Gambling is an industry tarnished with 'pariah' status. It is chastised by politicians looking to win votes from a socially conscious electorate, too, which explains the increasingly hostile regulatory environment. It's getting harder for gambling companies to operate profitably, even as more of them exploit digital and online income streams.
Regulatory change is undoubtedly the sector's biggest challenge right now. Traditionally, the online gambling groups have avoided many duties that high street bookies William Hill (WMH) and Ladbrokes (LAD) have been subject to. But that is about to change. From December this year, a new Point of Consumption (PoC) tax of 15 per cent will be levied on all revenue generated by an online gaming company's UK-based customers. There is, however, a great deal of uncertainty surrounding the new rules.
It is currently unclear whether the new tax will be introduced at 15 per cent, or in December as planned. George Osborne confirmed the terms in this year's March Budget, but analysts at broker Numis are not so sure. In fact, their positive outlook on the sector hinges on the belief that concerns over regulation have peaked, and that those gambling companies who have suffered share price declines in the last five months are due a re-rating.
There's hot debate about the real cost to those gambling companies expected to be hit by the PoC. Industry insiders think the full cost will not be laid on the consumer. Analysts at Deloitte believe consumers would react negatively to price increases and believe it would only take one high-profile operator to not pass on the cost to make it more difficult for others to. Arguably, it will be the smaller end of the market which will suffer most from a price war. They might tinker with the odds they offer to recover higher costs, but more crucial will be maintaining market share. And, again, it is the smaller companies who have most to fear.
This is where investors get the idea of just how much gaming firms will spend on marketing this year. A ramp-up in marketing spend began last year, but has taken on more importance as regulation tightens. Interactive gaming outfit NetPlay TV (NPT) splashed out on a three-year deal with ITV and sponsored both reality show Big Brother and its celebrity spin-off; 32Red (TTR) agreed a shirt deal with Rangers Football Club (RFC) for the 2014-15 season; and betting exchange Betfair (BET) will increase television coverage during the World Cup and Champions League broadcasts over the next 15 months. The strategy is clear - sign up as many new customers as possible before December to soften the impact of the PoC.
In the long term, however, operators must either raise prices or cut costs. The latter seems most likely, meaning large-scale marketing budgets are not sustainable. Investors are more likely to be impressed by strong quarterly figures, which would imply that temporary strategic measures are paying off and provide evidence of organic growth. First-quarter numbers from 888 Holdings (888) were sufficiently bullish, revealing an 11 per cent year-on-year rise in revenue and 7 per cent improvement on the final quarter of 2013. Consumer bingo did particularly well, with revenue up 9 per cent on the previous quarter. And this followed a strong set of full-year figures, which saw the group declare a 7ȼ special dividend. They also only pencilled in $20m (£12m) of extra costs as a result of new taxes - hardly dramatic for a company worth £500m.
In fact, the only gambling outfits unable to come up with stellar first-quarter news are the high street bookmakers. As well as the PoC, the Budget was unkind to them. A 5 per cent increase in fixed-odds terminal betting duty to 25 per cent and an additional 5 percentage point increase in Machine Gaming Duty (MGD) to 25 per cent left much of the sector disappointed. Both William Hill and Ladbrokes have flagged store closures in the wake of legislative announcements - 109 sites in the case of the former.
The government's main motivation for higher taxes appears purely political. The fixed-odds terminals have been described as the 'crack cocaine' of the gambling world, and Westminster wants to appear tough. But the Department for Culture, Media & Sport (DCMS) has not completed its review of the relationship between machine activity and problem gambling. This prompted analysts at Investec to speculate that the Budget measures were an attempt to levy higher taxes in case the DCMS found no evidence-based link between the two.
To cap it all, uncertainty remains regarding the possible introduction of a horse-race levy worth nearly 11 per cent for offshore bookies. Industry bosses are understandably furious and are clubbing together via the Gibraltar Betting and Gambling Association to voice their concerns to the relevant politicians. In fact, litigation is almost guaranteed should PoC come in on time and at 15 per cent.
IC VIEW:
Knowing how to calculate future costs of higher taxes and whether or not to force the consumer to take the hit is gambling's biggest challenge right now. Therein lies a delicate balance between keeping hold of - or even growing market share - but simultaneously raising prices as many smaller operators may be forced to do. The big bricks-and-mortar guys face different problems, largely centred around the cost of retail branches on the high street. Investors interested in the gambling sector must be careful until the changes become more concrete.
FAVOURITE:
While we are generally cautious about investing in the sector this year, those investors willing to take on some risk could turn their attention to long-standing Investors Chronicle favourite NetPlay TV (NPT). After a big marketing push, the number of new players jumped 25 per cent last year and gross bets exceeded £1bn for the first time. Yet the shares only trade on 11 times forward earnings, undemanding considering the year's achievements and a 30 per cent jump in the dividend. Aim-listed 32Red, which we recommended buying last year (54p, 19 Sep 2013), is another one to watch. After recent profit-taking, the shares trade on just 11 times forward earnings, handing investors a second bite of the cherry.
OUTSIDER:
Despite retiring our long-standing sell tip at the time of the full-year results in March, William Hill remains our outsider. Increases in MGD taxes hit the company with £10m of extra costs last year, but the duty has since been hiked again. It's now unclear whether the £15m-£20m of cost savings earmarked for 2015 will be enough for the group to avoid further asset sales. Admittedly, at just under 14 times forward earnings the share are not expensive, but it's hard to see how they will generate value for investors this year.
THE BROKER'S VIEW
"There will be a legal challenge to the government's plans to impose new gaming duty on offshore gambling operators," believes Ivor Jones, analyst at Numis Securities. Of the betting companies he covers, Mr Jones believes Betfair(Add, Target price 1,300p), 32Red (Buy, 100p) and 888 (Buy, 220p) would likely see the biggest financial impact if the duty were introduced.
But the new duties will also prompt the closure "of a number of betting shops", affecting high street bookies William Hill (Buy, 500p) and Ladbrokes, he says. There are "some big hurdles ahead", admits Mr Jones, especially as these two are effectively penalised twice by the increase in Machine Gaming Duty (MGD). As well as shutting shops to cut costs, they could face further regulation which would curb any return to growth in shop numbers. "William Hill's share price has a wall of worry to climb," says Mr Jones. "We believe we are at a trough in terms of trading and uncertainty. However, the shares will not make progress, in our view, until the government clarifies its policy in relation to betting shops."
After another record quarter, "there could be scope for forecast upgrades" at 888. However, if Point of Consumption (PoC) were introduced, current forecasts could take "a 30 per cent hit". There's also uncertainty as to the impact of the World Cup, and, due to intense competition, online gambling companies will "spend heavily on marketing". Consolidating its growing position in three US states is costing 888, too, says Mr Jones.
So far, collective lobbying efforts from the gambling operators appear to have failed, but this means they have "little to lose from a more combative approach". Ultimately, gambling operators have limited scope to pass on costs to consumers. All that will suffer is overall profitability.
