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Investing The Hard Way: Investment Lessons From G2E

TAGs: AGA, bally technologies, Editorial, g2e 2013, Global Gaming Expo, international game technology, MGM Resorts, Nevada, Patti Hart, ramesh srinivasan, reed exhibitions, Vince Martin

The gambling industry’s largest conference, the Global Gaming Expo, took place last week in Las Vegas. With a massive exhibit hall, multiple sessions on all aspects of the industry, and executives and thought leaders from around the world, G2E is simply the most interesting and informative gambling conference, bar none. (You can see  our complete coverage here.) 

While there was much to learn about the gambling industry, the conference also provided some interesting lessons for gambling stocks. Among them:

The gambling business is really hard. 

Investing The Hard Way: Investment Lessons From G2E

[img courtesy of G2E Facebook]

Sessions at G2E were filled with words such as “uncertainty,” “challenges,” and “unknown.” Whether the speakers were representatives of gambling operators, or suppliers, or Wall Street analysts, there was a remarkable sense of caution toward the future of the industry, and a number of still-unanswered questions. Will US iGaming expand past its three current markets any time soon? How will regulated online gambling impact land-based casinos? Can land-based casinos begin to capture under-35 or under-40 customers, who are used to having more technology in their palm of their hand than currently exists on most casino floors?

But from an investment standpoint, the caution is somewhat welcome. When Bally Technologies (BYI) CEO Ramesh Srinivasan advocates for careful, ‘sober’ investment in new technologies, including iGaming, shareholders should be relieved. The management of publicly traded companies are charged, first and foremost, with protecting shareholders’ hard-won capital; as such, a certain amount of level-headedness should be welcome by investors in the sector.

And from a valuation standpoint, there is a counterintuitive benefit to that type of skepticism. Rising sectors and markets are often described as climbing a “wall of worry”; when there are real fears in the market, contrarian logic usually says, that’s the best time to buy. It’s when the entire market is screaming, “Buy, buy, buy!” that prices are often set to tumble. See the “dot-com bubble” of 1999-2000, or real estate in the mid-2000’s, or, to a lesser extent, some iGaming-fueled gains in gambling stocks over the past two years.

In short, the industry’s caution of late should be of comfort to investors. But the many challenges facing the industry mean investors should maintain some caution of their own, and realize just how difficult earnings, revenue, and share price growth might be going forward.

No company better showed the difficulty of the business this week than International Game Technology (IGT), led by CEO Patti Hart. Hart came under fire last year from a number of observers – myself included – and eventually faced a proxy fight that threatened her job at the company. But IGT fought off activist investor Jason Ader – eventually ceding only a single seat on the company’s board – and, as I wrote a week ago, watched its share price rise to a three-year-high.

The momentum seemed to continue at G2E. On Tuesday, the company unveiled a new logo and announced a massive order for video poker machines from Caesars Entertainment (CZR). The company’s new Avatar game, unveiled at the conference, drew rave reviews from this site and was named the “Best Slot Product” at G2E by Global Gaming Business. No doubt, Hart and her fellow executives felt pretty good leaving the conference.

Things changed quickly on Friday, however. On Friday morning, Deutsche Bank analyst Carlo Santarelli downgraded IGT shares to Hold, and IGT shares fell nearly 7 percent. Using a similar argument to mine from just a week ago, Santarelli argued that the company’s increasing dividend and share repurchases were largely “priced in,” while decreasing yield from the company’s gaming operations would make earnings growth difficult going forward. Adding insult to injury, just a few hours later Hart was interviewed on Bloomberg television; at the end of the segment she faced questions about her resignation from the board at Yahoo! (YHOO) after accusations that she had inflated her resume. That ‘scandal’ had occurred some eighteen months ago, and Hart seemed somewhat surprised, and miffed, that it had resurfaced. But to be fair to interviewer Cory Johnson, Hart’s repeated non-answers – on Friday, she stated multiple times that “I stand behind my credentials,” yet failed to explain how the resume changed, appearing to place blame on what she referred to as “the Internet world” – are part of the reason questions are still being asked. The business is difficult enough; perhaps Hart should consider not making it tougher.

Online gambling is far from a slam dunk. 

Given G2E’s bent toward existing behemoths – land-based operators such as Caesars and MGM Resorts and Entertainment (MGM) and their suppliers such as Bally and IGT – it’s not surprising to see some skepticism – even trepidation – toward regulated US iGaming at the conference. The tone was in marked contrast to the iGaming North America conferences of the last two years, where in 2012, not long after the Department of Justice opinion that re-interpreted the 1961 Wire Act, speakers were estimating a US iGaming market of $12 to $20 billion per year. (The industry obviously remains well below those figures, even assuming above-average revenue in the New Jersey and Delaware markets in 2014.)

