Tag Archives: Supreme Court

Ramblin’ on Gamblin’

If you exclude investing, I am not a gambler. However I do find the gambling sector fascinating. I have been posting on the sector for over four years now (see posts under Gambling Sector category). As an example of an old bricks and mortar sector that has been revolutionised in recent years by the internet and smart phones, it is illuminating. As I said in a previous post, “this sector is haunted by regulatory risk” and this post will run through some regulatory developments, as well as business ones.

Late in December last year, Ladbrokes Coral (LCL) agreed to a takeover deal by GVC, the Isle of Man consolidator who owns BWIN, Sportbet, PartyPoker and Foxy Bingo. The smaller GVC, with 2017 revenue of €0.9 billion, structured an innovative deal for the larger LCL, with 2017 revenue of approx. £2.4 billion (I will update these figures when LCL announces its final 2017 figures in the coming days), with a sliding scale valuation based upon the UK Government’s triennial review of the sector.

The UK regulator and the government’s adviser on the issue, the Gambling Commission, today released its advice on fixed-odds betting terminals (FOBTs), often described as the “crack cocaine” of gambling. The Gambling Commission recommended a limit of £2 for “slot” style games, called B2 slots, and “a stake limit at or below £30” for other non-slot B2 games, such as the popular roulette games. Although LCL and William Hill shares popped today, the final decision is a political one and its by no means certain that a limit lower than £30 will not be implemented.

Based upon the sliding scale in the LCL/GVC deal and some assumptions on retail operating cost cuts based upon different FOBT stake limits, the graphic below shows the potential impact upon the business of LCL, William Hill (WMH) and Paddy Power Betfair (PPB). Again, LCL is based upon H1 results extrapolated and will be updated for the final 2017 figures.

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Based upon very rough estimates, the limits recommended could result in around 400 to 700 betting shops disposals or closures by the bigger firms, albeit that these shops are likely to be the least attractive for rivals or smaller firms. These estimates do not take into account potential mitigating actions undertaken by the betting firms. Lost FOBT revenue could be made up by increased sports betting facilitated by the introduction of self-service betting terminals (SSBTs) which allow punters to gamble on new betting products.

Point of consumption (PoC) taxes have been introduced in countries such as the UK and Ireland in recent years and are now payable in South Australia and have been announced in Western Australia. The other states in Australia are likely to introduce PoC taxes in 2019. These developments caused WMH to take a write-down on its Australian operations and sell them in March to the Canadian poker firm the Stars Group (formally the colourful Amaya), owner of PokerStars, PokerStars Casino, BetStars, and Full Tilt. The Stars Group (TSG) also increased its ownership in the Australian operator Crownbet in March which it intends to merge with the William Hill Australian operation. PPB was reported to have been interested in Crownbet previously but was obviously beaten on price by TSG. PPB had the exhibit below in their 2017 results presentation on the non-retail Australian market.

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A more positive regulatory development in the coming months could be a favourable decision by the US Supreme Court on the future of the Professional and Amateur Sports Protection Act of 1992 (PASPA). This whitepaper from the Massachusetts Gaming Commission gives a good insight into the legal issues under consideration and the implications for the sector in the US of different Supreme Court decisions, such as upholding PASPA or a narrow ruling or a full PASPA strike down. Other issues in the US include the terms under which individual States legislate for betting. The consultants Eilers & Krejcik opine that “a market incorporating both land-based and online sports betting products could be worth over two times a market that is restricted to land-based sports betting alone” although they conclude that “many – perhaps even most – states will choose to delay or forgo online”. It may be likely that many States will follow Nevada’s example and require online accounts to be initiated by a land-based provider with age and ID verification conducted on premises.

