The 2018 FIFA World Cup is over, and the 2018/2019 sports season is just starting. For the gaming industry, it's time to buckle down and start preparing for the recent changes in regulation that have been announced in several countries. Because of the social risks associated with gaming and the desire of governments to extract as much in taxes as possible from the industry, the sector faces almost constant regulatory change.

In May 2018, two decisions were announced that spelled massive upheaval for some of the world's largest gaming companies:

• The U.K. government completed its triennial review and decided to reduce to £2 from £100 the maximum stakes on fixed-odds betting terminals (FOBT). Not only will this slash the future earnings of U.K. gaming operators, the new limit is far lower than most observers had expected at the beginning of the process. This decision indicates that the U.K. government considers combatting the negative effects of gambling more important than the potential job losses and loss of revenues to the exchequer.
• Conversely, the U.S. Supreme Court repealed the Professional and Amateur Sports Protection Act (PASPA), paving the way for individual states to introduce legislation permitting sports betting, in a market that has previously been almost completely closed.

Combined with other regulatory changes, these alterations have created a far more uncertain environment for gaming companies. In December 2016, all our rated entities in the sector had stable outlooks; to date, only 50% of them still retain a stable outlook (see chart 1).

Chart 1

In this environment, several companies have turned to supersized consolidation deals, citing the need for geographic diversification, increased scale, and cost synergies to help them withstand regulatory changes, competition, and the need for heavy investments in marketing and IT platforms. Gaming companies are also acquiring others to increase their presence in regulated markets or to gain access to online gaming platforms and the underlying technology. In 2016, the online gross gaming revenue (GGR) represented just 10% of global GGR (then $360 billion). However, within the next seven years, we expect online GGR to reach at least 20%-30% of global GGR, particularly as the U.S. gaming market opens up.

There have been several large acquisitions in the past year, including the Ladbrokes acquisition by GVC, the acquisition of Snaitech by Playtech, and the acquisition of Sky Bet by The Stars Group. We expect more to follow in the coming years.

A Controversial Industry

Socially responsible investing (SRI) or the consideration of environmental, social, and governance (ESG) factors in the investment process has gained growing prominence over the past decade. Consultancy firm McKinsey last year estimated that 26% of professionally managed accounts around the world are sustainable investments, compared with 21.5% in 2012. A common approach to SRI is to avoid investing in activities considered to be unethical or immoral, and the gambling industry is frequently excluded from investment portfolios due to the social impacts surrounding gambling addiction.

So far, SRI seems to be having a negligible impact on demand for the gaming industry's debt. However, if the investors are correct that socially controversial industries will suffer in the long term as regulations and consumer tastes shift demand away from these products, it could affect the companies we rate and the overall industry. We anticipate that ESG analysis will be increasingly important, especially in the European market, where regulators maintain a keen focus on the potential social risks of gaming, as well as governance-related risks such as money laundering.

New Regulation Often Aims To Tackle Social And Governance Risks

Recent regulatory actions indicate that the social impact of gambling is garnering most attention. In May 2018, the U.K. government decreased the maximum stakes on FOBTs to £2 from £100 to reduce the risk of gambling-related harm. As a result, we have already taken some negative rating actions, and more may follow once the changes come into effect.

Regulators are also keen to rein in criminal activity in the gaming industry. The EU's Fourth Anti-Money-Laundering Directive came into full force in June 2017 and covers the entire gaming sector, not just casinos. The directive requires gambling providers to carry out due diligence checks on transactions of €2,000 or more.

Another governance issue that exercises regulators is tax evasion in the gaming industry. Companies are often based offshore, which can make them exempt from tax liabilities. In 2014, the U.K. government attempted to circumvent this by introducing legislation that taxed gaming companies on the place of consumption, rather than the place of supply. As a result, all remote gambling companies are taxed on the gambling profits they make from U.K. customers.

Regulatory Change Brings Uncertainty

Diversification works both ways--rated companies based in Europe could suffer from regulatory changes in both the European and non-European markets to which they are exposed. The U.S., Latin America, and Australia are all progressing regulatory changes and several European countries announced regulatory changes during 2018 that could weigh on ratings in future.

