Will online gaming turn out to be a busted flush?

[clevfan]

Will online gaming turn out to be a busted flush?

Sept 11
Tony Glover
Thebusinessonline

THE activity on Sportingbet's trading floor in its City of London offices is almost identical to that in any dealing room. Hunched over their computer screens, dealers generate hundreds of millions of pounds in revenues by constantly making new markets in high-risk investments.

But this City dealing room is different from the others in the Square Mile. It does not pretend to offer its clients anything more than a straightforward gamble and is the nerve centre of an internet gambling service which has more than 2.5m registered customers in 200 countries placing 1.2m bets a day. The men and women in front of the screens are not trading shares but setting internet betting odds.

Sportingbet has seen its annual revenues take off from £27.4m (E40m, $49m) in 2000 to more than £1.43bn last year with roughly half the company's profits coming from its poker operation, Paradise Poker, which has around 721,000 registered customers.

But the biggest gamble of all is not being taken by the armies of punters playing online poker at all hours of the day or night, but by the City itself.

In what is looking more and more like a replay of the dotcom boom, investors have sunk billions in internet gaming stocks despite the uncertain legality of their operations and the threat of growing competition from new websites.

A recent spate of listings by online gaming companies and takeover rumours have whipped up institutional investors to fever pitch in recent months. PartyGaming's listing earlier this year valued it at an incredible £4.64bn and was followed by a rash of other planned listings plus consolidation rumours.

Sportingbet stock, which originally listed on London's Alternative Investment Market (AIM) for smaller companies for 20p saw its share price reach £3.80p at the start of last week on news reports of a potential takeover of rival Israel-based Empire Online. There was also speculation that these reported merger talks could spark a takeover bid from Sportingbet's rival PartyGaming. The market has also been excited by Betfair's and 888.com's anticipated London flotations.

But in the world of gaming there are no dead certainties. The whole online gaming sector suddenly took a beating last week in the wake of a prediction of slower growth from PartyGaming, which recently listed on London's main stock exchange. Despite reporting an impressive 81% rise in half-year revenues and a 21% growth in profits, PartyGaming saw roughly £2bn wiped off its share price in a single day, leaving the company valued at roughly £4.2bn.

All the company had said was that, although it expected good year-on-year growth in the second half, this growth could be lower than the meteoric rise seen in previous interim periods.

The dramatic drop in the share price is evidence of the overheating of the online gambling market rather than any shock in PartyGaming's interim results. What was remarkable was not that investors started to get cold feet at the end of last week, and cash in their chips but that a dotcom company offering a gambling service of dubious legality should have been given a higher market value than Marks & Spencer in the first place.

Like most of the online gaming sites, PartyGaming's accelerating revenues and profits since it launched in 1997 have been driven by the growing popularity of online poker and the resulting success of its online poker arm PartyPoker. The popularity of online poker is a result of a renewed interest in the game that was sparked by major poker tournaments such as the World Series of Poker being televised across the world. This gave the online poker companies an opportunity to advertise their websites to the growing number of TV poker fans.

According to a source at PartyGaming, the adoption of internet poker was also aided by expertise gained in the internet porn industry, the worldwide web's other big money-spinner. To download pornographic images, the porn sites developed developed new digital compression techniques which are now used in delivering real-time poker action to the world's growing army of PC poker players. PartyGaming's own history bears testimony to the link between online porn and online gaming.

PartyGaming was founded in 1998 by a 38-year old US lawyer, Ruth Parasol, with the proceeds of the sale of the US porn interests which had made Parasol her first fortune. Parasol not only had the foresight to see that online gambling would be the internet's next big moneymaker but to focus the company's resources on developing its online poker service. She used the skills learnt from delivering porn to deliver gambling games like poker over the web. The economics of operating an online have represented a licence to print money over the past few years to those like Parasol who got into the game early. Online gaming companies take what is known as a "rake" of 1%-3% of the pot, the money being wagered on each hand. The computers dealing the hands and taking the cash can be located anywhere.

PartyPoker, for example, is based in Gibraltar, one of a handful of European locations where online gaming is legal and one which also offers considerable tax advantages. These concessions have also tempted the online business of Ladbrokes and online casino 888.com to locate there.

The company's servers, the powerful computers that deal tens of thousands of poker hands simultaneously are based in Kahnawake, a Mohawk Indian reserve in Canada. Most of the company's staff, with the exception of a small London-based marketing team, are located in Hyderabad in southern India.

US STUFF

By bypassing geographical boundaries in this way, online gaming companies have presented legislators with a legal challenge, especially in the United States. The links between the internet porn industry and online gambling, which had led to PartyGaming founder Ruth Parasol being labelled "the Princess of Porn", haven't helped.

While many US senators would like to see online gambling banned, this could prove difficult to achieve. According to one online gambling industry source: "The Christian right in the Bush camp privately admits that the only way forward is to regulate online gambling but to attempt to do this would appear to sanction online gambling and that would be political suicide for them."

This legal conundrum is a result of the chequered history gambling has had in the US, quite different to its relative social acceptability in European countries. Traditionally, there were always strong links between gambling and organised crime in the US and this is reflected in current legislation.

In the late 1950s, the US authorities began to acknowledge the scale of organised crime in the US and made efforts to stop its influence spreading. One easily recognisable centre of mob influence was Las Vegas, a town that had risen like a neon mirage out of the desert largely on the proceeds of Mafia crime.

