Strategy

Texas fold 'em

New U.S. laws against online gambling have dealt the online casino industry — and investors — a bad hand.

Oct. 2, 2006, will no doubt come to be known as Black Monday by Internet gaming executives. That was the first trading day after the U.S. government declared all bets are off when it comes to online gambling, enacting legislation that essentially bans the processing of online wagers by American gamblers. Within minutes, investors dumped billions of dollars' worth of shares in publicly traded online casinos, payment processors and online casino software developers. The market capitalization of U.K.-based Internet casinos and sports books such as PartyGaming PLC, and Sportingbet PLC, as well as Excapsa Software Inc., a Toronto-based maker of software for the online gaming industry that trades on the London Stock Exchange, were all cut in half. Shares of Canadian-based online gaming industry companies CryptoLogic Inc. (TSX: CRY), Chartwell Technology Inc. (TSX: CWH) and LasVegasFromHome.com Entertainment Inc. (TSXV: LVH) dropped as well, leaving both investors and online players wondering, “Where do we place our next bets?”

The crash came after U.S. senators attached anti-gaming legislation to the Safe Port Act, an anti-terrorism bill designed to increase maritime and cargo security at domestic ports. The amendment passed with little debate and is now awaiting President George W. Bush's signature. “Just what online gaming has to do with port security is beyond me,” says Keith Furlong, deputy director of the Vancouver-based Interactive Gaming Council, an industry association of companies involved in online gaming. “The issue of e-commerce is too complex, too important, and affects the livelihood of too many people to be passed without debate.”

In the poker world, the anti-wagering law would be called a bad beat–a surprising turn of the cards that instantly transforms a heavily favoured hand into a loser. While the U.S. House of Representatives had passed the legislation in July, it was widely expected to die before the Senate ended its current session later this month. An earlier attempt to attach the legislation to a defence bill authorizing ongoing military operations in Iraq and Afghanistan had failed, but last-minute deal-making by Senate Leader Bill Frist pushed the current bill through. “The bottom line is simple: Internet gambling is illegal,” said the Republican senator from Tennessee, in a press release issued after the bill was passed. “Although we can't monitor every online gambler or regulate offshore gambling, we can police the financial institutions that disregard our laws.”

Online gambling companies have always operated in a legal grey area when it comes to the U.S. While Internet casinos and sports books have set up shop in gambling-friendly jurisdictions such as Costa Rica and Antigua for years, the U.S. Wire Act makes it illegal for those companies to accept bets over the telephone. But whether it bans the use of the Internet to make those bets is still an open question. American legislation also prevents U.S. banks and credit card companies from processing bets from online casinos, but they could process interactions with online payment processors such as Neteller–an Isle of Man-based online e-commerce company with operations in Calgary–who, in turn, allow bettors to ante up for online poker tournaments, place online wagers on sporting events or even play online slot machines.

The new U.S. law makes it a crime to use credit cards or online payment systems for Internet betting, although exemptions are made for horse racing, fantasy sports pools, online state lotteries and aboriginal casinos. And while the law does not explicitly ban Internet gambling, it makes it all but impossible for online casinos to operate legally in the U.S., fundamentally altering the business model of many online casinos and sports books that rely heavily on the U.S. market.

But industry observers are already questioning just how effective the ban will be. For example, credit card companies assign an easily tracked transaction code to companies affiliated with online gaming, but there is no such code for paper cheques. They appear to be exempt from the legislation, says Nelson Rose, a law professor at Whittier Law School in Costa Mesa, California. Another problem with the new law is whether international financial institutions will comply with it. “The great unknown is how far into the Internet commerce stream federal regulators are willing to go,” says Rose. “While the Bank of America will comply, Neteller might not, because it is not subject to U.S. regulations. Will federal regulators then prohibit U.S. banks from sending funds to Neteller? And would they then prohibit U.S. banks from sending funds to an overseas bank, which forwards the money to Neteller?”

Good questions, but that hasn't stopped the move to ban online wagering in the U.S., just the latest gambit in what has been a recent global crackdown on the booming Internet gambling business. In recent months, online gaming executives such as Peter Dicks, former chairman of Sportingbet, David Carruthers, the former CEO of London-based Bet on Sports, and two executives from Bwin Interactive Entertainment AG, an Austrian online sports book and casino, were busted in high-profile arrests. Those arrests haven't scared off Calvin Ayre, a Canadian gaming entrepreneur and founder of Bodog.com, an online casino and sports book. While Ayre says he won't be travelling to the U.S. anytime soon, the crackdown forced him to postpone Bodog's popular online gaming marketing conference in June. But Ayre has no plans to stop doing business with U.S. gamblers. “At this point in time I see no reason to discontinue providing our broad-based entertainment services, which include an international record label, a publishing and a television production division, in addition to online gaming,” he said in an e-mail interview.

But many online gaming companies have decided to fold their cards and withdraw from the U.S. market entirely to ensure their executives aren't arrested–and to comply with the new law. Unfortunately, for them, the lion's share of online wagering continues to come from North America, where poker is about as American as apple pie, and Internet penetration is among the highest in the world. Online wagers in just poker and online casinos was expected to top US$7.8 billion this year, PartyGaming PLC CEO Richard Segal told investors at the Morgan Stanley online gaming investment conference earlier this year. About 45% of those wagers were going to come from North America. But the rules have now changed. Once the U.S. legislation becomes law, both PartyGaming and 888 Holdings announced they will no longer accept bets from American gamblers. It's a move that will devastate both companies. In the first six months of this year, roughly 52% of 888 Holdings' US$165.3 million in revenue came from American online wagers. PartyGaming, which hosts the poplar online poker site PartyPoker.com, reported that more than US$512 million of the company's US$661 million in revenues were generated from U.S. gamblers in the same period. “This development is a significant setback for our company, our shareholders, our players and our industry,” said PartyGaming CEO Mitch Garber, in a release.

