What's on the cards for the gambling industry?

New legislation could threaten the profits of gaming companies, says Jenne Mannion

Casino operators were dealt a blow this week when the Government announced restrictions as part of the long-awaited modernisation of the gambling industry. The share prices of Stanley Leisure, the biggest casino operator, and Rank each dropped by more than 5 per cent and London Clubs International fell by 1 per cent when the measures were announced on Monday. All have failed to claw back significant ground since.

Casino operators were dealt a blow this week when the Government announced restrictions as part of the long-awaited modernisation of the gambling industry. The share prices of Stanley Leisure, the biggest casino operator, and Rank each dropped by more than 5 per cent and London Clubs International fell by 1 per cent when the measures were announced on Monday. All have failed to claw back significant ground since.

The tougher-than-expected regime has prompted analysts and professional investors to downgrade their expectations for casino operators, but the news is not all bleak for gambling-type stocks. Investment professionals say bookmaking companies such as William Hill and Hilton Group are still worth a punt.

Casino stocks had been performing well amid hype that deregulation of the industry - operating under rules introduced in the 1960s - would prove favourable and boost demand. In anticipation of the relaxed gambling laws, Rank and Stanley Leisure expanded their casino operations. The speculation also prompted a takeover bid for Wembley Plc by US gaming companies.

David Phillips, a UK fund manager at Glasgow-based Britannic Asset Management, says while the overall changes are broadly positive for casino operators, there were some unexpected disappointments which have dampened enthusiasm for these shares.

"The industry thought that this modernisation would be an absolute windfall. The reforms are positive, but the casino stocks are not going to have as many opportunities as they had initially thought so this has put a dampener on share prices," he says.

In favour of the operators, the current system, whereby customers must become members at least 24 hours in advance of using a casino (called the 24-hour rule) will be abolished. Additionally, casinos will be allowed to advertise and promote themselves, a practice which is currently prohibited.

However, the draft Bill announced by Tessa Jowell, Secretary of State for Culture, included the unwanted surprise that there would be strict limits on the number of Las Vegas-style slot machines that casinos can offer. Additionally, only the largest resort-style casinos will be permitted to operate machines with unlimited prize money. Even then, these will be restricted to 25 games per table and 1,250 on any premises. Other casinos will be restricted to fewer machines that can offer much less attractive £500 payouts.

The Government's cautious approach follows the raising of concerns about gambling addiction, a problem that has emerged in Australia following the deregulation of its gambling industry. The softened approach is expected to ensure a smoother passage for the Bill through Parliament.

Leigh Harrison, a UK fund manager at Credit Suisse Asset Management, adds that there is a slight positive to come out of the tighter rules. "This will make entry into the UK markets by the big overseas companies looking to open resort-type casinos less attractive, so ultimately there could be less competition for UK operators."

Few investors are now excited about the prospects of pure casino stocks, with many investment analysts downgrading their expectations for share price returns following details of the Bill.

Neither Mr Phillips at Britannic, nor Mr Harrison at Credit Suisse, holds casino operators in his UK equity portfolio. Casino operators represent only about 0.25 per cent of the FTSE All Share index. Mr Harrison says: "The heat has gone out of the casino operating stocks following the government announcement. Share prices will drift for a while yet while the market digests the information."

The picture is much brighter for bookmaking shops like William Hill and the Hilton Group, 60 per cent of whose business is the Ladbrokes chain of betting shops. These types of companies have benefited from two important changes in recent years and the odds are in favour of continued strong performance.

The first positive step change was the abolition of betting tax for the customer in 2002. Instead the company pays the tax on profits, meaning the cost of placing bets is effectively about 10 per cent cheaper for the customer. The higher volumes of business as a result have been a win-win situation all round, with more business for the bookmakers and added revenues for the Government.

The second important change was the introduction of Fixed Odds Betting Terminals (FOBTs) in 2003, similar to virtual casino games. These have proved popular and have led to a bonanza in profits.

Meanwhile, these big changes have masked the progressive increase in commercialisation in the industry, which has also proved beneficial.

An research note issued by Ivor Jones at Citigroup Smith Barney says: "Within the last decade, betting shops have been transformed from offices that passively took bets on British horse racing to low-level entertainment venues which offer live sport, machines-based betting and virtual numbers and sports games. We believe this commercialisation has further to go."

Proliferation of sport on TV has also encouraged further business into these betting shops, although racing tends to be the main source of revenue. For William Hill, horse racing accounts for around 45 per cent of business (down from 85 per cent several years ago) and dog racing 21 per cent. Football is down at a lesser 7 per cent, but this has grown sharply in recent years and is expected to continue growing.

