Before you get too excited, realize that we’ve been here before. Several gambling stocks – notably Caesars Entertainment (CZR), which rose 60 percent in two days – jumped earlier this month on news that New Jersey Governor Chris Christie had issued a “conditional veto” of an iGaming bill in the state. Christie’s terms were quickly gauged as acceptable to the Legislature, leading to hopes that a new bill could be passed as soon as Tuesday.
This isn’t the first time gambling stocks have jumped based on iGaming hopes. In my very first column on this site, I noted that the short-term gains created by the late December 2011 Department of Justice opinion on the 1961 Wire Act had quickly dissipated. Indeed, many of the gainers in the wake of the New Jersey announcement would similarly retreat. Shares of Zynga (ZNGA) gained eleven percent, but have fallen back to previous levels; Boyd Gaming (BYD) – owner of 50% of Atlantic City’s Borgata – gained 9.5 percent, but now trades below where it closed the day before Christie’s veto. (For its part, bwin.Party Digital Entertainment (BPTY.L), which owns 65% of a US iGaming joint venture with Boyd and MGM Resorts International (MGM), has kept most of its 20 percent gains.)
These jumps are not necessarily surprising; stocks like Caesars and Boyd – due to their high debt loads – and Zynga – due to its still-unproven business model – are speculative stocks, and right now there is nothing more speculative than iGaming. To be sure, the New Jersey agreement would be big news; it would triple the population now exposed to legalized, regulated online gambling in the US, with much smaller states Nevada and Delaware already on board. Its legalization of a full suite of games, including banked games such as craps and blackjack, expands the market significantly relative to a poker-only bill. And the requirement that any operator own a physical casino in Atlantic City limits the competitive pool, and gives an edge to Caesars – which owns four different properties in New Jersey – and Boyd, whose Borgata is the largest and usually best-reviewed poker room in the city. H2 Gambling Capital told eGamingReview it projected a regulated New Jersey iGaming market would create $410 million in revenue in its first year, with the figure rising to $590 million five years later. At last week’s iGaming North America Conference, Deutsche Bank analyst Andrew Zarnett (9) said his firm estimated annual revenue at $250 million, while fellow panelist David Berman of Macquarie Capital went higher at $500 million, and moderator Steve Rittvo estimated the annual win at $600 million.
All that said, the retreats of the stocks aren’t all that surprising, either. Clearly, the “smart money” – in other words, deep-pocketed traders – are selling short any iGaming-induced rallies. Both CZR and BYD saw huge spikes in volume – the amount of shares traded in a day – on the New Jersey news, and both saw lower, but still well above-average, trading activity in the days following, as the stocks declined and short-sellers moved in. The logic is simple: those investors who believe most passionately in the potential for iGaming will buy on the news, leaving lower, and weaker, demand in the days following, usually leading to a lower share price.
From a longer-term perspective, the retreats still make some sense, as the financial benefit from iGaming is not quite as clear as the math first suggests. In Europe, EBITDA (earnings before interest, taxes, depreciation, and amortization) margins range from 20% at 888 Holdings (888.L) to 25% at bwin.Party to 30% at Betsson AB (BETSB.SS). Using an estimated EBITDA margin of 25%, and H2’s figure of $410 million, total pre-tax profit in the state would come in around $100 million in the first year, meaning a New Jersey regulated market could potentially create about $1 billion in additional market value for its participants. For Caesars, a solid piece of that market could materially affect a stock whose current market capitalization is about $1.45 billion; but the data also belies the incredible two-day jump the stock saw earlier this month, in which its market value rose by a staggering $680 million.
But even the addition of market value doesn’t occur in a vacuum; there are additional concerns. The first is taxation; Christie’s veto contained a suggestion for a 15 percent gaming tax, in additional to standard corporate taxes. For Caesars and Boyd, the tax issue is minimized because their corporate entities have been and likely will continue to report net losses; but should, for example, Caesars Interactive be spun off to evade the parent’s company’s crushing debt load, that separate company could see an effective tax rate of around 50 percent by the time state and federal corporate taxes are added in.
There’s also the issue of partnerships, and competition; that $1 billion is not going exclusively to one participant. Caesars and 888 will split their profits in some form; bwin.Party is taking 65% of its joint venture, leaving just 15% for Boyd and 25% for MGM if that company can re-enter the New Jersey market though its own share of the Borgata. And they won’t be the only players in the market; with the “bad actors” clause in the New Jersey bill re-written and its purchase of the Atlantic Club casino in New Jersey pending, poker behemoth PokerStars looks set to become a viable competitor. (That company is, of course, privately held, so any profits it makes will be unavailable to investors.) Beyond the properties of the aforementioned companies, there remain six casinos in Atlantic City; one, the Trump Plaza, was just sold for only $20 million, with its CEO saying he remains open to selling the company’s other property, the Trump Taj Mahal. With other smaller owners including Landry’s Restaurants (the Golden Nugget), and whoever takes the Revel out of bankruptcy, there is no doubt room for Zynga (ZNGA) or an experienced European iGaming operator to create a partnership – or simply buy a casino – and enter the market as well. Increased competition means increased marketing and player acquisition costs, and the intrastate requirements imposed by the 1961 Wire Act interpretation also mean that each entrant to the New Jersey market must build and maintain entirely new and costly servers within New Jersey (according to the bill, the servers must actually be physically located in Atlantic County, which includes AC.)
