There has been a lot of buzz over the last few months that online gambling is going to be the next big growth area for the gambling industry. Shares of GAN Limited (GAN) and DraftKings (DKNG -0.87%) have been on fire since reaching public markets, and Flutter Entertainment (FLTR -1.52%), which owns The Stars Group, has had a nice run as well.
Rising stock prices have been driven by stronger-than-expected online play during the pandemic and speculation that budget shortfalls in states across the country will open up online gambling. But the three aforementioned companies may not be the biggest winners in the industry, depending on how regulations play out.
How online gambling works
There are a number of ways gambling has been legalized in the U.S., and that makes the industry a little confusing. Some states allow online sportsbooks, others also allow casinos, and some even require a physical presence to operate there. If the rules were wide open everywhere, DraftKings and Flutter Entertainment would be the clear stocks to own because they're pure plays. As states open up gambling, beyond the 16 that allow some sort of betting today, they will see revenue grow.
But the casinos with a physical presence have an advantage in some states, and that gives them the opportunity to keep start-ups at bay for the time being. MGM Resorts (MGM -0.33%) is a great example of this, partnering with GVC Holdings to build sportsbooks and casinos in nearly every state where it's possibly legal.
GAN Limited is one of the companies offering services to casinos like MGM Resorts, giving them the software to help open a casino extremely quickly. The theory is that bringing a software company together with a gambling brand can be a way to grow the business for everyone.
IGT (IGT 0.15%) and Scientific Games (LNW -0.55%) have also built services casinos can use to build online gambling platforms.
What you'll notice is that traditional casino companies are primarily leaning on partners to bring online gambling to the market. In that sense, it's the software companies that have the most opportunity and are highly valued by the market. But these aren't your typical technology stocks because this is a highly regulated and very competitive market without a clear winner-take-all outcome expected in the future.
Image source: Getty Images.
Competition is fierce
The assumption is that online casinos and sportsbooks will print money for investors. But that may not be the case. States that open up to gambling often open the doors to many more online companies than they would physical casinos, which are often very limited.
For example, there are 22 online casinos operating in New Jersey, Pennsylvania has 10 online casinos, and Indiana has seven sports-betting apps. This just shows that when online gambling and/or sports betting are legalized, the competition comes in quickly.
Economics 101 indicates that the more competition there is the more companies will have to compete to attract customers. They do this in online gambling by offering financial bonuses, or bonuses from free games, and even advertising in traditional media to attract customers. If the number of competitors continues to be high, revenues and margins may both be lower than investors expect because of this competition.
How to play online gambling
I think there's more of an advantage than investors think in owning brick-and-mortar casinos and then moving online. MGM Resorts has been the most aggressive in entering online gambling through its BetMGM app and continues to add markets. That's my top pick to win long term.
DraftKings has a brand advantage compared to other online-only companies. And since it can offer its own products, rather than being a service provider for other brands, it's in control of its own destiny. But a market cap of nearly $12 billion is steep for a company that can operate in very few markets today.
What investors should worry about is that only 16 states have any sort of legal online betting, and the market may not open up as quickly as investors hope. I worry that betting on online-only gambling companies with rich valuations is a losing bet.