The U.K.

In May 2018, the U.K. government announced the findings of its triennial review, which included the decision to reduce the maximum stake for FOBT to just £2. We had initially expected that the new limit would be £20. This decision will hit the revenues and profitability of the largest retail-based gaming companies based in the U.K. for years to come. A second blow came when the government announced that it would increase remote gaming duty (RGD) to offset the loss of taxes on gaming revenues. Online gaming is gradually gaining scale and becoming a large part of these companies' activity, so the effect could be significant.

We do not expect the new legislation to come into force until late 2019 at the earliest, so the two largest rated U.K.-based retail gaming entities (William Hill and GVC) will mostly be affected from 2020. Given that William Hill derives about 55% of its EBITDA from retail gaming operations, we expect it to start closing unprofitable shops during 2019. This could cause its profitability and leverage to deteriorate. The negative outlook on William Hill reflects the possibility of a downgrade in the next 12-24 months.

Although we had previously seen Ladbrokes Coral as the entity most exposed to the £2 limit, its acquisition by GVC means it is part of a group that derives only 40% of its EBITDA from the U.K. retail gaming segment. GVC incorporated a contingent value rights (CVR) mechanism into the acquisition, which will reduce the impact of the £2 limit, provided that the government introduces the legislation before March 2019. Under this mechanism, GVC issued less debt than it would have if the maximum stake had been set above £2; as a result, its leverage is broadly unchanged. That said, GVC has high exposure to the U.K. online gaming industry, so its profitability is likely to be hit by the increase in RGD.

Germany

Although gambling regulations have remained broadly unchanged in Germany, changes are afoot. Germany has already brought in limitations on arcade operators (that is, minimum distances between arcades and relevant social institutions and limits on the number of gaming machines per arcade). This significantly reduced the number of amusement with prize (AWP) machines in 2017 and we expect a further decline in 2018. However, municipalities have offered hardship exemptions and active toleration until 2021, which has reduced the impact on arcade operators, such as Safari Holdings.

Online casinos have been prohibited since 2011, except in Schleswig-Holstein. Currently, many entities operate in Germany under an offshore online license and its unregulated market is growing. The lack of clarity regarding the status of online casinos, combined with increased costs associated with regulatory compliance and acquisitions, caused gaming technology supplier Novomatic to terminate its relationship with the business-to-business costumers in the German online market in January 2018.

Currently, Germany caps at 20 the number of permanent sports betting licenses it makes available, although some additional operators operate with temporary licenses. The cap remains in force despite several attempts to eliminate it by sports betting operators that have not been able to secure a permanent licenses. Should this cap be lifted, we would expect competition to surge given that the global sports betting segment has seen significant growth.

Italy

Italy, like Germany, has brought in limitations on arcade operators. New distance laws are forcing many gaming establishments to close, and around 250,000 of the AWP machines in the country (which represent 34% of all machines in the market) have been removed. Although earnings from land-based activity will go down as a result, we don't expect these changes to have a material impact on profitability at the companies we rate. Utilization rates for AWP machines have historically been very low, and should increase as a result of the change.

In July 2018, the newly appointed Italian government announced a ban on advertising of gaming and betting through media channels (including sponsorships), as one of its first steps. This ban will come into effect on Jan. 1, 2019. We believe that pure online players will suffer more from this measure than land-based operators such as Gamenet, Sisal, and Snaitech. Land-based operators will be able to advertise their products in their shops.

The government also increased gaming taxes (PREU) on AWPs (by 0.35%) and video lottery terminals (VLTs) (by 0.3%), starting Sept. 1, 2018. From May 1, 2019, these taxes will see a small additional rise, with further increases due in Jan. 1, 2020 and Jan. 1, 2021. The profitability of Italian gaming companies, especially smaller operators, will likely take a hit as a result, and so we have revised our forecasts downward. We assume that larger operators will be able to offset some of the loss by reducing payout ratios over time.