William Hill and Hilton Group are the UK's two largest bookmaking stocks; both are listed in the FTSE 100 index. Stanley Leisure also has exposure to bookmakers. Further down the market cap spectrum there are internet-based betting companies that you can invest in, namely Sportech and UK Betting. Overall bookmakers account for only around 0.75-1 per cent of the FTSE All Share. Like casino operators, they are classified within the "leisure and hotels" sector of the market.

Mr Phillips warns that there are low barriers to entry in the bookmaking market and the threat of competition is particularly prevalent for smaller internet-based companies. This is less of an issue with William Hill and Ladbrokes, which carry a strong high street presence and branding.

Mr Phillips favours the Hilton Group to gain exposure to this area of the market. He says: "Hilton offers the dual attraction of a bookmaker and the recovering hotel industry."

Mr Harrison is not enthusiastic about bookmaking stocks. He did hold William Hill but sold within the last couple of weeks, prior to the announcement. He says that, while he likes the company, he decided to cash in on strong returns.

Ross Hollyman, a UK fund manager at GAM, prefers William Hill and Hilton to smaller stocks like Stanley Leisure. He says smaller stocks have highly volatile earnings streams. Stanley Leisure, in May, for example, warned annual profits might have dropped because some London casino players had had big wins, while others had not paid their debts on time.

Indeed, both the profits of casinos and bookmaker earnings can be volatile because they are susceptible to high-level wins. William Hill, for example, made a loss - reported to run into six figures - following France's 2-1 win over England in Euro 2004 last Sunday. And casino operators can lose millions in one night with high-roller wins.

LOOKING FOR A SAFE BET?

* RANK GROUP

UBS Investment Research has cut price targets for the casino operator given there would be lower long-term growth prospects due to the restrictions on their operations going forward.

Alistair Scobie at Credit Susise First Boston is neutral. "Like-for-like sales in its Hard Rock division remain under pressure and there is increased competition in gaming post deregulation."

Citigroup Smith Barney rates Rank as a sell.

One year share price: +15.3% (ASX average +9.4%, Leisure sector average +33.2%)

Three year share price: +38.9% (ASX average -19.5, Leisure sector average +18.1%)

* STANLEY LEISURE

UBS has cut the price target for Stanley Leisure - the purest play on UK casinos - also due to the implications associated with the new rules for casinos.

Ivor Jones at Citigroup Smith Barney is classifying this stock as a hold. "The company is well positioned for deregulation and we believe this strength will be realised by current management as they deliver sharply increased profitability, or may be recognised through a bid from a new entrant to, or consolidator of, the UK market."

On the downside, Citigroup believes Stanley is undelivering on a number of key businesses.

One year share price: +37.5%

Three year share price: +66.3%

* HILTON

Citigroup Smith Barney rates Hilton as a buy. The Citigroup research note says: "One plank of our buy base on Hilton is that the group's healthy cash generation combined with limited development projects in hotels imply there is potential for cash return." David Phillips, a fund manager at Britannic, points to the added benefit of the recovering hotels sector.

One year share price: +40.8%

Three year share price: +18.3%

* SPORTINGBET

James Ridgewell, manager of the New Star UK Special Situations fund, likes Sportingbet, but says after excellent share price performance it is more of a hold than a buy. He says the company has a vast number of brands serving more than 880,000 customers in some 150 countries. Being telephone and internet-based, it has low overheads and costs so is highly cash generative. Sportingbet also ensures it is not subject to big losses by monitoring and controlling the odds it pays through a central computer.

One year share price: +266.4%

Three year share price: -13.5%

* LONDON CLUBS

Mr Ridgewell sold his holding in London Clubs International following the disappointing rules announced this week. He says: "I feel the share price had got ahead of itself in the lead up to deregualtion and I expect it will be a long time before it makes any further significant progress. One of the negative factors is that there will be much more competition as a result of this deregulation."

One year share price: +417.0%

Three year share price: +285.2%

* WILLIAM HILL

Citigroup Smith Barney rates this as a buy. A research note says: "The business is highly cash generative with positive working capital and very few demands on capex as the shops are leased and the fit-outs notoriously low cost. A key risk is that the cash is diverted into a major acquisition, although we doubt management will risk their laudable reputation by overpaying."

One year share price: +96.4%

Three year share price: NA - (listed June 2002)