PartyGaming's Meltdown and Lessons Learnt

News from International Herald Tribune (Oct 3, 2006)

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Congress passed legislation over the weekend that would make it a crime to use credit cards or online payment systems for Internet betting. As a result, several online-gambling companies said Monday that they planned to stop doing business with customers in the United States — by far the largest market for Internet gambling.

PartyGaming, which generates 78 percent of its revenue in the United States, said it would suspend all “real money” transactions with United States-based customers if President Bush signs the bill into law, as is expected within the next two weeks.

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Without doubt, PartyGaming's shares have plunged significantly; dropping over 60% in one day. Stopping online transactions for online gambling would literally abolish PartyGaming's lucrative revenue from US customers and would shrink its revenue by over 75%!

As I have recommended PartyGaming Company for my Lau Model Portfolio, I believe that it would be useful to bring it up for discussion and reflection. As Buffett said, always learn your mistakes and the mistakes of others and most importantly, do not repeat them!

When I first evaluated PartyGaming, I was very enticed by its huge growth potential. PartyGaming is the market leader in online poker and online casino. It is 3 times bigger than the next online poker competitor. Also, it uses in-house software, understands the needs for excellent customer services, introducing more games like PartyGammon, targeting non-US customers, etc.

As I mentioned before, the biggest risk that PartyGaming faces is the "illegal status of online gambling" in US. Initially, I judged that it was a low probability event as

1) It is hard to regulate

2) It doesn't make sense to make online gambling but sparing other gambling like horse betting

3) US has tried on numerous occassions to ban online gambling but to no avail

4) It is legalised in UK and US as a "UK partner" should be on the same side as UK

5) World Trade Organisation ruled last year that US laws on online gambling contravened its rules.

Now, it seems that online gambling in US is in jeopardy. It is very highly likely that online gambling would not be able to survive in US as they enact the ban on online credit cards transactions for online gambling.

So, what have I learnt from this meltdown.

1) Margin of Safety: It is paramount to calculate margin of safety prior to investing. In this particular case, as I have minimised the risk of PartyGaming, margin of safety that I have calculated was not sufficient to cover the severe plunge of PartyGaming shares price.

2) Diversification: When I said diversification, I don't mean buying 100 stocks. :) If you are an experienced investor, Joel Greenblatt mentioned that 6-8 stocks would be a sufficient diversification of portfolio.

3) Cost averaging down: If you are confident in the company's future, cost averaging down will create a superior return in the long run. Our famous Bill Miller emphasized that he always buys more in the company that he invests. Nobody knows where is the bottom, and by averaging down, you will get to own the companies that you like at a very attractive price. Even Warren Buffett doesn't know when is the bottom.

My current view on PartyGaming:

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PartyGaming is a well-run, cash-generative company and a great market leader in online poker and online casino. Despite losing significant amount on revenue from US market, it will still grow big and strong over the years. It has great potential in non-US market. Personally, I'm going to cost average down.

I believe that current uncertainty and pessimism creates great buying opportunity!

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Further suggested reading:

1) Guardian Limited: Online gaming firms consider legal challenge to US ban

2) Gambling911.com: Former New Jersey Attorney General doesn't see online gambling legislation lasting

IMPORTANT: Due your own due dilligence prior to investing.

Happy learning and growing,

Dah Hui Lau (David)