Sports betting in the US is generally low margin with WMH reporting US gross win margins around 6%. Other tailwinds to the US sector include rent seeking participants such as the sports bodies looking for “integrity fees”, a figure of 1% on the amount staked (called the handle in the US) have been suggested, or aggressive tax policies and levels by individual States. This paper by Michelle Minton outlines some fascinating background on PASPA and argues that any legalisation of betting across the US must be pitched at a level to counter the illegal market, estimated at $120 billion per year to be 20 times the size of the current legal sector in the US.

Philip Bowcock, the CEO of William Hill, in the 2017 results call summarised the opportunity in the US as follows:

“We do not quite know how the economics will work out because, as I said, there are three ways this could potentially go. It could either go purely retail, only taking sports bets in a retail environment. It could be the Nevada model, which is retail plus a mobile app signed up for in the retail environment. Or it could go completely remote registration, which is as we have in the UK. I do not expect every state in the US to regulate, and if they do, to go for that end model. I think each one is going to be different, and that is going to decide where we are as to what the economics are going to be.”

So, they are some of the regulatory issues challenging the sector today. In terms of historical and 2017 sportsbook margins shown below, I have spend some time revisiting my data and extracting more accurate data, particularly in relation to historical Ladbroke sportsbook net revenue margins. H2 sportsbook results, particularly Q4 results, were very favourable for the bookies. I estimate that the Q4 figures for PPB improved their full year net revenue margin on its sportsbook by 120 basis points. I debated whether to adjust the 2017 figures for the Q4 results but decided against it as the results reflect the volatility of the business and good or bad results should be left alone. It is the gambling business after all!!! As above, the LCL numbers are those extrapolated from H1 results with an uplift for the H2 favourable results and will be updated when the actual results are available.

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On the specific results from PPB, their 2017 EPS came in at £3.98, ahead of my August estimate of £3.72 for 2017 (see post here) but still behind my more optimistic March estimate of £4.14 (see post here). The lacklustre online sportsbook results are a concern (revenues up 8% compared to 14% and 25% for WMH and LCL respectively), as are the declining online gaming revenues. Increases in PoC taxes in Australia will impact operating margins in 2019 and FX will be a tailwind in 2018. Increased IT resources and investments in promoting new products and the Paddy Power brand are the focus of management in 2018, ahead of the World Cup. Discipline on M&A, as demonstrated by walking away from a CrownBet deal, are also highlighted as is potential firepower of £1.2 billion for opportunistic deals.

My new estimates for 2018 & 2019, after factoring in the items above, are £4.36 and £4.51 respectively, as below. These represent earnings multiples around 17 for PPB, not quite as rich as in the past, but justified given the 2017 results and the headwinds ahead. PPB must now show that it can deliver in 2018, a World Cup year, to maintain this diminished but still premium valuation.

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The coming months in this sector will be interesting. The fate of firms such as 888, with a market cap around £1 billion, will likely be in the mix (interesting that its fits within PPB’s budget!). WMH and 888 have tangoed in the past to no avail. Further dances are highly likely by the players in this fascinating sector.

Pimping the Peers (Part 1)

Fintech is a much hyped term currently that covers an array of new financial technologies. It includes technology providers of financial services, new payment technologies, mobile money and currencies like bitcoin, robo-advisers, crowd funding and peer to peer (P2P) lending. Blockchain is another technology that is being hyped with multiple potential uses. I posted briefly on the growth in P2P lending and crowd-funding before (here and here) and it’s the former that is primarily the focus of this post.

Citigroup recently released an interesting report on the digital disruption impact of fintech on banking which covers many of the topics above. The report claims that $19 billion has been invested in fintech firms in 2015, with the majority focussed in the payments area. In terms of the new entrants into the provision of credit space, the report highlights that over 70% of fintech investments to date have being in the personal and SME business segments.

