Description

PartyGaming is both an event-driven name and a GARP name that offers you two ways to make a double digit return and one way to make a triple digit return, with relatively limited downside risk.  PartyGaming is a leading provider of online gambling services.  It is best known for online poker, but it also has a strong presence in online casino games and online bingo, and has a smaller presence in online sports betting.  Importantly, PartyGaming only operates in markets where online gambling is legal.  The underlying thesis to the investment is that both national and municipal governments across Europe and North America are experiencing large budget deficits and are desperate for incremental tax revenue, yet loathe to raise taxes both for political reasons and for reasons of not wanting to further stress a consumer already under pressure.  Online gambling is a huge business in all these jurisdictions, however, without regulation, profits go untaxed.  Last year, Italy legalized online poker, and in June, France legalized online poker and sports betting.  There are a number of other initiatives underway in both Europe and the US to legalize/regulate/tax online gambling.  In addition, PartyGaming is in the process of merging with one of its top competitors, bwin Interactive Entertainment, which is the leader in online sports betting in Europe, and has poker, casino, and bingo businesses as well.  There is a large amount of cost synergies in bringing together these two companies together and a fair amount of revenue synergies as well.

There are a couple of ways to make a double digit IRR here and one scenario in which this company could be a multi-bagger.  I will get into more detail below, but briefly, the three scenarios are:

1. European deregulation proceeds as expected, the end markets grow, PartyGaming maintains share, and earnings organically grow by 10-15% which should lead to stock price growth of an equal amount.  Given the depressed multiple versus the historical multiple, there is the potential for multiple expansion and 20%+ returns if the earnings trajectory proves to be positive and robust.
2. PartyGaming and bwin complete their merger, synergy guidance of 28% EBITDA accretion proves to be low-balled and comes out closer to 40%.  Right now the companies are trading as if there is a high risk the deal doesn't close, despite the presence of large shareholders publicly committed to the deal.  You have 20%+ upside in this scenario.
3. The US federally legalizes online poker, or a subset of states, legalize intrastate online poker.  PartyGaming either directly or though a JV with a land-based US casino operator re-captures the share they had in the US prior to their exit in 2006.  Prior to exiting the US, PartyGaming traded between 1000 and 1750 pence, and the current quote is 265 pence.

PartyGaming (PRTY.LN) trades on the London exchange and bwin Interactive (BWIN.AV) trades on the Austrian exchange.  bwin is also an attractive investment at current levels, but this discussion will focus on PartyGaming. 

First, a bit of history.

History of Online Gambling in the United States

Online gambling proliferated in the 00s along with the widespread consumer adoption of the internet.  The US quickly became the largest market in the world, and was bigger than all other markets combined.  While not explicitly illegal in the US, online gambling was thought to violate the Wire Act, and therefore was de jure illegal, if not de facto illegal.  Simply put, companies that operated online gambling in the US were operating in a very grey zone, but the government had taken a very laissez faire attitude towards prosecution.  That all changed in 2006, when political motivations caused the industry to come under attack in Congress from Republican leadership seeking the support of the Christian Right.  It became a pet issue for then Senate Majority Leader Bill Frist, who at the time was contemplating a 2008 bid for President.  After much debate, it looked like the legislation specifically banning internet gaming was not going to go through and the stocks reflected no legislative risk.  Then, as a complete surprise over the first weekend of October in 2006, the Unlawful Internet Gambling Enforcement Act (UIGEA) was slipped into the Security and Accountability For Every Port Act (the SAFE Port Act, a post 9/11 homeland security initiative).  This caught Wall Street by surprise, and PartyGaming fell 58% on Monday, October 2, 2006, dropping to 450p from 1070p the prior Friday.  Three weeks later, it was down another 40% to 270p, for a total post-legislation drop of 75%, which was appropriate, since at the time, about 90% of operating earnings came from the US.

It is now almost 4 years later, and the stock is essentially trading at the same place it was in October 2006, however in the last 4 years, the earnings from Europe have almost doubled as the number of countries in Europe where online gambling is legal has increased significantly.

It is worth noting that UIGEA did not actually make internet gambling illegal, but that it made the transfer of funds from a financial institution to an internet gambling site illegal.  Thus, enforcement of UIGEA falls under the control of the Treasury Department, and the burden of preventing internet gambling falls on financial institutions such as banks and credit card issuers. 

