The Pick of Online Poker Stocks

In April UK investment bank and advisors Daniel Stewart & Company published a gambling sector note with its opinion on moves to regulate online poker in the U.S..

Daniel Stewart analyst James Hollins explains how the market views these proposals and gives his pick of the Europe’s online poker stocks and the potential upside for shareholders in a post-Unlawful Internet Gambling Enforcement Act world.

Legislation

We are hearing from a number of sources that Senator Harry Reid, the Democrat Senate Majority Leader from Las Vegas, is rapidly preparing a Federal Bill that will look to regulate and tax online poker in the U.S..

We are led to believe that the proposed Federal legislation will encompass just online poker (not casino and certainly not sports betting).

We would expect the Bill to be broadly based on several other Bills already put forward by long-standing advocate of regulation, Democrat Representative Barney Frank (supported by Democrat Representative Jim McDermott and over 60 co- sponsors), as well as the poker Bill introduced by Democrat Senator Robert Menendez.

These have also recently been complemented by an online gambling taxation Bill put forward by Senators Ron Wyden and Judd Gregg. Interestingly, this is part of a Financial Stimulus package and is the first bi-partisan Bill to be introduced (Senator Wyden is a Democrat and Gregg a Republican Senator for New Hampshire).

While hope remains for any one of these Bill’s passing into law, the fact that Senate Majority Leader Harry Reid is proposing a Bill that seemingly seeks to emulate the underlying message of each of these other proposals, we would expect these Senators to support a Reid Bill.

Critically, we are also hearing that the Reid online legislation and taxation Bill is likely to be supported by the US President.

Once again, this is speculative, but the legislative efforts appear highly tangible at this stage.

Regulation Not Prohibition

Online gambling was essentially outlawed in the U.S. in September 2006, where historic “grey” legislation was replaced with current legislation (the UIGEA) that would effectively cut off source payments into online gambling sites.

As a prohibition measure, this has not worked.

We argue that the most effective method to control gambling addiction and corruption is to regulate the industry (rather than attempt to prohibit), with wide-ranging legislation that will also generate meaningful tax income.

If the latest rumours are true, then this is what the U.S. legislators have finally realised. Essentially, while pro-gambling lobbying is hardly a vote winner, the ability to regulate and tax an industry that is massive, illegal, growing, and generating zero tax dollars is an opportunity that the under-fire Reid is looking to take ahead of the U.S. mid-term elections in November 2010.

His approach is entirely correct, in our opinion.

The Potential Winners

With regards U.S. licensing, the jury is out on whether the European-based operators will be able to secure a licence. It is likely to go one of three ways:

One — the U.S. legislation favours domestic land-based operators by effectively excluding offshore operators with the introduction of a stringent base for licensing that could not be circumvented by ex-U.S. owned companies.

Two — the legislation favours land-based U.S. operators but would allow other operators to secure a licence if they built or acquired a land-based presence.

Three — the legislation is open to ex-U.S. operators that are clean and pass tests of appropriateness for securing a licence.

Naturally, scenario three would be the most exciting for the European-based operators as they could potentially pass the requisite tests, and would likely pass given their scale and experience in operating in regulated markets such as the UK and Italy, having invested heavily in “Know Your Customer” and anti-money-laundering technology.

Scenario two could also prove fruitful if operators could cost-effectively build an offline operation and subsequently secure a licence.

Scenario one has the least potential upside, but is a genuine possibility.

Given its likelihood, as well as the potential time and costs associated with securing a business-to-consumer (B2C) licence, we believe it more prudent to focus on stocks that can generate meaningful business-to-business (B2B) revenue in the U.S., with the added potential bonus of business-to-consumer revenue.

In this respect, therefore, our preferred stocks would be those with a scalable B2B poker operation, while also favouring stocks that have had major U.S. brands that could still generate meaningful upside.

Playtech is our top pick in the sector, with 21 percent upside to our 625p target price.

Playtech has, in our opinion, the most to gain from B2B upside in the U.S.. However, while this is speculative, we believe that the current outlook for organic growth across European territories is suitably attractive to justify our target price, particularly given its discounted rating against the sector (13.6x FY10E P/E, a 5 percent discount to the sector) and a solid dividend yield to FY10E of 3.7 percent.

bwin Holdings is a key buy, with 17 percent upside to our €48 target price.
bwin stands at a small premium to the sector (14.6x FY10E P/E, a 2 percent premium), pricing in some of its European growth potential (market leader in Italian poker and European-wide sports) and also an element of possible sector consolidation (rumours of a merger with PartyGaming persist). However, we feel it has excellent European prospects that are not captured in its share price, with possible U.S. and mergers and acquisition catalysts that could see the shares outperform materially.

Sportingbet is a key buy, with 32 percent upside to our 100p target price.

Although U.S. upside is possibly limited to a licensing deal and greater liquidity in its Paradise Poker brand, Sportingbet could still generate solid and high-margin U.S. income (Department of Justice settlement permitting). More importantly, the investment community is undervaluing the group’s existing European operations that have market-leading presence across key territories such as Spain and Greece, while generating solid cash and earnings growth. The 16 percent FY10E sector discount is unwarranted and we see attractive potential upside, notably as it moves to the Official List in the UK during June 2010.

PartyGaming is a buy, with 17 percent upside to our 366p target price.

PartyGaming is well placed to benefit from any potential U.S. upside. Compounded by rumours of a bwin merger, the shares have traded firmly in recent months and stand at a 16 percent premium to the sector on FY10E EPS (16.5x vs sector at 14.2x). This precludes us making the stock a key buy, although, as noted above, the valuation would change materially on any form of U.S. re-entry. We expect the group to deliver solid European organic growth, notably in key regulating territories such as France (B2B deals signed with PMU and AB Groupe), Italy, and Denmark.

Neovia is a buy, with 46 percent upside to our 92p target price.

Neovia has been through considerable change during the past two years, with a platform overhaul and focus on expanding its product range across its e-wallet, payments processing and Net+ cards. We believe that it has an exciting and highly cash generative outlook, with potential U.S. re-entry on the radar for its payments products, excluding the online gambling industry until it is regulated. The shares stand at an unwarranted 15 percent discount to the sector on FY10E earnings and are supported by net cash of $74m (against a market cap of $117m).

888 Holdings is a buy, with 42 percent upside to our 145p target price.

888’s shares have been relatively flat recently, with concerns over its soft trading in February 2010. However, we view this as only a very short-term issue and expect the group’s excellent online casino product to deliver solid organic growth across Europe. Although France has limited upside appeal for 888 given regulation does not allow for casino operations, 888 is driving expansion of its B2B division, securing strategically attractive deals with the likes of Harrah’s Interactive and an extension to its B2B deal with Cashcade. The shares are trading at 12.9x FY10E EPS, representing a 9 percent discount to the sector.

Other companies

Although upside from the U.S. is the key focus of this note, for completeness and based on European organic earnings growth, our other stock recommendations are:

Ladbrokes, Hold, Target Price (TP) 159p
Net Entertainment, Hold, TP Skr 72
Paddy Power, Hold, TP €23.4
Rank Group, Sell, TP 75p
Unibet, Buy, TP Skr 253
William Hill, Buy, TP 258p

Visit DanielStewart.co.uk for further information on European gambling stocks.

The opinions expressed in this article are solely the authors and do not necessarily represent those of Card Player Media.