Online Gaming in the U.S., Pt. I: History Lessons

So, do you feel like reading another article debating if, when and how online gaming will come to the U.S. market?

Yeah, me neither. So, let’s be clear from the start: This is not one of those articles.

But because many U.S. companies have little experience and familiarity with online gaming, many people in the bricks-and-mortar casino world are likewise unfamiliar with the opportunities, the technology and the revenues possible.

First, a little background.

The global online games market, at a little more than 10 years old, is already worth about $4 billion to $7 billion. It is expected to be worth $30 billion in the next five years, according to recent reports.1 Online casinos in the U.K. alone generate about $1.5 billion (U.S.).

Now, no one knows the future when it comes to online gaming and the U.S., but what we can do is examine historical precedents, past and present technology trends in the macro, and do some solid analysis on how to prepare for—and benefit from—emerging change.

To perhaps put an even finer point on it, in many ways it doesn’t matter what happens in the U.S. The toothpaste is already out of the tube.

The Europeans, among others, are gaining valuable experience and building their infrastructure, and have been doing so for years. And most of them will continue to live comfortable lives regardless of whether a tribal casino in South Dakota, a major state east of the Rockies, or a Congress in Washington, D.C., ever gets its act together.

A common saying heard in the land-based casino world is, “No one wants to be IBM; everyone wants to be Microsoft.” Meaning, due to cost and complexity, most in the gaming industry would prefer to be content-oriented instead of hardware-oriented.

But with online gaming emerging as a major economic and social force around the globe, the question is no longer, “Who will be the next Microsoft of gaming?” The important question is, “Who will be the Google or Facebook of gaming?”

Love it or hate it, online gaming is a reality. So maybe the real question is, “How best can the traditional land-based market deal with this reality?”

Online gaming has been a reality for a number of years. Regulated or unregulated, approved or unapproved, anyone with an Internet connection can spin the reels with online slots, compete in online poker tournaments and bet on sporting events around the globe. And while there are a variety of technologies designed to block players in non-approved jurisdictions like the U.S., even a tech-savvy fifth-grader could get around those restrictions.

So, we’ve established online gaming is here, most likely to stay. But how important is this emerging market?

Well, it looks like it’s pretty darn important. Every possible economic indicator shows quite clearly that it is popular, profitable and growing. In fact, it is one of the few sectors of the gaming industry that has grown consistently through the current economic downturn. In 2008 alone, the year that saw the eye of the financial hurricane come ashore, online casinos and other gaming sites earned a record estimated $20 billion.

Or, umm, something like that. The truth is, many gaming experts and investment firms don’t know exactly how much the online gaming industry makes. “There still aren’t a lot of publicly reporting companies out there, relative to the size of the industry as a whole,” explained Bob Schuijt, a veteran online game distributor based in Boca Raton, Fla. “What we do know is that we all seem to be doing quite well.”

Other analysts foresee online betting to continue to grow at a breakneck pace. Even if the U.S. economy shrinks further. Even if the global economy remains weak. And even if the U.S. never opens its doors to online gaming.

“We’re really nowhere near market saturation or maturity, as far as I can tell,” Schuijt noted. And as someone who spends a chunk of each day interacting with the online casinos and operators, he’s probably in a good position to know.

So the natural questions are, “What makes online gambling tick even in dire economic conditions?” and “How did we get here?”

To get an idea of the answers, it’s important to understand a bit about the history of online gaming. But don’t worry. In an industry where the veterans are rarely over 40 years old, and where anyone with half-a-dozen years of experience is considered a village elder, this history lesson shouldn’t be too long or complex.

So, what exactly constitutes online gaming? The answer is, well, everything. By and large, the online gaming world offers everything that traditional land-based casinos do. That means card games, table games, slots, roulette, sports books and a variety of mutations.

Today, online casinos generally offer odds and payback percentages that are comparable to land-based casinos and poker rooms. Due to their lack of bricks-and-mortar real estate costs, some online casinos can advertise higher payback percentages for slot machine games and more attractive odds at their sports books.

But things weren’t always so neat and tidy. The years 1996 through 2002 were something of a Wild West period for the online gaming industry. It, along with everything else on the Internet, was brand new. During that time, tech-savvy entrepreneurs were forging a new road.

“Back in the early days, you could just put up a website, do some custom games on a server in your garage, and money just poured in,” Schuijt said. (A bright-eyed tech-enthusiast himself, he wrote his MBA thesis on online gaming around that time.) “In those earlier days, there were really no accepted tech or gaming protocols, and no professional management. And a lot of ‘colorful characters’ were in charge of the sector. And even with all that … it was still wildly profitable.”

As time and technology rolled on, more pressure started to be applied from the land-based U.S. operators to officially outlaw online gaming in America. The general feeling both then and now was that this was primarily an economic issue. So, in 2006, Congress passed a law that outlawed the processing of payments for gambling, effectively forcing it offshore in the U.S.

Which, of course, is not nearly the same thing as actually eliminating it.