PartyGaming eventually settled with the Department of Justice and made a reparations payment of over $100 million to atone for its activities in the US prior to 2006.  Internet gambling has continued to grow in the US over the last 4 years, although since 2006, the primary players have been private companies, as they are overtly breaking the law.  The two biggest players in the US are Full Tilt and PokerStars, and they are also PartyGaming's primary competitors in Europe.  Full Tilt and PokerStars make so much money illegally in the US that they are able to greatly outspend PartyGaming in consumer marketing in Europe, which has led to share declines for PartyGaming and share gains for Full Tilt and PokerStars over time.  The US has been rather laissez faire again on the enforcement front with Full Tilt and PokerStars, although that can partially be attributed to a desire among several prominent Democrats (particularly Barney Frank, head of the House Financial Services committee) to repeal UIGEA and legalize online poker in the US so that it can be taxed and used as a "pay for" offset for various social programs and stimulus spending.  If UIGEA gets repealed, PartyGaming will be able to re-enter the US and go back after all the business it lost in 2006.  It would have a competitive advantage to other firms if this were to happen because it has a large customer list, and there are still millions of Americans who play on its free site, PartyPoker.com.  Additionally, companies that have been operating illegally in the US since 2006 (Full Tilt and PokerStars) are not expected to get licensed in the case of legalization.  If regulation efforts fail in the US, it is likely that UIGEA will start getting enforced, which could pressure the US-derived cash flow for Full Tilt and PokerStars, and level the playing field somewhat in Europe, giving PartyGaming the opportunity to go after some of the market share it has lost.  Clearly, legalization/regulation on a federal level is the preferred outcome for PartyGaming, but in the case of the rejection of such legislation, the enforcement of UIGEA could be a positive catalyst as well, albeit one of smaller magnitude.

Current State of Regulation

Online poker and sports betting is currently legal in the UK and France.  Tournament online poker is legal in Italy, and online cash poker games are expected to be legalized in Italy shortly.  Regulation/legalization is currently under discussion in Germany, Greece, Demark, Spain, and Belgium. 

In the US, a marked-up version of a bill that would legalize online poker passed the House Financial Services Committee in July 2010 and is expected to move to the House floor for debate during the lame duck congressional session in November, after the elections.  Barney Frank has been the main advocate of online poker legislation in the House, and he has generally had the support of the Democrats, the Republicans from Nevada, and moderate Republicans and Libertarians from California and other states.  In the Senate, Bob Menendez from New Jersey has introduced internet poker regulation legislation, and it is rumored that Senate Majority Leader Harry Reid also has a draft bill, although it is unlikely that he will introduce it prior to the November election as he is in a tight race.  The main opponents to legalization continue to be the Christian Right.

There are several states that have introduced proposals on a state level for intrastate online poker regulation.  These states include California, New Jersey, Florida, and Iowa.  With the exception of Iowa, each of these states would be a material increase to the addressable market for the public online gambling companies.  California itself could increase the addressable online poker market by 20%, perhaps significantly more.

It should be noted that advocates of regulation cite the opportunity for better consumer protection if it were to be regulated than if it continues to operate as a black market (can enforce age minimums, fund only with cash people have - debit cards versus credit cards, make sure sites don't cheat, use software to identify problem gamblers, etc.).  Many financial institutions in the US would also like to see UIGEA repealed because the law as it stands places the burden of enforcement on them.  The opponents of regulation tend to invoke morality and religious principles, despite the fact that 48 of 50 states already have some form of gambling, if you include lotteries.

Also in North America, British Columbia recently legalized online poker, and Ontario and Quebec are expected to follow suit shortly.

The bwin-PartyGaming Merger

On July 29, 2010, bwin Interactive and PartyGaming entered into a merger agreement.  Of the legal, online gambling operators, bwin is by far the strongest in sports betting and PartyGaming is by far the strongest in poker, although bwin also offers poker and PartyGaming also offers sports betting.  There will be massive cost synergies from this deal because the companies will be able to merge their infrastructure/back-ends for both businesses.  There will no longer be duplicative R&D/IT spending, and hosting and security functions can be merged.  For poker, liquidity (the number of players on a site) is very important to players, and the merged company will have better liquidity.  On the sports betting side, PartyGaming will be able to get rid of all but their best bookies and fold their business into bwin's.  Additionally, there should be marketing savings over time as fewer domains will need to be supported.  Finally, there could be additional revenue synergies as the combination of the customer lists will allow for cross-marketing of products across the customer bases.  Synergy guidance was given as 28% EBTIDA accretion but the number could be closer to 40%.  PartyGaming stock is only up 4% since the merger was announced (it has retraced after initially jumping 20% the day of the announcement), so almost none of the benefits of the merger have not been priced into the stock at these levels.