Rather, most speakers at this year’s G2E likened the legalization of online gambling to a new entrant to a saturated market: it might work to grow overall gambling revenue, but it could also have a deleterious effect on existing operators. Gambling consultant Randall Fine – until this week a member of the marketing team at Atlantic City’s Revel – argued that iGaming in New Jersey would be “catastrophically dilutive” for the state’s land-based casinos. Indeed, it’s not hard to see the logic of Fine’s argument. If online gambling means a 10 percent decrease in visitation to Atlantic City, it could easily cause a 12-15 percent decrease in gambling revenue, as (theoretically) many of AC’s most profitable customers, the ones most oriented toward visiting the city simply for gambling, choose to stay home and use their gambling budgets online. That decrease, however, given the operating leverage of the land-based casino’s business model, would only be matched by a corresponding decrease in costs of 3-5 percent. So that small drop in revenue could eliminate most, if not all, of the pre-tax profits that many Atlantic City casinos are generating. With overall revenue in that market continuing a precipitous decline, it’s not impossible to imagine AC operators – particularly the laggards in the market – becoming essentially “zombie casinos.” Management would then attempt solely to mitigate losses at the land-based casinos in order to maintain the licenses that support the potentially profitable iGaming businesses.

For an example, look at the 2012 results from Caesars. The company is the dominant operator in Atlantic City, with four properties in the city. In 2012, its Atlantic City region (which also includes Harrah’s Philadelphia, whose impact from iGaming would be mitigated by the fact that most of its customers are from Pennsylvania, with a likely substantial minority from southern New Jersey) generated $1.68 billion in revenues, down 8.6 percent from 2011. Its total Property EBITDA (earnings before interest, taxes, depreciation, and amortization) was $265.6 million, down 4.5 percent from the year prior. That decline accelerated in the first half of 2013, with revenues down nearly 12 percent year-over-year and EBITDA down 16.6 percent.

Assume, then, that legalized online gambling in New Jersey knocks down revenue another 10 percent on its own. All told, including the natural revenue declines from the increased competition in the region, Caesars would see a revenue drop of roughly 20 percent from its 2012 levels – a $300 million decline. But costs simply will not drop as fast – perhaps in the range of 10 percent. After all, the buildings still need to be maintained, utilities still need to be paid, and management and licensing costs remain largely unaffected. In this scenario, Caesars’ pre-tax income in its Atlantic City region goes from $266 million to about $100 million – a 62 percent decline. And, at that point, is it really worth it for Caesars to pay interest on the debt associated with those casinos, or upgrade its facilities, or even repair a broken escalator? And, again, Caesars is a dominant operator in the city: what of the Atlantic Club, or the Golden Nugget, two of the city’s smallest operators in terms of market share?

You should buy shares in US casino operators hand over fist. Or you should sell them as quickly as you can. Wait, definitely buy. No, sell. 

I’m being somewhat facetious, obviously, but there were moments at the conference where US gambling companies seemed headed for new all-time highs, and others where they seemed destined for a mass bankruptcy. On Wednesday, Union Gaming analyst Bill Lerner pointed out that room supply on the Las Vegas Strip had barely budged. Should visitation levels increase at even modest rates, that would allow casinos to both increase occupancy and boost pricing power, allowing the figure known as REVPAR (revenue per available room) to increase strongly. And, as Lerner noted, those increases would be almost pure profit; a room that would have otherwise sat empty, but is now sold for $100, results in $85-90 going straight to the pre-tax bottom line since the marginal cost of housekeeping and, perhaps, running the heater or air conditioner for a night is so small. With MGM, in particular, improving its balance sheet and paying down debt, its current losses could quickly and forcefully swing to a profit, driving its shares up significantly. 

Of course, in the same session, Deutsche Bank analyst Andrew Zarnett asked a simple, but provocative question: with growth in the US regional market largely stagnant, why are US companies proposing billion-dollar projects in markets such as Maryland and Massachusetts? Among the companies aiming to build those ambitious complexes is none other than MGM, most notably in its proposed design for a casino near Washington, D.C. 

The issue is the operating leverage I discussed two weeks ago on this site: small moves in revenue can have massive consequences in terms of earnings for casino operators, particularly those with high debt levels such as MGM and Caesars. It’s why shares in the sector have been so volatile, and part of why I have been consistently wrong in gauging US operators, particularly those in regional markets. And it’s why the casino business is so fascinating, and why G2E is such an important event. 

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