In the US, Lending Club and Prosper are two of the oldest and more established firms in the marketplace lending sector with a focus on consumer lending. Although each are growing rapidly and have originated loans in the multiple of billions in 2015, the firms have been having a rough time of late with rates being increased to counter poor credit trends. Public firms have suffered from the overall negative sentiment on banks in this low/negative interest rate environment. Lending Club, which went public in late 2014, is down about 70% since then whilst Prosper went for institutional investment instead of an IPO last year. In fact, the P2P element of the model has been usurped as most of the investors are now institutional yield seekers such as hedge funds, insurers and increasingly traditional banks. JP Morgan invested heavily in another US firm called OnDeck, an online lending platform for small businesses, late in 2015. As a result, marketplace lending is now the preferred term for the P2P lenders as the “peer” element has faded.

Just like other disruptive models in the technology age, eBay and Airbnb are examples, initially these models promised a future different from the past, the so called democratization of technology impact, but have now started to resemble new technology enabled distribution platforms with capital provided by already established players in their sectors. Time and time again, digital disruption has eroded distribution costs across many industries. The graphic from the Citi report below on digital disruption impact of different industries is interesting.

click to enlargeDigital Disruption

Marketplace lending is still small relative to traditional banking and only accounts for less than 1% of loans outstanding in the UK and the US (and even in China where its growth has been the most impressive at approx 3% of retail loans). Despite its tiny size, as with any new financial innovation, concerns are ever-present about the consequences of change for traditional markets.

Prosper had to radically change its underwriting process after a shaky start. One of their executives is recently quoted as saying that they “will soon be on our sixth risk model”. Marrying new technology with quality credit underwriting expertise (ignoring the differing cultures of each discipline) is a key challenge for these fledging upstarts. An executive in Kreditech, a German start-up, claimed that they are “a tech company who happens to be doing lending”. Critics point to the development of the sector in a benign default environment with low interest rates where borrowers can easily refinance and the churning of loans is prevalent. Adair Turner, the ex FSA regulator, recently stirred up the new industry with the widely reported comment that “the losses which will emerge from peer-to-peer lending over the next five to 10 years will make the bankers look like lending geniuses”. A split of the 2014 loan portfolio of Lending Club in the Citi report as below illustrates the concern.

click to enlargeLending Club Loan By Type

Another executive from the US firm SoFi, focused on student loans, claims that the industry is well aware of the limitations that credit underwriting solely driven by technology imbues with the comment that “my daughter could come up with an underwriting model based upon which band you like and it would work fine right now”.  Some of the newer technology firms make grand claims involving superior analytics which, combined with technologies like behavioural economics and machine learning, they contend will be able to sniff out superior credit risks.

The real disruptive impact that may occur is that these newer technology driven firms will, as Antony Jenkins the former CEO of Barclays commented, “compel banks to significantly automate their business”. The Citigroup report has interesting statistics on the traditional banking model, as per the graphs below. 60% to 70% of employees in retail banking, the largest profit segment for European and US banks, are supposedly doing manual processing which can be replaced by automation.

click to enlargeBanking Sector Forecasts Citi GPS

Another factor driving the need to automate the banks is the cyber security weaknesses in patching multiple legacy systems together. According to the Citigroup report, “the US banks on average appear to be about 5 years behind Europe who are in turn about a decade behind Nordic banks”. Within Europe, it is interesting to look at the trends in bank employee figures in the largest markets, as per the graph below. France in particular looks to be out of step with other countries.

click to enlargeEuropean Bank Employees

Regulators are also starting to pay attention. Just this week, after a number of scams involving online lenders, the Chinese central bank has instigated a crack down and constituted a multi-agency task force. In the US, there could be a case heard by the Supreme Court which may create significant issues for many online lenders. The Office of the Comptroller of the Currency recently issued a white paper to solicit industry views on how such new business models should be regulated. John Williams of the San Francisco Federal Reserve recently gave a speech at a recent marketplace lending conference which included the lucid point that “as a matter of principle, if it walks like a duck and quacks like a duck, it should be regulated like a duck”.

In the UK, regulators have taken a gentler approach whereby the new lending business models apply for Financial Conduct Authority authorisation under the 36H regulations, which are less stringent than the regimes which apply to more established activities, such as collective investment schemes. The FCA also launched “Project Innovate” last year where new businesses work together with the FCA on their products in a sandbox environment.