Valuation

Scenario 1 - Merger doesn't close, European regulation proceeds as expected but nothing happens in US (10% chance).  In this situation, PartyGaming is current trading about 11x 2012.  Earnings should grow about 10% without any yet unannounced markets regulating but further regulation could bump the growth rate closer to 15%.  Given the net cash position of the company and the high free cash flow conversion of earnings, an internet company with this growth profile should trade closer to 14 or 15x PE.  At 14x 2012, PartyGaming would trade around 294, about 10% above the current quote.

Scenario 2 - Merger closes, European regulation proceeds as expected but nothing happens in US (65% chance).  The combined entity had approximately 200 mm euro in 2009 EBTIDA and synergies were guided to 55 mm.  Management has admitted in private meetings that their synergy guidance is between the low and mid range of their internal estimates.  The 55 mm is 27.5% accretive to EBITDA, and there is a good chance they have low-balled the synergies and they are closer to 80 mm and it is 40% accretive.  Using historical multiples (10x EBITDA), the guided synergy number implies a price of 322p and the higher synergy number implies a price of 332p.  Using the lower synergy number, PartyGaming would have 21% upside from the merger at current levels.

Scenario 3 - Merger, US Regulation happens (25%).  It's hard to even contemplate what the company is worth if the US were to come back as a market.  In 2003, the company made $400 mm in EBITDA (virtually all of it in the US), compared to about $150 mm in estimated pre-merger EBITDA in 2010 (all of it from Europe, none from the US).  And the US market has grown a lot since 2003.  So re-capturing 75% of their market share based on 2003 market size could theoretically triple the EBITDA of the company, all of which would accrete to the equity as the company is debt free (about 15% of the share price is net cash).  Thinking about it another way, PartyGaming traded at an average price of about 1250p in 2004 and 2005, before US regulatory fears arose.  And that was when the US market was smaller, only the UK was legal in Europe, and profits from Europe were negligible.  A re-entry into the US would mean such explosive growth, it's almost hard to calculate a target in that scenario.  Weighing 7 years of market growth against and the addition of a profitable European business against the increased competition in the space generally as well as the possibility that US economics might need to be shared with a US land-based casino entity in a JV, I'll pick a target of 1000p (+275%) if the US gets legalized.

So when you put it all together, you are basically getting a big fat free call option here on regulatory change in the US.  Odds are against the US regulating, but the odds of it happening aren't 0%.  It's probably more like 20-30%.  It's hard to imagine that the market is this inefficient, but remember in 2006, the stock was down 60% in a day and 75% over a few weeks on Wall Street improperly handicapping the Washington risk.  Wall Street was wrong before, and they could be wrong again, in which case you probably have a multi-bagger.  And if nothing happens, you still have a stock that trades less than 12 PE, with a PEG ratio under 1x, with a high operating margin business (30% EBITDA margins), high free cash flow conversion, a pristine balance sheet, and high barriers to entry (need licenses to operate, requires high IT investment to enter, and like most consumer businesses on the internet, most of the share is with 3 or 4 companies that had a first mover advantage).  So heads you make a ton of money, and tails, you probably make 10-25%.  Not a bad bet (pun intended).  Also, I could be underestimating organic growth excluding the US, because a bet on internet gambling regulation is essentially a bet on continued fiscal deficits across the world.  Since the online gambling happens whether it is regulated and taxed or not, the only opposition tends to come from religious groups, which aren't a big political force in Europe like they are here. 

Risks

1. Legal.  There is always the chance of lawsuits pertaining to operations prior to 2006.  While PartyGaming has settled already on a Federal level, states or individuals can take action with a civil suit.  PartyGaming has been under pressure over the last week after being named in a suit being brought forth by the state of Kentucky to recoup online gambling losses suffered by KY residents between March 2005 and October 2006.  PartyGaming believes that they are not liable to these charges and will fight them vigorously.
2. FX.  The company reports in euros and trades in pounds, so variations versus the US dollar can impact stock return.  Changes in relative value between the USD and the GBP can of course be hedged out.
3. Competition.  It's a competitive market and while PartyGaming has good competitive positioning, unless the US starts prosecuting Full Tilt and PokerStars OR opens up its markets for PartyGaming to participate in a legal way, then PartyGaming will have two competitors in the market with deeper pockets.  The impact of this situation has already played out to a large extent in terms of market share, earnings, and multiple compression.

Catalyst