The most important question is whether iGaming will augment, or cannibalize, the revenues of the land-based casinos such as Caesars properties Caesars Atlantic City and Bally’s. Proponents of iGaming argue that the ability to use loyalty programs and comps to cross-market between legacy brick-and-mortar customers and (theoretically) new iGaming consumers, boosting both player pools. Skeptics argue that much of the revenues gained from online gambling will come from consumers who will simply play slots at home, rather than expanding their gambling budgets to fit both types of play. The question is a key one, particularly for a company like Caesars. According to the company’s third quarter results (2012 results are released today), the company is on track to create about $1.8 billion in net revenue in its Atlantic City region. This region includes Harrah’s Philadelphia, which according to the Pennsylvania Gaming Control Board generated about $343 million in gambling revenue in fiscal 2012. That property has no hotel, so we can estimate Caesars’ Atlantic City revenue at about $1.4-$1.5 billion in 2012.
And here’s the catch. Casinos have huge fixed costs – most notably, the cost of paying off the loans to build the facilities and the high annual cost of maintaining them. Incremental revenue – the last few customers through the door – are therefore hugely important. If a casino is break-even on December 30th, and does $1 million worth of revenue on December 31st, it will likely make $700,000 or $800,00 for the year. Once the building costs are paid for, the lights kept on, the air conditioning running, and the slot machines paid for, the cost to take care of a gambler is very small, and the profits from that gambler become very large. (This is amplified in the case of casinos with hotels; the daily cost of having a hotel room occupied versus unoccupied is on the level of a few dollars a day, versus the $50-200 charged by most casino properties.) This explains why gambling companies become such volatile investments (and such common candidates for bankruptcy or other restructuring). The leverage created by high fixed costs mean that very small changes in revenues – on the order of 10 or 15 percent – can create substantial swings between profit and loss. Indeed, in last year’s S-1 filing with the Securities and Exchange Commission ahead of its initial public offering, Caesars noted that a mere $5 increase in spending per trip by non-lodging guests to Atlantic City would increase annual profits by $15 million.
Of course, the reverse may be almost as true; moderate declines in spending can have severe bottom-line effects, as everyone in Atlantic City knows, given its continually plunging revenue. To its credit, Caesars has managed the revenue decline and managed to keep profit from falling sharply, largely through lower property taxes and cost-savings initiatives. But this can’t last forever, and if iGaming cannibalization exists, it could be a tipping point for Caesars’ land-based operations. If we assume that cannibalization costs Caesars just 5% of revenue in Atlantic City, it would create a roughly $70 million decline in and of itself. (Worth noting: Harrah’s Philly is excluded from these calculations, but it no doubt generates customers from southwest New Jersey, just across the Delaware River, and would like face a small impact as well.) If cost-savings initiatives begin to run out of juice, that decline could easily cost $20, $30, or even $40 million in pre-tax profit, essentially wiping out the gains due to Caesars from iGaming even if it grabs 25 or 30 percent of that market. And even if iGaming gains do outstrip land-based losses, the net effect on the company’s earnings profile will become smaller, as it will any gains in its stock price.
The larger point here is that the bull case made by excited iGaming investors, centered on the fact that online gambling is seemingly “lucrative” and “inevitable,” is just far too simplistic. There are real concerns here, ranging from competitive aspects to regulatory and tax issues to the overall effect on the gambling business as a whole. It’s simply way too early for anyone, no matter how well-educated or well-connected, to be making accurate guesses as to how the US online gambling industry will evolve; where it will succeed; and who will be the winners – and losers – along the way. By the same token, it’s too early to place any real amount of money behind those guesses. There’s nothing wrong with investors waiting a while to see how things play out and get a little more information. For proof, all investors need to do is look at companies in the space. The companies who moved first, and aggressively, into social and online gaming – IGT with its purchases of Entraction and Double Down Interactive, Caesars’ $200 million buy of Playtika – wound up overpaying, to the point that IGT CEO Patti Hart may lose her job over it. Companies that avoided the 2011-12 euphoria about social gaming avoided those outlays; while IGT spent $500 million on Double Down, bwin.Party is spending one-tenth that much to develop a social gaming strategy in-house, in large part because it felt the prices paid by IGT and Caesars had, in a matter of months, already proven to be too high.
Investors may have the same opportunity to buy lower. Once the New Jersey bill is signed, and its sports betting lawsuit decided, iGaming may fade from the news for a time. With little momentum apparent in other states, online gambling may become “out of sight and out of mind,” and lose its ability to support stocks like Caesars, Boyd, bwin.Party, and Zynga. At that point, those stocks may be cheaper; and we may even know a little bit more about how the complicated, messy US iGaming industry will finally play out. Until then, there seems likely to be a lot of volatility, and lot of noise. That might work well for traders, but for investors, patience with iGaming seems very likely to be a strong virtue indeed.