Although today Vegas is largely controlled by legitimate businesses, in the late 1950s it was largely owned and run by organised crime, which was intent on extending the tentacles of its criminal empire by offering punters across the US the ability to make phone bets on practically anything.

In an effort to limit mob influence, the US passed a key piece of legislation, the Federal Interstate Wire Act. This was drafted to prohibit the wire transmission of sports bets by organised crime at a time when the internet would have sounded like something from a late night science fiction TV show,

Nevertheless, in 2002, Jay Cohen, owner of the Antigua-based World Sports Exchange online sportsbook, was sent to jail for violating the Wire Act through internet gambling. In 2000, Cohen had voluntarily returned to the US planning to prove that the Wire Act did not apply to internet gambling. After a two-week trial in a Manhattan courtroom, Cohen was sentenced to 21 months in prison, a term he began serving in October 2002.

According to the US Department of Justice, the trial proved that Cohen had solicited Americans to call the World Sports Exchange using toll-free 800 telephone numbers and to contact World Sports Exchange through its website. The Wire Act makes it a crime to use phone lines in interstate or foreign commerce for the placement of sports bets or for the transmission of information assisting in the placing of bets on sporting events. The trial demonstrated that through advertisements placed in various American newspapers and magazines, the World Sports Exchange had invited customers throughout the US to contact World Sports Exchange by telephone or internet and open a sports betting account.

Although the Wire Act specifically refers to bets being made using the phone rather than the internet, the current trend towards the convergence of phone and internet networks could result in making the Wire Act more relevant to online gambling than it is today. Online search engine Google recently launched its Google Talk internet telephone service and, last week, internet shopping giant eBay was rumoured to be planning a $2bn-$3bn bid for internet telecoms specialist Skype. The merging of the internet and telephone services in this way potentially has terrifying legal repercussions for the online gaming sites.

Roughly half Sportingbet's profits come from its Paradise Poker operation in the United States. In the seven months to July 2004, the most recent statistics available, around 79% of Paradise Poker's deposits were taken from US-based customers, with only 11% coming from Europe and 10% from the rest of the world.

Morgan Stanley's equity research team recently warned of the danger of a US clampdown for Sportingbet: "The legal position of gambling in the key US market remains uncertain, and a severe clampdown would wipe over 60% off our forecasts."

Goldman Sachs also issued a general warning for the whole online gaming sector: "A US ban on online poker would materially impact trade. Of the players surveyed, 25% said that they would stop playing; 15% said they would play less; 29% would not change their habits and 31% were undecided."

WHEN PartyGaming's share price plummeted last week, much was made of the risks investors faced from customer churn. New online gaming sites now offer start-up bonuses of up to $600 to tempt players from established online gaming companies such as PartyGaming.

But another potentially more damning condemnation of the industry is coming from groups such as Gamblers Anonymous, which are starting to report an increase in the number of gambling addicts - many of them women - becoming hooked on internet gaming.

This is a charge the industry will find it hard to deny. All the major online gambling companies stress that playing poker online is attracting customers who would not otherwise wish to play. Online poker is, for example, far more appealing to women than finding a game in a smoked-filled room with testosterone fuelled male gamblers in a dodgy part of town.

Some companies are now also making an active effort to introduce customers to new forms of gambling to existing customers. Goldman Sachs recently highlighted this cross-selling as a key strength for the UK's Sportingbet. The company has developed a "shared purse" technology that enables customers to use the company's various services such as placing bets on horse races or using its Paradise Poker site with re-registering bank details. This ease of user is intended to introduce new forms of gambling to existing customers.

A Sportingbet spokesman said: "Imagine someone who places a bet on, for example, a Manchester United football match in the UK or a Miami Dolphins game in the US. Perhaps they regularly place a bet on Monday evening at 5:30 for their team to win. We can now offer them an initial gift of say $50 to start them off at the Paradise Poker table."

But while the moral majority in the US may balk at this type of cross-selling, investors on this side of the Atlantic see the matter from a different historical perspective. Goldman Sachs' London-based equity research team, sees this type of cross-selling as a positive trend.

"Shared purse technology, which allows a player to maintain a single account and play the various online games it offers (already in place for Sportingbet) could drive additional growth," the Goldman team said in a recent survey on online gaming.

Perhaps it is the City's heritage of risk-taking and traditional gambling that has warmed institutions to online gaming.

Historically, the City of London, now one of the world's leading financial centres, was built on betting, or wagering as it was once known. Men used to betting fortunes on the throw of a dice or turn of a card gathered together in coffee houses to form what would become the foundation of London's banking and financial institutions, including the London Stock Exchange.

Many 18th-century English aristocrats involved initially found it hard to understand that financial services could be seen as a gentlemanly occupation in the same way that gambling was. But today the wheel has come full circle and it is online gambling services such as SportingBet and PartyGaming that are trying to convince the world of their respectability.

A source close to Sportingbet told The Business: "There seems to be a special affinity between City brokers and other people who sit in front of screens playing games like poker instead of playing the markets. The interest exhibited on the part of the institutions has been remarkable. A couple of years ago, online companies were lucky to attract one or two analysts to a strategy meeting. Today they attract scores."

Even before last week's warning of slowing growth from PartyGaming, Goldman Sachs was already saying that the big online gaming sites' customers could be enticed away by offers of free cash to play with and lower rake-offs.

With odds like these facing the online industry, it is over-enthusiastic City investors rather than online poker players who should be calling Gamblers Anonymous.