This article is the first in a two-part series focusing on the developing U.S. real-money online gambling market. This article will focus on the politics of this very fluid market and recommend a general investment approach. Part 2 will concentrate on which specific companies have an edge in the world of real-money online gambling.
Recently, America's most talked about Governor, Chris Christie, shot down a bill legalizing online gambling in the state of New Jersey. However, he acknowledged he would sign a bill "if it had a 10-year trial period and a higher tax rate on casinos." This acknowledgement has likely changed the landscape of real-money online gaming in America. The rejected bill, which will be amended, reintroduced, and most likely passed in March 2013, becomes a model for other states with large casino constituents. Make no mistake, this piece of legislation puts the future of New Jersey's online gaming firmly in the hands of New Jersey's physical casinos. We are seeing a divergence in how online gambling will unfold on a state by state basis. Legislation created by states with large casino industries will focus on making casinos the epicenter of online gambling. States where lottery gaming commissions are in control are free to seek bids from vendors and create state-wide online gaming systems from scratch.
Politics of Online Poker
Let's review the current legislative events that have led up to this moment. At the end of 2011, the Department of Justice clarified an old interpretation of the Federal Wire Act of 1961 to remove online poker from its list of forbidden games of chance. Since this time, states have commenced legislation determining if, and how, online poker will be legalized in respective jurisdictions. So far, only Nevada, Delaware, and Washington, D.C., have officially legalized online poker. But Governor Christie's recent comments have to be putting pressure on the U.S. Congress, which verged on passing a bill in December 2012. Federal regulators want states to decide if online poker will be allowed in each individual state. However, there are fears that conflicting and confusing rules will result:
Without such a [federal] bill, the 50 states would be free to promulgate 50 different sets of online-gaming rules.
Gaming attorney Tony Cabot described the state-by-state split this way:
...states that have strong casino industries like New Jersey, where the legislation will allow those licensees and potentially other licensees to offer interactive wagering, and then you have the lottery states: those are the states with strong lotteries and either a weak or no casino industry. You have to watch those states carefully because in many of those states, the lottery has more flexibility to offer, particularly, games of chance online without necessarily having to go back to the legislature-specific legislative authorization. You may have some states that are going to gear up their interactive divisions where their state lottery is and get online much quicker than the casino states can.
But one thing our governments are good at, is getting organized when revenue opportunities become obvious. Complete online poker legalization is "in the cards" for one reason: immense tax revenues during a time when state budgets are struggling.
Gaming industry experts estimate that 10 million to 15 million U.S. gamblers wager $4 billion to $6 billion online, through websites whose owners are based outside abroad. It's impossible to estimate, they say, how much of that total poker represents; but whatever the figure, participants playing through overseas providers pay no U.S. income tax on their winnings.
States With Large Casino Constituents
In order to create in-state jobs, tax revenue, and closely regulate the games, casino states will adopt "casino-centric" legislation. This legislation will be designed to protect and enhance revenues of in-state gaming companies and to put them at the epicenter of Internet gaming. Casinos are already heavily regulated and taxed, so it is very convenient and safe for state governments to require online gaming activity take place on the premises of casinos. Again, this was the main thrust of the proposed New Jersey legislation.
Consider the following excerpts from New Jersey's recently rejected bill:
k. Internet gaming as authorized and limited under this act... requires that all hardware, software, and other equipment that is involved with Internet gaming will be located in casino facilities in Atlantic City. All that is needed by a customer is a computing or similar device of general application and a communications connection through a common carriage or similar medium. For example, in an online poker or other card game, the 'table' is the server hosted by the operator in the casino premises in Atlantic City. The 'cards' are played on that table in Atlantic City, and the wager is placed on and accepted at that table. No activity other than the transmission of information to and from the players along common carriage lines takes place outside of the casino premises
5. 'Internet gaming' means the placing of wagers with a casino licensee at a casino located in Atlantic City using a computer network of both federal and non-federal interoperable packet switched data networks through which the casino licensee may offer authorized games to individuals who have established a wagering account with the casino licensee and who are physically present in this State.
This legislation requires the act of wagering to take place at a "virtual table" in a physical casino and players have to be physically present in the state (via geolocation). The bill also sets up regulations around licensee companies.
States with weak casino industries will look to lottery gaming commissions to create regulations. In states like California, state legislatures are getting their feet wet by exploring the sale of state lottery tickets online. In Massachusetts, there is proposed legislation to allow poker players to purchase "online credits" via the state's 7,400 retail lottery agents ensuring those agents still get a 5% commission.
[Massachusetts] State lottery officials have suggested the online offering could start with PowerBall and Mega Millions ticket sales and some form of instant ticket games (which have been described by others as indistinguishable from slot machines). Later options could include Keno and other 'games of chance.' A social gaming option, including fantasy sports, may also be included.
Hawaii is one of two states that do not allow gaming of any form, yet there is a current bill in the state legislature to create a governmental online gaming regulator, decide on rules and regulations, and then choose "gaming providers."
