RP iGaming Index: Built-in underperformance

Following another turbulent month, Regulus Partners’ Paul Leyland argues a major corporate shift will be required to stop the underperformance of iGaming stocks. November was another difficult month for iGaming stocks, with the index falling a further 15.6%, continuing to underperform in a weak and volatile overall market (NASDAQ -5.6%). However, while a relatively high-risk consumer-facing sector can be expected to underperform in turbulent markets, since inception the index is now down 25% vs. a 6% (or more range-bound) fall in the NASDAQ. Moreover, these November falls were broadly based – with 31 fallers of 35 (16 double-digit) and only four risers (two double-digit, both digital: Stride and Aspire) – while individual companies are probably watching their share prices aghast, none are really being singled out beyond wider sector concerns (though William Hill is now approaching an all-time low since IPO in 2002). We have spent the last three editions (all of them since Regulus Partners started writing the commentary, in fact) attempting to explain why the market might be hitting gambling stocks so hard and all of these drivers remain intact, in our view. Indeed, the fact that they are not going away means that there is every possibility of more pain to come, especially if macro uncertainty increases. We will not rehash the same points in this edition – though we do hope to be explaining why the index is outperforming at some point. Instead, we will address a macro trend that seems to be affecting stocks more than most: what has gone wrong with land-based and why isn’t online the answer? Markets are relatively simple mechanisms and while sometimes individual funds or special situations might like to get into the weeds of operational detail, this layer of corporate activity is typically overlooked (even though it forms the most part of most results commentaries). Macro positioning followed by a company’s ability to meet or exceed its earnings targets are far more important. This is why (usually bad) management teams complain about a public company being in hock to its quarterly numbers, while a private company has the luxury of long-term planning. This is patent nonsense, in our view – but a convenient excuse nevertheless. Markets can in fact be enormously tolerant of losses and many funds explicitly take a long-term view (possibly more than much venture capital or private equity money, and certainly the many business owners who prioritise exit). Markets are only tolerant when they back the macro positioning and (a crucial and, rarely an or) back management to deliver. This combination gives a company a clear public mandate to invest and build for the long-term: just look at NASDAQ’s tech giants for proof of that. However, as soon as the market loses faith in the macro positioning, or starts having concerns about a management’s ability to exit, all investors (over whatever term) will be at least in part looking at the need for an exit: a poor quarter means an exit on poor terms – hence the cycle of short-termism starts, with management trying to manage their own lack of vision by meeting quarterly numbers to keep investors from dumping or turning  activist, and in so doing often making decisions that undermine the company’s long-term future. Land-based gambling offers a big problem here. Not all of it: entertainment-driven, destination-led gambling (if well-executed) continues to grow and has strong fundamentals – as have offers tapping into the ever-stronger earnings power of the super-rich (VIP casino); often (but not always) exposure to these market segments goes together. However, volume-driven, transaction-led gambling often finds itself struggling with channel shift, customer relevance (especially in terms of recruiting new ones) and inspiration for R&D: this is affecting suppliers as much as operators, in our view. Equally, the management requirements of land-based gambling are often the polar opposite of online (service/maintenance vs. marketing/development; big share in mature markets vs. growth across a range of variously (un)regulated jurisdictions). Also, the online value chain is structurally more fragmented: even online sector giants such as Playtech struggle to dominate market share the way the land-based majors do. Finally, costs and complexity keep rising, meaning any slowdown in top-line momentum has a clear and unpleasant medium-term impact on revenues – with cost cutting only ever being a short-term (and often highly disruptive) solution. The trouble is, markets can see and judge all this pretty quickly since it is being played out across a number of sectors – and no amount of fanfare over game launches, tactical M&A or product awards can cover it up. As we pointed out in our first edition, the market is far more exposed to volume-led, transaction-led land-based gambling and early generations on online businesses than easier growth segments: it could be argued therefore that the index is structurally built to underperform until this is fixed, either by dynamic corporate action, or (more likely to work) dynamic IPOs. Stock in focus: Scientific Games Scientific Games is largely a collection of volume-led land-based gaming supplier businesses, assembled rapidly by a ‘deal junky’ and then attempted to be addressed by financial engineering. It now has a much more operational focus but this has not yet persuaded markets that value can be added. In the short term, it is pretty easy to see why, with an underperforming online asset (only 7% revenue) and a declining core commercial gaming business (at 55%). However, with US$8,7bn of debt, operational focus is key in our view. The problem is, this is something of a market blind spot (for logical reasons in terms of return on effort and the need to operate on public domain information): the market will reward success, but only if or when success is proven, and this will inevitably take time. In the meantime, Scientific Games has fallen 26% in November and 68% since the index’s inception. However, Scientific Games’ debt is a big part of this: its EV has fallen ‘only’ 25% during the same seven-month period – painful enough, but more logical given the concerns.