Interesting Pairs Trade: Churchill Downs (Short), Penn National (Long)

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 |  Includes: BYD, CHDN, DDE, LVS, MGM, PENN, PNK
by: Valuentum

Our Valuation of the Gaming Industry

Overall, we think the gaming industry is fairly valued at this time. The industry's market cap is trading between 80% and 120% of our estimate of its fair value based on our DCF process. However, we do think an interesting pairs trade exists between Churchill Downs (NASDAQ:CHDN) and Penn National (NASDAQ:PENN), two constituents we cover.

We use a firm-specific ValueRisk™ measure to determine whether a firm is undervalued or overvalued based on our DCF process, but we consider an industry to be undervalued if it is trading below 80% of our estimate of its fair value and overvalued if it is trading at over 120% of our estimate of its fair value. We think these fair value ranges are appropriate given the diversification benefits of holding a basket of stocks.

Although we point to Penn National as an interesting long opportunity within the space, we don't find the industry as a whole attractive based solely on valuation. On the other hand, we view Churchill Downs as significantly overvalued and a good short candidate at these levels. In fact, we are currently evaluating opening up a put position in Churchill Downs in our Best Ideas Newsletter.

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Source: Valuentum Securities, Inc.

Boyd Gaming (NYSE:BYD)

Fair Value: $5 per share

We think Boyd Gaming's shares are worth between $3 and $8 each. The wide margin of safety around our fair value estimate is driven by the firm's VERY HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $5 per share represents a price-to-earnings (P/E) ratio of about 42.2 times last year's earnings and an implied EV/EBITDA multiple of about 8.9 times last year's EBITDA.

We forecast a compound annual revenue growth rate of 2.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.3%. We assume an average operating margin of 8.2% during the next five years, which is below Boyd Gaming's trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will fall steadily at an annual pace of 2% for the next 15 years but grow 3% in perpetuity. For Boyd Gaming, we employ a 7.9% weighted average cost of capital to discount future free cash flows.

Churchill Downs

Fair Value: $28 per share

Our discounted cash flow model indicates that Churchill Downs' shares are worth between $20 and $36 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $28 per share represents a price-to-earnings (P/E) ratio of about 22.4 times last year's earnings and an implied EV/EBITDA multiple of about 8.1 times last year's EBITDA.

We forecast a compound annual revenue growth rate of 7.2% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 12.5%. We project a 5-year projected average operating margin of 10.5%, which is above Churchill Downs' trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of about 4% for the next 15 years and 3% in perpetuity. For Churchill Downs, our model uses a 9.4% weighted average cost of capital to discount future free cash flows.

Dover Downs (NYSE:DDE)

Fair Value: $4 per share

We think Dover Downs' shares are worth between $2 and $6 each. The relatively large margin of safety around our fair value estimate is driven by the firm's VERY HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $4 per share represents a price-to-earnings (P/E) ratio of about 18.7 times last year's earnings and an implied EV/EBITDA multiple of about 7 times last year's EBITDA.

Our model reflects a compound annual revenue growth rate of 3.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -0.6%. Our model reflects a 5-year projected average operating margin of 6.9%, which is below Dover Downs' trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 5.3% for the next 15 years and 3% in perpetuity. We use a 7.6% weighted average cost of capital to discount future free cash flows.

Las Vegas Sands (NYSE:LVS)

Fair Value: $39 per share

Our discounted cash flow model indicates that Las Vegas Sands' shares are worth between $26 and $52 each. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $39 per share represents a price-to-earnings (P/E) ratio of about 51.5 times last year's earnings and an implied EV/EBITDA multiple of about 18.9 times last year's EBITDA.

Our model reflects a compound annual revenue growth rate of 18.3% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 32.4%. Our model reflects a 5-year projected average operating margin of 23.8%, which is above Las Vegas Sands' trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 7.4% for the next 15 years and 3% in perpetuity. For Las Vegas Sands, our model uses a 10.6% weighted average cost of capital to discount future free cash flows.

MGM Resorts (NYSE:MGM)

Fair Value: $11 per share

Our discounted cash flow model indicates that MGM Resorts' shares are worth between $7 and $15 each. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. Our fair value estimate is $11 per share. We project a compound annual revenue growth rate of 15.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -7.8%. Our model reflects a 5-year projected average operating margin of 9.8%, which is above MGM Resorts' trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 8.7% for the next 15 years and 3% in perpetuity. We employ an 8.4% weighted average cost of capital to discount future free cash flows.

Penn National

Fair Value: $50 per share

We think Penn National's shares are worth between $35 and $65 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $50 per share represents an implied EV/EBITDA multiple of about 9.9 times last year's EBITDA.

Our model reflects a compound annual revenue growth rate of 7.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 0.3%. We project an average operating margin of 14.1% during the next five years, which is below Penn National's trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 1.7% for the next 15 years and 3% in perpetuity. For Penn National, we use a 8.6% weighted average cost of capital to discount future free cash flows.

Pinnacle Entertainment (NASDAQ:PNK)

Fair Value: $10 per share

Our discounted cash flow model indicates that Pinnacle Entertainment's shares are worth between $7 and $14 each. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $10 per share represents an implied EV/EBITDA multiple of about 7.8 times last year's EBITDA.

Our model reflects a compound annual revenue growth rate of 5.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 5.9%. Our model reflects a 5-year projected average operating margin of 11%, which is above Pinnacle Entertainment's trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 5.4% for the next 15 years and 3% in perpetuity. For Pinnacle Entertainment, our model uses a 8.9% weighted average cost of capital to discount future free cash flows.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.