PartyGaming is far too good to be floated

The prospectus for Party-Gaming, the online poker company being floated on the London Stock Exchange, is a rollicking read. It provides more reasons to give the shares a wide berth than I have ever seen in any document on any company, even brokers' notes explicitly designed to push down a share price.

One inescapable question is whether all those wealth warnings in the document are a bluff or even a double-bluff on the London market being perpetrated by the authors of the prospectus, the bankers of Dresdner Kleinwort Wasserstein (DKW).

By the look of it, however, it's almost midnight and DKW has a stinking hand. Would you, should you - oh audacious investor - put your money down just for the sheer thrill of the ride?

Now the scariest stuff in the book is all about whether what PartyGaming does is lawful. Yes, believe it or not, DKW is trying to float a company on London's senior market - the one that is supposed to benefit from a gold standard of market regulation - without being able to provide an assurance about whether or not the majority of that company's earnings are derived from an illegal activity.

Linger on the following corporate statement, with all its resonant implications: "There is uncertainty as to the legality of online gaming in most countries, and in many countries, including the United States, the group's activities are considered to be illegal by relevant authorities".

So PartyGaming and its directors "rely on the apparent unwillingness or inability of regulators generally to bring actions against businesses with no physical presence in the country concerned".

It's hair-raising stuff. And there's more: "As PartyGaming generates most of its revenue from customers in the US (approximately 87 per cent in the first quarter of 2005), any action by US authorities that succeeds in prohibiting or materially restricting PartyGaming from offering online gaming in the US would have very serious consequences for the group and could result in investors losing all or a very substantial part of their investment."

That last bit is printed in bold: no one should accuse DKW of being coy about the dangers.

But here's the funny thing. My first concern about PartyGaming is not whether the US authorities will at some point endeavour to close the business down. In fact, the legal risks may be something of a Hitchcockian McGuffin, a sub-plot that takes attention away from the real story.

For me, the really gripping question is why this business is being floated at all - because, strange as it may seem, if I owned it, I would not sell a single share.

Its financial characteristics are to die for. Here's the beautiful profile: turnover has grown from $30.1m (£16.6m) in 2002 to $153.1m in 2003 and to $606.6m last year; pre-tax profit has risen from $5.8m in 2002 to $89.2m in 2003 and to $371.7m in 2004; and all this has been generated with minuscule capital expenditure, such that most of the profit is lovely cash.

Thus in 2004, PartyGaming generated $429.1m in net cash from operating activities. Of this, just $18.3m went on purchases of property, plant and equipment or other investing activities. And a spectacular $353.3m dropped into the pockets of its fortunate owners as part of a reorganisation of the group's assets.

Now if I controlled a business that gushed a return of that ilk, I would keep very quiet about it. Quite apart from anything else, PartyGaming's best hope of protecting its spectacular profit margins - almost 60 per cent even after paying tax - is not to tell anyone about them.

The last thing it should want to do is to show off the vital statistics in a prospectus and thereby attract copycat competitors who would provide the same service on better terms for the punter (its prospectus also helpfully points out that "given the availability of 'off-the-shelf' poker software and access to poker networks, the barriers to entry for launching a new online poker site are low").

Until recently, the owners of this golden egg-laying goose seemed to understand the imperative of keeping it fairly well hidden. They run the business well away from jealous eyes, in the tax haven of Gibraltar.

The home in Gib brought the added benefit that the group pays only a trivial amount in tax. But this points to a further potential cost of floating: in a world where the tax authorities of developed economies are increasingly trying to get their mitts on revenues from international companies it is not normally astute to publicise such clever fiscal arrangements.

However, PartyGaming's creators - the curious quartet of Dikshit, Parasol, de Leon and Bhargava - suddenly don't object to becoming famous. It's pretty easy to see why. They would pocket around £900m for themselves by selling 755m shares, and would retain shares worth almost £3.5bn.

What's more, there really does not seem to be much of a justification for the float other than to allow them to scoop the pot. PartyGaming has no need of additional capital and is not trying to raise any.

Is there reassurance to be derived from the arrival on the board of two relatively well-known British businessmen, Michael Jackson and Brian Larcombe, who are becoming chairman and deputy chairman? Is it a sign that the shares will go up and up that Jackson has promised to invest £1m in PartyGaming's shares at the offer price and Larcombe has agreed to buy £590,000 of shares?

Not really. Jackson is receiving a £1.5m one-off cash payment on top of his £500,000 salary while Larcombe is receiving £1m on top of his £175,000 annual remuneration. What's striking is that neither of them is putting all of their respective special payments into PartyGaming's stock - which isn't the greatest vote of confidence.

But why shouldn't PartyGaming be a haven for precious life savings? Well, as assessed by discounting future cash flows, its proposed market value of between £4.44bn and £5.08bn assumes that profit margins before tax and interest will fall from 64 per cent to 50 per cent in 2007, that compound annual growth in turnover will be 40 percentish until then, that growth will then fall to 5 per cent or 6 per cent for a further eight years and will then be nil forever after (based on research by DKW's analysts).

In other words, the price does not contain nearly enough of a discount for the strong likelihood that there will be some kind of setback one day - such as the possibility that the remarkable popularity of online poker might be a passing fad, or that competitive pressures will escalate, or that the tax rate will rise, or that the US authorities will attempt to stop American punters from playing.

The germane point for me is that this business was fabulous when unknown and private - and the risks it faces increase massively in the public domain.

If PartyGaming were as good as it looks, Dikshit et al could take out hundreds of millions of dollars in dividends every year while retaining all the equity in it. Thus my fear is that their share sale represents a lack of confidence in its future.

Any investor with self-preservation instincts would call DKW's bluff and walk away from this game.

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