Online bet causes sweaty palms at the City's top table

PartyGaming seemed to hold all the aces when it floated, but now its shares have dived. As rival gambling sites follow it to market, Abigail Townsend asks if investors should fear a busted flush, or accept that sometimes you lose

It was the latest craze - the gamble investors couldn't get enough off. If it was online, and punters could bet or play casino games, then it was a winning hand - surely?

Some Jonahs muttered darkly as they recalled another internet boom exploding only a few years back, but the cheerleaders were adamant: this time it was different.

The internet was no longer uncharted territory and the companies - be they poker sites, sports gambling services, spread betters or betting exchanges - had healthy cash flows and were turning in a profit. What was to fear?

As it turned out, quite a lot. Shares in PartyGaming, the online poker site, dived 30 per cent last week after management warned that the popularity of poker might wane while marketing and advertising costs would rise. The group will be promoted to the FTSE 100 despite the £2bn slide - that's how hyped its June listing was - but market sentiment was rocked.

"This is a very new space and there are a lot of uncertainties," says Matt Tucker, a fund manager for UK equities at Threadneedle. "There are other areas where you can invest where you know a bit more about what is going on. We will look at the other IPOs [initial public offerings] coming up, but it's a very risky space. It could continue to be very big but the risks are large."

But to write off an entire sector would be wrong. According to research by The Independent on Sunday, London Stock Exchange investors have more than £10bn of their money devoted to gambling - of which at least £2.5bn is in online gaming. And that will rise as new companies come to market in the months ahead.

It is also a mistake to lump companies together. Internet gaming and gambling encompasses various categories, each with their own risks, upsides, market leaders and unique prospects.

Cards and casinos

These sites allow punters to play games like roulette and poker, for cash stakes, and PartyGaming is undoubtedly the best known. Founded in 1997, it became the world's largest online betting group when its founders floated 25 per cent of the business - London's biggest IPO for two years.

When rumours emerged that Empire Online was in deal talks, everyone assumed that PartyGaming was the prospective buyer. Empire, founded by the Tel Aviv-born Noam Lanir and floated on the Alternative Investment Market this summer, gets commission for every punter it directs to gaming sites. PartyGaming is its biggest client.

In the end, Empire's £790m suitor turned out to be Sportingbet. The primary interest of this operation is sports betting, but, sensing the growing popularity of online gaming, it recently snapped up Paradise Poker.

Ukbetting is another sports service that has diversified into poker, and it now accounts for 60 per cent of group profits, against just 10 per cent in 2003.

These are not the only players. Upcoming floats include the £700m debut of Gibraltar-based 888.com, the world's biggest online casino, which is 70 per cent owned by the Israeli brothers Aharon and Avi Shaked; and smaller rival 32Red, although founder Ed Ware will not be selling his 36 per cent stake. Sweden's PokerRoom and PokerStars, controlled by the Israeli Scheiberg family, are also mulling listings, and consolidation is predicted.

Yet this segment has the biggest risks and PartyGaming's warning hit hard. "You expect the first six months to be in the bag, so it's not going to have helped sentiment and investors will use it to try and push prices down," warns one analyst.

PartyGaming garners 87 per cent of its revenues in America, where poker is huge but the Department of Justice considers online gambling illegal. Operators get round this by basing themselves offshore, but the authorities are not happy. "It's difficult to see the current situation existing in the medium term," says a City analyst. "They are not paying [US] tax and the Americans won't like that."

PartyGaming claims that, based on case law, its US operations are legal. But the issue still hit its float valuation.

The other danger is how long the craze will last. What shocked most analysts was PartyGaming's poor retention rates, as casual customers logged on and played - but then didn't come back. "Churn was a lot higher than expected, and when [other] people come to market and are able to spend lots, will you be able to keep [customers] then?" asks Dario Betti, senior analyst at research firm Ovum. Some are seeking ways round thus round this, however. PartyShare.com, for example, plans to pay players a quarterly dividend.

Betting exchanges

These allow punters to lay and match bets online. The best known is Betfair, the world's largest. Founded by Andrew Black and Edward Wray, it is now gearing up to float and could fetch from £500m to £1bn. Rivals include Betdaq, although in terms of market share, it runs a distant second.

Betfair offers poker as well, and the introduction of the game helped bolster turnover by 61 per cent, to £271.m, and push annual pre-tax profits up to £107.1m. But most agree that betting exchanges cater for a different sort of punter to dedicated casino sites.

"Exchanges are like the zeitgeist - they have all this amazing new technology and people want to be part of the movement," argues one insider.

Bookies, however, hate them. They claim the sites pay more favourable taxes, creating an unfair playing field, and are lobbying the Government. But even if they win this battle, it is unlikely to finish off exchanges. Existing operations will simply move offshore.

Then watch the bookies admit that perhaps exchanges aren't the devil's own after all and launch their own.

Spread betting

The City loves this sort of gambling. But the Square Mile's denizens aren't investing - they're playing. Spread betting allow punters to gamble on fairly much anything, from stock market swings and sporting results to the outcome of the Conservative leadership contest.

Sporting Index claims to be the world's largest sport and entertainment spread better, with a market share of around 70 per cent. Founded in 1992, it was snapped up by Duke Street Capital for £53m in 2002, and the private equity firm is now looking to sell for between £100m and £200m. Around 40 interested parties, both trade and finance, have already registered their interest.

There is a perception of lower risk when compared to the PartyGamings of this world. "With Sporting Index, there's a tribe of people who use it on a regular basis," says a company insider. "They are passionate and they have an opinion. It's more of a culture."

Sporting Index offers gaming, but players can lay their hands to lose if they so wish and still make money.

Cantor Index and City Index are the other spread-betting leaders, although their focus is less sports-oriented. Cantor Index is owned by the American trading giant Canter Fitzgerald; City Index is part of Intercapital Private, a major shareholder in ICAP, the London-listed derivatives broker.

Bricks and mortar

Bookmaker Ladbrokes, part of Hilton, claims to be Europe's "most popular poker site" with more than 93,000 active customers - a 182 per cent leap on the previous year. That gives ladbrokes- poker.com site an estimated 35 per cent of the European market - though it is the US where the big money lies.

William Hill is ahead of Ladbrokes overall. As a recent Goldman Sachs note says: "Online remains the one area where William Hill comfortably exceeds Ladbrokes, with margins of 51 per cent compared with 31 per cent". In its most recent results, its interactive business accounted for 26 per cent of group earnings before tax and interest.

Meanwhile, Rank owns online betting business Blue Square and offers various games including poker and bingo. Coral Eurobet also runs online gambling operations and will join the new wave hitting the market when owner Charterhouse launches an £800m float this autumn. Bingo operator Gala, which offers an online version of the game, is also expected to float.

This is where much of the smart money is going, because a well-known brand name is everything online as new punters tend to prefer companies they know and already use.

Success is not guaranteed, though: casino operator Stanley Leisure's loss-making e-gaming operations are under review. And while Rank's latest interim gaming revenues were up 20 per cent, profits were dented by higher costs and weaker margins.

Whichever sector you look at - from established bricks and mortar operators to new boys on the block such as PartyGaming - the risks are there. Yet taken as a sum of all its parts, this is a burgeoning industry.

According to Mr Betti at Ovum, the global online betting market took more than $6bn (£3.3bn) in wagers last year, and is set to hit $11.9bn by 2009. And with those sorts of odds, will investors stay away for long?