Back in 2013, I asked the question whether financial innovation always ended in lower risk premia in this post. In the reinsurance sector, the answer to that question is yes in relation to insurance linked securities (ILS) as this recent post on current pricing shows. It has occurred to me that the new collateralised ILS structures are not dissimilar in methodology to the 100% reserve banks, under the so-called Chicago plan, which economists such as Irving Fisher, Henry Simons and Milton Friedman proposed in the 1930s and 1940s. I have previously posted on my difficulty in understanding how the fully collaterised insurance model can possibly accept lower risk premia than the traditional “fractional” business models of traditional insurers (as per this post). The reduced costs of the ILS model or the uncorrelated diversification for investors cannot fully compensate for the higher capital required, in my view. I suspect that the reason is hiding behind a dilution of underwriting standards and/or leverage being used by investors to juice their returns. ILS capital is now estimated to make up 12% of overall reinsurance capital and its influence on pricing across the sector has been considerable. In Part 2 of this post, I will look into some of the newer marketplace insurance models being developed (it also needs a slick acronym – InsurTech).

Marketplace lending is based upon the same fully capitalized idea as ILS and 100% reserve banks. As can be seen by the Citigroup exhibits, there is plenty of room to compete with the existing banks on costs although nobody, not yet anyway, is claiming that such models have a lower cost of capital than the fractional reserve banks. It is important not to over exaggerate the impact of new models like marketplace lending on the banking sector given its current immaterial size. The impact of technology on distribution channels and on credit underwriting is likely to be of greater significance.

The indirect impact of financial innovation on underwriting standards prior to the crisis is a lesson that we must learn. To paraphrase an old underwriting adage, we should not let the sweet smell of shiny new technology distract us from the stink of risk, particularly where such risk involves irrational human behaviour. The now infamous IMF report in 2006 which stated that financial innovation had “increased the resilience of the financial system” cannot be forgotten.

I am currently reading a book called “Between Debt and the Devil” by the aforementioned Adair Turner where he argues that private credit creation, if left solely to the free market under our existing frameworks, will overfund secured lending on existing real estate (which my its nature is finite), creating unproductive volatility and financial instability as oversupply meets physical constraints. Turner’s book covers many of the same topics and themes as Martin Wolf’s book (see this post). Turner concludes that we need to embrace policies which actively encourage a less credit intensive economy.

It is interesting to see that the contribution of the financial sector has not reduced significantly since the crisis, as the graph on US GDP mix below illustrates. The financialization of modern society does not seem to have abated much since the crisis. Indeed, the contribution to the value of the S&P500 from the financials has not decreased materially since the crisis either (as can be seen in the graph in this post).

click to enlargeUS GDP Breakdown 1947 to 2014

Innovation which makes business more efficient is a feature of the creative destruction capitalist system which has increased productivity and wealth across generations. However, financial innovation which results in changes to the structure of markets, particularly concerning banking and credit creation, has to be carefully considered and monitored. John Kay in a recent FT piece articulated the dangers of our interconnected financial world elegantly, as follow:

Vertical chains of intermediation, which channel funds directly from savers to the uses of capital, can break without inflicting much collateral damage. When intermediation is predominantly horizontal, with intermediaries mostly trading with each other, any failure cascades through the system.

When trying to understand the potential impacts of innovations like new technology driven underwriting, I like to go back to an exhibit I created a few years ago trying to illustrate how  financial systems have been impacted at times of supposed innovation in the past.

click to enlargeQuote Money Train

Change is inevitable and advances in technology cannot, nor should they, be restrained. Human behaviour, unfortunately, doesn’t change all that much and therefore how technological advances in the financial sector could impact stability needs to be ever present in our thoughts. That is particularly important today where global economies face such transformational questions over the future of the credit creation and money.