming ETF (NYSE: BJK) tracks casinos, casino hotels, bookies and online gaming on a global basis using the MVIS Global Gaming Index. It's small at $27m with a 2.4% yield, while its total expense ratio is 0.65%. It holds GVC, William Hill and Paddy Power Betfair as well as North American and Asian operators including Las Vegas Sands and Stars Group. Although traded in the US, it can be held by UK investors.
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Stephen Connolly is the managing director of consultancy Plain Money. He has worked in investment banking and asset management for over 30 years and writes on business and finance topics.
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