A record-shattering 5,661 card sharks were at Harrah's (NYSE:HET) Rio Hotel and Casino in Las Vegas earlier this summer to compete in the World Series of Poker, the game's richest and most storied event. Poker has grown immensely since aptly named amateur Chris Moneymaker beat 839 pros two years ago to take the title, parlaying a $40 online poker entry into a million dollar payday.
The poker rush
Just as thousands of Americans rushed to California to seek their fortunes in gold in the 1840s, untold numbers of Americans are flooding the Internet to strike it rich in poker. The World Series alone has grown more than 1,000% since 2000:
| World Series Year | No. of Entrants |
|---|---|
| 2000 | 512 |
| 2001 | 613 |
| 2002 | 631 |
| 2003* | 839 |
| 2004 |
2,576 |
| 2005 | 5,662 |
Of course, just as was the case with the Gold Rush, the vast majority of those who go to Vegas to find their fortune in a hand of cards will not come out ahead. Moneymaker's success catalyzed a massive boom that has been spread by the popularity of televised poker and the explosive growth of online poker. People around the world can now play the game from the comfort of their own homes.
Dealing on the Internet
The growth in online poker has been nothing short of staggering. According to industry research group PokerPulse, online poker has grown from a $300 million per year industry in 2003 to a projected $2.9 billion per year industry in 2005.
Even more amazing, this growth shows little sign of letting up. PokerPulse data show that online poker traffic for March 2005 is actually up a whopping 50% from September 2004. Industry analysts anticipate an industry growth rate of 100% for 2005. Such rapid growth has prompted hundreds of companies to launch online card rooms. Just like the players coming to seek their fortunes in Vegas in person, most of these online players will likely fail.
So besides the occasional shark, who is getting rich off the online poker boom?
The house always wins
Among publicly traded companies, one of the primary beneficiaries has been Toronto-based software developer Cryptologic (NASDAQ:CRYP), a recent Motley Fool Hidden Gems selection. Cryptologic builds and supports online casino software, which it then licenses to a number of international clients, including Interpoker, Betfair, and the Ritz Club London. It earns money by "raking" a small percentage of each pot from every hand played. These dollars and cents really add up. In 2004, $12.7 million of its $63.7 million in total revenue was generated from online poker operations. That was up from practically nothing in 2002 and up 145% from 2003. Nearly half of Cryptologic's growth has come from poker since 2003:
| Cryptologic Revenues | |
|---|---|
| 2002 | $34.4 million |
| 2003 | $44.2 million |
| 2004 | $63.7 million |
| 2005 | $40.2 million (YTD) |
| Cryptologic Earnings | |
|---|---|
| 2002 | $2.1 million |
| 2003 | $9.4 million |
| 2004 | $13.7 million |
| 2005 | $9.6 million (YTD) |
Almost as appealing as the mouth-watering industry growth rate is the industry business model. Online gaming sites share the same statistical edges that their brick-and-mortar casino brethren have enjoyed for many years -- statistical edges that over time pay for these multibillion dollar megaresorts many times over. The difference is that online gaming sites make do without the whole multibillion dollar megaresort expense thing.
For the cost of developing and supporting their poker software, the online poker industry is expected to rake in a projected $2 billion in revenue this year. It's no wonder Cryptologic achieved profit margins of more than 21% in 2004, and those margins are likely to grow as business scales up.
The 200-plus competing poker rooms notwithstanding, the competitive landscape is dominated by the top players. According to PokerPulse, the top 10 poker sites account for more than 90% of the industry's revenues. The social nature of the game creates a sort of "network effect" whereby players will naturally gravitate toward the sites with the greatest availability of opponents and games.
In the two years since commencing its poker operations, Cryptologic has already forged its way into the Top 10. While it continues to lag industry heavyweight Party Poker and a few other top players, the Cryptologic network of sites recently ranked fifth in online poker revenue (Cryptologic is the only one of these that trades on a U.S. stock exchange). The company's growth strategy of selectively licensing its software to well-established gambling brands has produced revenue growth far exceeding the industry's already lofty growth rates. It has also specifically targeted the European market, which it has identified as being earlier along in the industry growth curve than the United States.
The explosion of online poker has not gone unnoticed by Wall Street. Cryptologic stock currently trades at around $24 per share -- a more than threefold increase from two years ago. Its market capitalization is nearly $330 million. With trailing earnings of $16 million, the stock is priced for growth at more than 21 times earnings. Back out the $93 million cash on the balance sheet (with no debt), and the company trades at 16 times earnings.
Cryptologic's current valuation is dependent on the continued growth of online poker and myriad other online casino gaming rooms (from which it still generates the majority of its revenues). So how much further does online poker have to grow? With revenues having grown 10-fold over the past two years, online poker growth is certain to level off. The stock pulled back from its recent highs after management projected year-over-year revenue growth of "only" 25% for the upcoming quarter. But interestingly, the projected $12 billion in online gaming revenue this year still represents only 5% of the entire global gaming market, suggesting that the current poker boom still has room to grow. Cryptologic management points to industry consolidation and European markets as future drivers of growth.
If this year's World Series of Poker is any indication, the poker-playing public has not lost its appetite for the card tables just yet.. We've seen many fads before, and at their heights (cigars, Pokemon, hula hoops, etc.), it seems that they're can't-miss propositions. But forget about poker for a second. Would you consider gambling to be a fad?
I didn't think so. Online gaming, I believe, is here to stay.
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Gerald Kim does not own shares of any company mentioned in this article. The Motley Fool has an ironclad disclosure policy.