So, states with weak casino industries and dominant lottery commissions are gradually moving lottery ticket sales and games of chance online. In these states, it may or may not be required to host gaming servers within casinos.
Assumptions and Remaining Questions
Although there are still quite a few legislative hurdles to jump over, let's assume that real-money online gaming will be widely available in America within the next one to three years. Let's assume this will, initially, be a state-driven event. However, as Congress sees more and more states push through legislation, it will eventually pass a federal bill.
During this "state-driven" phase, questions such as the following still need to be answered:
1. Will online poker players be able to compete against players from other states, or just players within the state? Anthony Cabot, a Nevada attorney and gaming expert said this:
Poker doesn't work in a small state like ours [Nevada]. Poker requires liquidity. People only play on poker sites if there are a lot of people playing on that site and the game has the limits they want.
For states with small poker playing populations, interstate cooperation would be essential. Calvin Ayre's blog reports that state governments may already be on top of the issue of "sharing" the poker playing population:
Meanwhile, without even one state-approved operator up and running, Gov. Brian Sandoval has asked the Nevada legislature to approve interstate online poker. It seems like this might dovetail with one of the changes Gov. Christie made in his conditional veto in New Jersey. Christie altered the language allowing New Jersey to work with other states on online gambling from 'an interstate compact' to 'a reciprocal agreement.' Where an 'interstate compact' implies a relationship between an unspecified number of states, a 'reciprocal agreement' implies a relationship between just two parties. Two parties like, say, the gaming industry's two leading states.
2. Will states allow house-backed gaming, or just online poker? The rejected New Jersey bill allows for the following games:
poker, roulette, baccarat, blackjack, craps, big six wheel, slot machines, mini baccarat, red dog, pai gow and sic bo
3. States with large casinos such as Nevada and New Jersey are concerned the availability of online gaming might decrease patronage to these destinations. Is this true, or will it actually peak interest?
The future of online gaming looks bright, however, a state-driven solution is really the first step. It effectively fragments any national online gaming market and creates many smaller markets. Here are some obvious and not so obvious predictions:
- The creation of small Internet gambling websites in authorized states
- Non-casino entities such as Zynga (NASDAQ:ZNGA) will likely need to license servers, server space, or 'virtual tables' from casinos.
- Casinos gain a new revenue stream through licensing.
- States will need to have reciprocal agreements to get enough players to create necessary scale. Poker players want large tournament fields and a variety of limits and games, so websites with the most players will attract more players.
- Eventually, websites within states will combine networks, create universal APIs, or generally consolidate through acquisition to create enough scale.
- Casinos with physical properties in the most states will have an early advantage. This is because they already have state gaming licenses and most casinos have working software in some stage.
- Internet Gambling will slowly be deployed on a state by state basis.
- Zynga, whose advertising revenues jumped 35% in the latest quarter, could become the online gambling industry's "advertiser of choice". Could they also become a web traffic affiliate to the entire industry thereby getting paid for referring real-money customers?
- Zynga may become a casino take-over target solely because of the size of its audience which is pre-disposed to games of chance.
- Zynga could utilize some of its $1.3 billion in cash to purchase cheap casinos with gaming licenses. This may be a faster method to penetrate the market rather than waiting 12 to 18 months for gaming licenses and casino partnerships to develop.
- States with large casino bases will pass more "casino-centric" legislation. States with no casinos will rely on lottery gaming commissions to define online rules and regulations.
- Eventually, Congress will pass a Federal Bill attempting to create standards among the states.
The real-money online gaming market will initially be very fragmented and crowded. There are currently 19 companies which have applied and received interactive gaming licenses just from the state of Nevada. 12 of these are for online gaming operator licenses, while the others were filed for licenses supporting the budding industry. On Feb. 12, Goldman Sachs downgraded Boyd Gaming (NYSE:BYD) after a multi-day run in stock price fueled by online gaming optimism:
[online gambling] could take longer than expected to roll out and will be very competitive, with high promotional activity, which in turn could lead to lower-than-expected margins.
After studying the industry, I generally agree with this take. Nevada has roughly a population of 3 million people and New Jersey 9 million. For the number of enterprises vying to operate online, there will not be enough players. Competition will be fierce and casinos will ramp up incentives to pay affiliates for pushing web traffic to their web sites.
Thus, I advocate a "picks and shovels" strategy for investors wanting to jump into this market. Companies like Bally Technologies (NYSE:BYI), International Game Technologies (NYSE:IGT), Shuffle Entertainment (NASDAQ:SHFL), Multimedia Games (NASDAQ:MGAM), and even Zynga with its ability to be at the "top of the funnel" and drive web traffic, will initially make better investment choices than the online gaming operators.
In Part 2 of this series, I will focus on the "picks and shovels" companies that have an edge in supporting the gold rush of real-money online gaming.
Disclosure: I am long ZNGA. Prior to Feb. 7, 2013, I was long ZNGA and BYD. After studying the online gaming market for approximately 60 hours since then, I have sold my stake in BYD. I may go long BYI, IGT, or SHFL over the next few days. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.