Are online betting firms a gamble?

Could online gaming companies be among the stockmarket investments to make in 2011? The listing of Betfair (BET) at the end of October on a fancy multiple and the $3.3 billion megamerger between bwin and PartyGaming (), due to complete in the first quarter, appear to have added lustre to the sector recently.

Then there is the prospect, albeit a slight one, of the liberalisation of the US online gaming industry that has put the industry firmly on the radar of investors both sides of the Atlantic.

It is understandable, as even a cursory look at the stockmarket gains of the biggest online gaming companies between 2004 and 2006 reveals how quickly fortunes were made - and lost.

The iGaming Global Top 30 index, made up of the 30 biggest online gaming companies, soared 40% between July 2004 and August 2005. This was followed by 12 months of extreme volatility before tanking, thanks to a controversial piece of legislation in the US.

Since 2006, online gaming's backstory has been dominated by the US Unlawful Internet Gambling Enforcement Act (UIGEA). The multibillion-dollar global industry virtually collapsed after its biggest market - the US - was closed down overnight when Congress introduced a surprise clause to legislation that September, in effect making internet betting illegal - a blow for investors and a hugely expensive move.

British-based companies were among the biggest casualties. As soon as the London Stock Exchange opened the following Monday morning, shares in PartyGaming - then a FTSE 100 (UKX) member - slumped by 58%, while rivals 888 Holdings (888) and Sportingbet (SBT) saw their shares slide by 26% and 64% respectively.

An estimated £4 billion was wiped off the sector's value. Companies were forced to concentrate on other global opportunities, but the businesses have never fully recovered from the shock of losing their most lucrative market.

Last year, online gambling was worth an estimated $5.4 billion (£3.5 billion) overall, a figure that could rise to $16 billion if the US market was opened up, analysts say.

There is renewed hope that a winning hand may soon be dealt to the sector. Back in July, Barney Frank, Democratic chairman of the House of Representatives Financial Services Committee, renewed his protracted campaign to repeal the UIGEA, which prohibits the transfer of funds from a financial institution to 'illegal' internet gambling sites.

On 28 July, American lawmakers on the Financial Services Committee voted by 41-22 to approve the move, meaning that legislation can now be introduced (Frank's Internet Gambling Regulation, Consumer Protection and Enforcement Act) that would seek to regulate many forms of online gambling.

As a result of his efforts, Frank (who does not gamble) has been praised by online gamblers - as well as many Republicans - and vilified by gambling opponents.

But his once-controversial views on online gambling may be becoming orthodox. One banker working in the industry says: "The argument in favour of regulation, as opposed to prohibition, is beginning to become mainstream, even in America."

You can see why if you glance at the forecast numbers. With the US nationwide unemployment rate at 10%, 48 of 50 states facing budget shortfalls, and a federal deficit approaching $1.3 trillion, the economic backdrop against which to promote regulation and taxation of internet gambling has arguably never been more favourable.

The US government's non-partisan accountants, the Joint Committee on Taxation, estimate online gambling could generate up to $42 billion in new revenue by 2019, depending on the number of states that opt into a federal regulatory programme.

Online gaming, say Frank and his supporters, is a multibillion dollar, job-generative reservoir just waiting to be tapped. With the US economy in such a mess, can the country really afford to miss out on the bonanza that regulation and taxation would bring?

"We are seeing things from a legislative perspective that are quite exciting for us," says Jim Ryan, chief executive of PartyGaming, whose comments reflect the mood of a growing contingent of gambling operators in the US and UK.

There has been speculation that PartyGaming and bwin have decided to merge at this time precisely because they will be better placed than any other operator to seize a huge market share should the US decide to legalise online gambling.

Analysts agree the enlarged company is in a strong position. In a recent note to investors, Morgan Stanley leisure analyst Vaughan Lewis said: "With its expertise...market-leading technology, strong marketing capability and good brands, we think the combined entity of PartyGaming and bwin would be extremely well positioned to benefit from any market opening in the US."

And in a Barclays Capital note, the investment bank said: "In the event of federal regulation, we believe PartyGaming would be the likely key beneficiary.

"Under this hypothetical scenario, we estimate the potential [underlying profits] uplift could be 94% for PartyGaming and 58% for bwin and 888. On a state-by-state hypothetical scenario, we estimate the uplift for the group would be considerably lower, but still meaningful."

Stakeholders in the US are finally understanding the risks and implication of a 'do nothing' strategy. With billions of dollars out there to harvest and market share to win, the entire online gaming sector looks ripe for an upturn in coming months.

Investing in online gaming companies has always been a white-knuckle ride and there looks to be every sign that this particular circus is once again rolling back into town.

This article was taken from the February 2011 issue of Money Observer.