Spain

Spain's government chose to reduce the online gaming tax to 20% from 25% in May 2018. We don't expect this to support a significant improvement in profitability at Cirsa and Codere as they still have limited exposure to the online gaming sector. After Italy's ban on advertising of gambling, the new Spanish government is considering following suit. Measures being considered include banning betting ads in the early evening, when children are watching T.V., and limiting celebrity participation in ads. If these measures are passed as planned, they would likely come into effect on Jan. 1, 2019. Again, we don't foresee this having material effect on operating performance at Cirsa and Codere.

Rated Spanish gaming companies make much of their profits in Latin America, where gaming markets are constantly evolving. In some countries, like Brazil, gaming remains unregulated. While there is a lot of untapped growth potential, these markets also carry potential risks, most associated with foreign-exchange volatility (as seen with the recent depreciation of the Argentine peso) or political issues, rather than regulatory changes. We expect some Latin American countries to start to address regulation of the industry soon. This should present companies that already operate there with new opportunities, as they are familiar with those markets and their specific attributes.

Greece

In Greece, OPAP S.A. has a monopoly for land-based operations, while the rest of the legal gambling market comprises several online operators that hold interim licenses. In 2016, the Hellenic Gaming Commission introduced regulations allowing the installation of VLTs and then updated the rules in the fourth quarter of 2017.

Although the updated regulations reduce the number of VLTs that may be installed (to 25,000 from 35,000), the license period has been lengthened by eight years and was granted solely to OPAP. This will substantially boost OPAP's margins. In addition, the recent changes are expected to shrink the Greek illegal gambling market, which will also significantly benefit OPAP.

Other areas and products

In most European countries, national lotteries are government-run. Private operators run the national lotteries in only a few countries, such as Albania, Austria, Cyprus, Czech Republic, Greece, Ireland, Italy, and the U.K. We consider that companies that operate lotteries have lower operational risk than those operating more-volatile betting products, because traditionally, governments award long-term exclusive licenses to national lottery operators. Governments also have an interest in keeping the businesses profitable because they offer strong cash generation via taxes and the amount of money staked has historically been stable. Although we believe that other countries are likely to privatize national lotteries in the near future, the timeframe for these changes remains unknown.

Regulation in the Baltic region has historically been more favorable than in other European countries. The flat tax per gaming machine benefits larger operators, whose revenue per machine is higher, and the region's governments make limited taxation changes. The region's online market is growing rapidly and displays intense competition.

Although most of our rated companies operate in regulated markets, some still have operations in unregulated markets, or in countries where gaming remains illegal. In Turkey, online gambling was banned in 2006; the legal offline market is operated through state-owned monopolies. That said, some companies use offshore licenses to operate in Turkey.

In our view, these operations are exposed to diverse legal sanctions; in July 2017, the Turkish government announced a two-year crackdown on illegal gambling, both retail and online. Operations are also exposed to substantial foreign exchange risks--for example, the sharp depreciation of the Turkish lira in August 2018 will have a material effect on the earnings of companies operating in Turkey, such as Intralot.

Consolidation Is The Name Of The Game

European gaming markets have seen a massive spike in the total value of mergers and acquisitions over the past year (see chart 2). Although many transactions bring increased scale, geographic diversification, and cost synergies, some were motivated by the need to access specific technological expertise and the licenses necessary to increase an acquirer's presence in certain regulated markets.

Chart 2

We expect online GGR, as a proportion of total GGR, to at least double within the next seven years. The likely opening up of sports betting in the U.S. will accelerate this move, making an attractive platform and the technology to support it assets worth acquiring in their own right.

Table 1 shows the acquisitions valued above £100 million that have completed since the beginning of the year involving rated entities within the European gaming sector.

Table 1

GVC's acquisition of Ladbrokes Coral provided the former with access to strong brand names, diversification in the European retail gaming segment, and an improved presence in the regulated U.K. market (which contributes about 63% of total revenue). The opportunity to make potential cost savings through synergies was also important to this transaction; we consider that GVC is highly likely to insource Ladbrokes Coral's online offering, hosting it on GVC's own platform.