But let’s step back from the gaming industry for a moment and look at the bigger picture of entertainment, technology and commerce.

As it happens, gaming isn’t the first sector to face this kind of change. It has very interesting parallels between America’s reaction to online gaming and the course of action followed by the major record labels in response to early music file-sharing services like Napster.

Unfortunately, the recording industry has become the veritable poster child for what a doctor might diagnose as The Worst Possible Way to Respond to a Changing Landscape Disease. Seriously, MBA grad students are probably writing thesis papers with this exact title right now.

Music, MP3s, and the Internet all converged in 1999 in the form of Napster. Napster was an open-source file-sharing network that allowed people to download perfect copies of songs at the click of a button.

Rather than accepting the reality of the situation, the RIAA (the Recording Industry Association of America) and industry backers instead attacked the then-nascent file-sharing services. They sued the pants off of Napster in 2000.

Instead of embracing this incredible new development in technology and the new social trends toward distributed, digital entertainment and content management—and finding ways to profit from it—the recording industry first and foremost feared it. And sought to legislate away the unpleasant reality.

That proved to be a strategy of roughly the same business sophistication as, say, holding your breath until you turn blue. Reality has a pesky tendency to still be there when you wake up in the morning, whether you like it or not.

At the end of the day, the technological music genie was out of the bottle. Legislating against this fact was, predictably, ineffective. And soon the entire world of content and entertainment had to deal with it. Instead of going away, the music genie soon evolved into a movie genie, a software genie, and an all-purpose-everything-that-can-be-converted-to-digital-format genie.

Today, the recording industry has yet to recover from being on the wrong side of technology and history. And, at this point, there’s no reason to believe the recording industry will ever recover, or at least not to its prior glory.

Of course, even during the dawning age of online music, a number of observers pointed out the fallacious assumptions the record labels were making. These observers suggested that the right thing to do was to stop cursing the darkness and light a candle. You know, wake up and smell the MP3 coffee.

Which is to say, come to an arrangement with the new technology and the new services. And better yet, find a business model to satisfy what music consumers so clearly wanted: easy digital music downloads.

Unfortunately for the recoding industry, it chose to continue to burry its head in the sand, and actually moved ahead with what is possibly the least PR-friendly business tactic in the history of carbon-based life: suing its own customer base.

But, eventually, technology, emerging markets and belated common-sense all had a nice sit-down dinner at the table of reality (catered by Apple, which, between 2002 and 2010, has served up more than 260 million iPod entrées).

Revenue today from the iPod and iTunes is probably worth something like $500 million net, per year, to Apple alone. Maybe more. And certainly much more to the industry as a whole.

So, not shockingly, it seems that a cooperate-and-embrace-change approach has worked out for everyone’s benefit—and certainly more so than the sue-your-own-customers approach. Even the old record labels managed to benefit. In fact, many major record labels today generate much of their annual revenue from the very thing they fought: digital downloading.

This sideways jaunt down corporate memory lane should make one thing above all others clear: The gaming industry is coming upon its own inflection point. It’s the point where technology and social trends are clearly moving in a particular direction. The question faced by the bricks-and-mortar side of the industry in the U.S. is equally clear: Does the sector want to deal with the new reality, and take steps to profit from it … or does it want to deny it, just because it’s new and different?

This might sound like a big problem. And it is. But it’s an even bigger opportunity. To go back to our music analogy, despite plummeting CD sales for the last 15 or so years, the amount of money consumers actually spend on entertainment has stayed stable for the last hundred years.2 Possibly it has even grown, according to some recent Harvard research3 and statistics from the U.S. Department of Labor.

The money is out there, and people are spending it. They just aren’t spending it the old-fashioned way. So, while total entertainment spending may not really have changed (with or without the advent of a Napster), the share of spending that any particular entertainment industry subset receives definitely does fluctuate over time.

Spending on recorded music has, in fact, taken up a wide range of U.S. gross domestic product over the last 90 years. The invention of the LP and the CD caused a long and dramatic upturn in music spending. But before that, a deep and dramatic downturn came in the 1920s—thanks to the invention of the radio.

Most likely, statistics will sooner or later reflect something similar in the gaming industry.

The fact that prerecorded music today accounts for a smaller-than-average fraction of entertainment spending today implies that the right products and services simply aren’t reaching mainstream America in the way consumers want.

Hopefully, the bricks-and-mortar gaming industry will not be yet another entertainment sector that ignores the desires of the general public, fails to embrace new technology and trends, and therefore falls into what seems to be an otherwise inevitable trap.

Does online gaming eat away at a customer base that would otherwise spend time at a traditional land-based casino? Some studies indicate that they are actually fundamentally different markets and demographics.

The truth is, no one really knows yet whether they are all the same market. But historically speaking, it’s probably not a good idea to bet on it.

Right now, some major U.S. gambling operators, suppliers and casino brands are investigating their online future. A few, like IGT and Harrah’s, are already taking the first serious steps by acquiring or developing the technology, games and marketing savvy to compete for this new and lucrative frontier.

Stay tuned. Things are just starting to get interesting.