Quick Take on CRYP

Enlightened American examines the numbers on Cryptologic (CRYP), but I thought a strategic snapshot might be worth considering.

Cryptologic's business appears to be comprised of two segments. First, CRYP operates an online gambling business. Second, CRYP contracts to provide software support to competitors' online gambling businesses.

The first business is heavily regulated in the United States wherever it is not absolutely illegal, which at the moment seems to be the case (in law you often can't be sure), but the market remains potentially enormous in other jurisdictions. In Asia, for example, gambling is a huge business -- though whether gambling outside the view of onlookers has the same attraction, one might not know. I assume that there are plenty of people who would happily gamble without the risk of public humiliation, and without the expense of travel or the risk of being mugged for winnings. However, doing an Internet business barred from the United States seems like launching a medical product that cannot be marketed in the United States: it better work extremely well, considering the handicap it faces. Perhaps cards and dice translate easily enough to make this work less problematically than I'd fear.

The second business, though it seems more straightforward, is actually more difficult. To achieve large and growing long-term income in this business, it appears that Cryptologic must obtain -- and retain -- the business of its direct competitors. If partnership with Cryptologic succeeds, the growing competitor has a strong incentive to increase its margins by taking the back-end of its gambling operations in-house. The logic in operating a gambling game isn't somehow irreplaceable; software to perform particular transaction algorithms (like dealing poker to a varying number of players who bet real or virtual funds) represents a commodity. Given the growth in low-cost offshore application programming, I'd think that any revenue stream based on financial success (say, transaction volume) rather than uptime would tend to motivate customers to own their code as soon as growth allowed. I would expect Cryptologic's gambling-house customers to use Cryptologic as a bootstrap into operations, and either to fail or to outgrow Cryptologic as a supplier. I would fear this second business would merely enable competitors to incubate new business without the up-font cost of custom software development.

What is Cryptologic's moat? Has Cryptologic got anything that can't be readily duplicated?

I would want to know how Cryptologic expects to grow either business before becoming even slightly interested in investing. In the first business, it will be beset by competitors -- some of which may have regional cultural advantages in attractive target markets -- and in the second it appears to be offering a commodity service to direct competitors.

Am I missing something?

The Enlightened American's big investment question is whether CRYP can plausibly return to profit levels enjoyed before the U.S. banned its business. I think this is precisely the kind of question that leaves me cold on CRYP: gambling is heavily regulated and there's little reason for confidence that even pro-gambling jurisdictions want gambling done online when there's more economic impact within the jurisdiction from in-person gambling. Whether the issue is Kentucky horse tracks, Nevada slots, Atlantic City cards, or Baden-Baden's high-stakes post-spa betting venues (where locals are not allowed to gamble, just the tourists), governments have some incentive for predisposition toward in-person gambling. Maybe remote islands with little enterprise than financial institutions feel differently, but areas with broad-based enterprise could easily decide they have more to worry about money laundering (crime? terrorism?) than they have to gain from online gambling (which they aren't likely to tax successfully unless the casino is physically located within their jurisdiction). Given the potential for discriminatory pro-local electronic gambling legislation to land a country in strange legal problems under trade treaties, it's easier for jurisdictions which don't need online gambling to ban it altogether -- even if (and particularly if) in-person gambling is a source of lawful and taxable revenues.

With this in mind, I'm not sure what information about prior revenues or the growth of the market really means for security of the investment. In the meantime I'll stick to a company with a sustainable competitive advantage, like Apple or American Capital, whose industries' trend toward growing global acceptance.