As stand-alone businesses, GVC and Ladbrokes Coral had similar online revenues of about €1.0 billion. However, GVC's capitalized development costs were about €20 million in 2017; Ladbrokes Coral spent approximately £80 million with its technology partners (including Playtech Ltd.), in the same period.

Playtech's own acquisition of Snaitech for £850 million in 2018 should enable it to increase the proportion of its revenue from the regulated market and its business-to-consumer activity, and will provide the company with an opportunity for vertical integration, even as it prepares itself to face the potential adverse effect of the GVC-Ladbrokes merger and increased competition in Asia.

Stars Group's acquisition of Skybet is consistent with its strategy of expanding into online sports betting market, a high-growth market compared with the saturated online poker market. The transaction enabled Stars Group to acquire technological capabilities that it can make use of in its other geographic markets.

The total consideration for these acquisitions is high--the EBITDA multiple for online assets was more than 10x the EBITDA. However, acquisitions do not always translate into a success story. In its 2017 accounts, William Hill recorded a goodwill impairment of about £240 million against the £480 million it invested in Australia in 2013. This impairment reflects regulatory changes in Australia, including the ban on credit betting and the introduction of a point-of-consumption tax by certain states.

Financial policy in the European gaming sector has tended to be relatively conservative in recent years. Typically, the S&P Global Ratings-adjusted debt-to-EBITDA ratio stands at about 3x-4x (see chart 3). Leverage at some companies, such as William Hill, is currently even lower, in preparation for changes in the markets. Therefore, most companies are well-positioned to bid for the most attractive assets in the market. Additionally, European players pay a portion of the purchase price with equity and do not entirely rely on debt to fund such acquisitions.

Chart 3

A Credit-Positive Regulatory Change In The U.S.

On May 14, 2018, the U.S. Supreme Court ruled in favor of New Jersey's effort to legalize sports betting in the U.S. This is one of the biggest changes to U.S. gambling regulation in years. The court ruling has repealed PASPA, a 1992 law that banned sports betting in most of the U.S., which in turn enables individual states to introduce legislation permitting sports betting, if they wish.

This change creates a big opportunity for growth in a market that has potential to be a significant size. We see it as credit-positive for the gaming sector and for some of our rated gaming companies. The opportunity to create a new revenue stream through gambling taxes will provide states with a strong incentive to permit sports betting.

In our view, it will take at least two or three years for the market to develop enough to start generating significant revenues. Brand recognition will be hugely important, especially to online bettors. The companies best-positioned to take advantage are large U.S.-based operators that have a diversified, national presence and experience in Nevada.

Companies like MGM Resorts, Caesars Entertainment, Boyd Gaming, and Penn National Gaming will be able to quickly export their expertise to other states. Most national operators have own-branded mobile apps in Nevada and existing relationships with business-to-business software and technology providers, which should help them move their sports book operations into newly regulated states.

Nevertheless, as the joint venture formed by MGM and GVC shows, some U.S. companies may seek to build on the technology platforms and sports-betting expertise of large European gaming companies. Some of the European gaming companies--particularly U.K.-based operators such as William Hill PLC, GVC Holdings, and Paddy Power Betfair--could significantly benefit from the opening of the U.S. market.

These companies are among the largest sports betting companies in the world, and have the expertise to enter this newly developing market. Companies are already trying to generate a first mover's advantage and build up their networks. Mergers and acquisitions and the formation of joint ventures are the quickest ways to get into this market. Different approaches include:

• The acquisition of U.S.-based FanDuel by Paddy Power;
• The joint venture recently formed by GVC and MGM; and
• William Hill's partnership with Eldorado Resorts.

Over the next few years, we anticipate that declining revenues in their domestic market could encourage U.K. gaming companies to compensate by expanding in the U.S. market, which is likely to see significant growth. The approach each state takes toward the regulation of sports betting will have a tremendous effect on how the local market will develop and its attractiveness to new entrants. Regulatory choices will affect the earnings, EBITDA, capital expenditure requirements, and cash flows of the companies investing there.

