OREANDA-NEWS. Strong competition and weaker operating margins for betting shops, as well as a heavy tax and regulatory burden and high capex requirements, will drive a major rationalisation of the betting industry in Europe, Fitch Ratings says.

The recent proposed Ladbrokes/Gala Coral and Paddy Power/Betfair mergers are the starting points in this process, which should result in generally improved credit profiles and more resilient business models in the medium term for the emerging groups as synergies and cost cutting programmes take effect. Deals are unlikely to be debt-funded, given the existing debt profile of the sector, and in some cases may be accompanied by fresh equity injections, as we have recently seen ahead of the proposed Ladbrokes/Gala Coral merger.

The EMEA gaming market is very competitive, with over-the-counter business in UK betting shops particularly hard hit. The competitive pressures will only accelerate as online and app betting take bigger market shares and we therefore expect the number of operators and physical outlets to drop significantly in the next three to five years.

The drive to merge is also the result of new tax and regulatory challenges. For example, in the UK the introduction of a GBP50 'marker' on machine gaming, prompting punters to review their machine spend, is likely to reduce gross win for betting groups by up to 5%. Governments' desire to raise revenue and cut spending will also hit operating margins. The UK has increased its tax on gaming machine profits from 20% to 25%, while in Italy the state is cutting the fees paid to gaming concessions.

Merged gaming companies should be able to offset the impact of increased taxes and regulation by reducing their cost base through improved IT systems, greater economies of scale and more efficient labour policies. There may however be execution risks linked to different cultures, particularly where older traditional bricks and mortar betting groups merge with young online companies.

We believe that the transition from physical outlets to online betting will continue the need for heavy and prolonged capex investment in gaming platforms and software. As the life of games shortens due to increased customer expectations, the level of capex as a percentage of sales may be higher than historically. This is already the case with sportsbook betting, which is taking business away from more traditional betting forms, such as horse racing. An attractive sportsbook offer, however, requires large and continual capex, allowing real time and complex and varied betting packages. If these investments fail to translate into stronger profit and cash flow they could act as another driver for consolidation.

This higher capex could be at least partially offset by lower lease costs as companies close physical outlets, although this may take time to feed through and companies that have signed long leases could see a spike in costs if they decide to buy themselves out of some of those agreements.