Other online operators may not survive the shock of losing access to the huge U.S. market, says Dan Ahrens, who manages the Gaming and Casino Fund, a Dallas-based mutual fund focusing on the North American casino and gaming industry. With shares of online casinos trading so low, smaller players may be forced to merge with stronger casinos. “Its pretty hard to imagine what kind of contingency plans these guys will have to come up with to replace 50% to 75% of their revenue,” he says.

Canadian companies are also closing their doors to U.S. bettors. Canada's publicly traded online gambling companies don't actually take bets but provide software and technical support to the online casinos. Toronto-based CryptoLogic announced that WagerLogic Ltd., the company's wholly owned subsidiary that licenses its gambling software to operators of Internet casinos, would no longer do business with companies accepting bets from the U.S. And while the company said that more than 70% of the revenue from its licensees comes from outside the U.S., the move will still cost CryptoLogic about US$30 million a year in lost revenue. “While the new U.S. developments will be a challenge for the whole industry, our company's diversification, strong balance sheet, thriving European customers and potential new business in emerging markets enable us to face the future with confidence,” said CryptoLogic CEO Lewis Rose in a release.

CryptoLogic's announcement that it was leaving the U.S. market, along with the news that the company would be moving its head office from Toronto to Ireland (where Internet gambling is legal), was not enough to keep investors from dumping its stock. CryptoLogic shares fell as much as 28%–or $6.93–on Black Monday, before recovering slightly to close at $19.87 per share. Other Canadian players saw smaller declines. Calgary-based Chartwell Technology, which provides online gaming software for sites such as ESPNPokerClub.com and Collegepokernetwork.com, saw its share price go from an intraday high of $1.91 per share to a low of $1.60, before recovering to $1.80. Meanwhile, shares of Vancouver-based LasVegasFromHome.com Entertainment, whose software powers online poker sites such as TigerGaming.com, dropped from a high of 12¢ per share to a low of 10¢, before closing at 11¢.

Las Vegas From Home, for one, had already decided to leave the U.S. market to focus on the Asian market. The decision was not based on the growing risk associated with doing business in the U.S., but because competition in the American gaming space is so intense, says president and CEO Jake Kalpakian. As part of its strategy, Las Vegas From Home had entered into an agreement to sell its U.S. business–a deal that is now likely dead in the water, says Kalpakian. “I was going over the contract of the deal on Friday afternoon when I heard about the U.S. bill,” says Kalpakian. “As soon as I heard that, I thought, 'Well, that puts the kibosh on that deal.'”

That's not the only deal that has been derailed. Sportingbet has terminated talks to merge with Antigua-based World Gaming PLC, which made news in 1999 when the company was the subject of a high-profile police raid on its Vancouver headquarters. Back then, the company went by the name Starnet Communications, and it was ultimately forced to pay more than $100,000 in fines and turn over nearly $4 million in ill-gotten profits for running an illegal online gambling operation. Those kinds of police raids are largely a thing of the past as online gaming companies have matured into a mature, transparent and professional industry.

The industry will find a new way do business with Americans, says Rob Begg, vice-president of marketing at Halifax-based SportsDirect Inc., which provides online content to dozens of sports betting information websites affected by the new legislation. The new law is just the latest hurdle that the gaming industry has to overcome, he says. When regulators targeted online gaming executives and the computer hardware that powered their online casinos, companies moved their equipment offshore into gaming-friendly jurisdictions. Later, when financial institutions refused to process credit card transactions from online gamblers, the industry set up alternative payment systems such as Neteller. “The online gaming industry will survive this and find a way to continue to do business,” says Begg. “This isn't the first time regulators have fired a shot across the bow of the online gaming industry.”

However, even if players can find ways around the U.S. law, the ban will have a severe impact on Internet casinos–particularly online poker, says Julian Easthope, a London-based online gaming analyst with UBS Investment Research. Popular poker sites need a steady stream of new players–particularly bad players to feed the hunger of good players who actually make money from the site. “While the good players may find ways around this payment processing clampdown, it seems unlikely to us that the poor players will be quite so persistent,” says Easthope. “This will lead to a rapid decline in the use of online poker sites.”

Yet, the stakes are too high for Internet gaming companies to leave the U.S. market altogether. “This is like Prohibition in the 1920s,” says Furlong, of the Interactive Gaming Council. “There is a strong demand for sports betting and online gaming in the U.S., and somebody is going to fill that demand.” Global online gaming revenues have grown from roughly US$3 billion in 2001 to an estimated US$15.1 billion this year, according to Christiansen Capital Advisors, a Maine-based gaming consulting company. Before the enactment of anti-gaming legislation in the U.S., those revenues were expected to grow to more than US$24 billion by 2010.

The new U.S. legislation has certainly crippled the online gaming industry, but will it wipe out the industry? With so much money still left on the table, don't bet the farm on it.