A Busy Year For Rating Actions

In 2018, we took over 15 rating actions on gaming companies, affecting 10 of the 15 rated companies in the sector. Some companies saw more than one rating action. We also assigned two new ratings.

Most positive rating actions stemmed from good operating performance and consolidation in the market. Several acquisitions led to the formation of larger, stronger, and more diversified gaming groups. On the negative side, most rating actions stemmed from changes in regulation and weaker-than-expected operating performance.

Bookmaker-friendly results in the first and second quarter of 2018 supported an improvement in EBITDA margins for several companies, but also encouraged a gradual reduction in amounts staked (due to lower recycling of money played). In our view, a prolonged period of bookmaker-friendly results could have a negative long-term effect on the industry, and might drive rating actions as companies lose scale.

We expect to see continued regulatory change and further consolidation in the European gaming market; both should remain the main catalysts for future rating actions on sector players (see chart 4).

Chart 4

Related Research

• Credit FAQ: If Sports Gaming Is Legalized, Which Gaming Operators Do The Odds Favor?, April 3, 2018
• Industry Top Trends 2018: Hotels, Gaming, And Leisure, Nov. 14, 2017
• Online Demand Will Help European Gaming Companies Offset Increased Taxes And Regulations, Sept. 6, 2017

Rating actions

• Italian Gaming Company Gamenet Group Ratings Placed On CreditWatch Positive On Agreement To Purchase GoldBet, Sept. 10, 2018
• LHMC Bidco, Cirsa Gaming Corp. Parent, Rated 'B+'; Outlook Stable, Aug. 14, 2018
• U.K.-Based Cyan Blue Holdco 2 (Sky Bet) Ratings Withdrawn On Debt Repayments, Aug. 7, 2018
• Greece-Based Gaming Company OPAP Upgraded To 'BB-' Following Greece's Revised Country Risk Assessment; Outlook Stable, Aug. 2, 2018
• Odyssey Europe Holdco (Olympic Entertainment) Assigned 'B' Rating; Outlook Stable, July 17, 2018
• U.K. Betting Operator William Hill PLC 'BB+' Rating Affirmed Despite Change In Regulation; Outlook Negative, June 6, 2018
• Italian Gaming And Payments Operator Sisal Group 'B+' Rating Affirmed; Outlook Remains Negative, May 30, 2018
• Spain-Based Cirsa Gaming Corp. S.A. Ratings Placed On CreditWatch Negative After Blackstone Takeover Announcement, May 4, 2018
• Greek Gaming Company Intralot Outlook Revised To Negative On Increased Leverage; 'B' Ratings Affirmed, April 25, 2018
• Italian Gaming Company Snaitech SpA 'B' Rating Placed On CreditWatch Positive On Announced Acquisition By Playtech PLC, April 24, 2018
• Online Gaming Operator GVC Upgraded To 'BB' From 'BB-' On Ladbrokes Coral Acquisition; Outlook Positive, April 19, 2018
• Italian Gaming Company Gamenet Outlook Revised To Positive On Proposed Refinancing And Sound Operating Performance, April 16, 2018
• Online Gaming Operator GVC Holdings Assigned 'BB-' Rating And Placed On Watch Positive On Ladbrokes Coral Acquisition, March 5, 2018
• Spain-Based Cirsa Gaming Corp. Upgraded To 'BB-' From 'B+'; Outlook Stable, Jan. 25, 2018
• Greece-Based Gaming Company OPAP S.A. Upgraded To 'B+' Following Similar Action On Sovereign; Outlook Stable, Jan. 24, 2018
• Gaming Company Novomatic Downgraded To 'BBB-/A-3' On Weaker Profitability And Credit Metrics; Outlook Stable, Nov. 29, 2017
• U.K.-Based Gaming Operator William Hill 'BB+' Rating Placed On Watch Negative On Suggested Change In Regulation, Nov. 3, 2017
• U.K.-Based Gaming Operator Ladbrokes Coral 'BB' Rating Placed On Watch Negative On Suggested Change In Regulation, Nov. 3, 2017