DOJ Opinion Will Promote Further Divergence In Casino Stocks, Hurt Smaller Operators

by: Vince Martin

Gaming stocks jumped on Tuesday after the Department of Justice released an opinion last Friday after the market close, which many observers saw as the first step toward legalization of online gambling in the United States.

The opinion does not legalize gambling en masse, nor does it affect the 2006 Unlawful Internet Gambling Enforcement Act (UIGEA), the cause for the Black Friday shutdown of offshore poker sites earlier this year. But experts feel that state-run lotteries and online gaming, which had been traditionally defined by the DOJ as illegal under the 1961 Wire Act clarified on Friday afternoon, may now legally proceed. Given the massive pressure on state budgets, it seems likely that some of the 48 US states with some type of legalized gambling (Utah and Hawaii being the two exceptions) may move forward with online gaming.

Several casino operators have already made preparations for online gaming. Senate Majority Leader Harry Reid (D-NV), pushed for a national legalization bill late last year, which many felt was payback for the industry's strong support in a tough 2010 re-election campaign. Just before "Black Friday," Wynn Resorts (NASDAQ:WYNN) had partnered with PokerStars to push for legalization of online poker and, ostensibly, plan for a Wynn-branded or associated product targeted to American consumers in the future. That partnership ended less than three weeks later, when PokerStars was shut down by the US Attorney in Manhattan. In late October, MGM Resorts (NYSE:MGM) and Boyd Gaming (NYSE:BYD) formed a joint venture with Digital Entertainment, a publicly traded European online gaming company. Both brands pledged to create sites with their brands, utilizing's existing technical infrastructure, should poker be legalized in the US. And Caesars Entertainment has already struck a deal with 888 Holdings, another European gaming outfit, with their collaboration awaiting US legalization.

As Roth Capital Research analyst Todd Ellers pointed out Tuesday (per Barron's):

Casino operators with strong brands (i.e. Caesars, MGM, Las Vegas Sands (NYSE:LVS), & Wynn) would also benefit from operating virtual casinos if authorized by enough states.

(It's worth pointing out that LVS CEO Sheldon Adelson has come out strongly against online gaming, arguing that legalization could lead to a wave of underage gambling. Yet, should such a bill be passed, the possibility exists that LVS would dive in anyhow. For now, it does seem that at best it will be playing catch-up, which likely explains why LVS lagged WYNN, Caesars, MGM, and BYD in Tuesday's trading.)

Potential online gaming could be a boon for these companies, which could leverage their well-known brands -- Caesars' Rio, the home of the World Series of Poker; MGM's Bellagio; Wynn's stylish Wynn and Encore properties -- into instant appeal and cachet in the American online gaming market. The potential of the market is huge. Realize that, in 2006, when the midnight passage of the UIGEA -- attached, unbeknownst to most observers, to the SAFE Ports Act -- knocked European operators out of American online poker -- and only poker -- those companies lost a combined $7 billion in market capitalization in one day. PartyGaming co-founder Anurag Dikshit was the 207th richest person in the world in 2006, based solely on his 29% stake in the company. A successful entrance into that market could be lucrative and accretive, even for behemoths such as Wynn ($14B market cap) or MGM ($5B market cap).

Of course, online gaming would provide more competition for existing "bricks-and-mortar" casinos, which may hurt the industry, and, in particular, its smaller operators. Companies like Pinnacle Entertainment (NYSE:PNK) and Isle of Capri (NASDAQ:ISLE), whose operations lie outside the traditional gaming hotbeds of Las Vegas, and Atlantic City, may see potential customers forego the drive and simply play keno, poker, or blackjack in the comfort and privacy of their living rooms. Without the strong brand appeal of their larger competitors, these operators would seem to lack the ability to make profitable entrances into online gaming, when and if it arrives.

Should it arrive in the US, legalized online gaming will only deepen the existing divide between the industry's major operators and its smaller, regional players. WYNN, LVS, and MGM have a key advantage over smaller rivals such as Pinnacle, Isle of Capri, and Penn National (NASDAQ:PENN): a presence on the Chinese island of Macau. In its 2011 review of the worldwide gaming market, PriceWaterhouseCoopers projected that gaming revenue growth will grow 5 percent annually in the US between now and 2015, compared with 18.3 percent growth in Asia, led by booming demand in Macau. Gaming revenue in Macau jumped 57.8% in 2010 alone, while staying flat in the US from 2006 to 2010, with only moderate growth expected for 2011. On its third quarter conference call, Wynn Resorts CFO Matt Maddox boasted of the future for growth in Macau:

Harry, our opinion is, I think Macau is probably in the third or fourth inning of development. And if you look at what's going on in Cotai, there's continued to be excess demand for the current supply. In fact, if you try to book a room at Wynn Macau on any weekend between now and the end of the year, it would be almost impossible. So if you look at it today, I think this era could easily support a Wynn Cotai property. And 5 years from now, we think that the market has continued growth underneath it.

Wynn is not alone in their optimism; Fitch Ratings upgraded the company's debt in July, based primarily on Fitch's projections for revenue growth and profits in the market. (The stock hit a 52-week high that day, and continued to rise, but has actually given back some 30% since then.) Indeed, Wynn Macau accounted for 78% of the company's net income in the third quarter. LVS and MGM have posted similarly impressive figures from their Macau properties -- adjusted cash flow from MGM Macau was up 80% year-over-year in the most recent quarter, according to the MGM conference call.

There are some worries about the continued pace of growth in Macau -- any struggles in the mainland Chinese economy will likely impact revenue growth -- but the island remains an opportunity for tremendous growth in a region already accounting for substantial profits for its US-based operators. On the other hand, the US market is showing little signs of growth, hurt by economic headwinds and drastically expanding competition. 39 states now authorize casinos on private and/or Indian land, as Massachusetts authorized four sites earlier this year. As noted earlier, revenue has remained flat since 2006, despite the addition of four new states for gambling, and several dozen new casinos nationwide. No city better shows the potential cannibalization of gaming revenue better than Atlantic City. Once the only destination on the East Coast, it was initially hurt by the development of Foxwoods and Mohegan Sun in Connecticut, which pulled away New York City-area customers. But the city is now surrounded, as Delaware, Pennsylvania, Maryland, and New York, have authorized and/or expanded casino operations, aiming to capture customers who previously traveled to the shore. Revenue has dropped in Atlantic City for 38 consecutive months, and PWC expects 2015 gaming revenue to be off nearly half compared to 2006 levels, despite the addition of the $2.4 billion Revel casino next year. Such a drastic drop in revenue can be fatal to casino operators, whose often-high leverage magnifies the impact of even minor sales decreases. (Simply ask Donald Trump, whose Atlantic City operations have gone bankrupt twice.) A similar fate may befall other locations, as state governments desperate for tax revenue expand gaming beyond the market's demand. Casinos in Indiana may be crushed by a proposed casino in downtown Chicago. Connecticut tribal casinos Foxwoods and Mohegan Sun have defaulted on, and restructured, their debt, respectively, amidst gaming expansion in surrounding states, and face further competition from proposed Massachusetts gaming outfits. Delaware casinos are begging the state government for tax relief, threatening layoffs if no deal can be reached.

The possibility of casino-branded online gaming may only serve to exacerbate the issues facing many regional casinos, and add to the disparity between the two tiers of US casino operators. On the top tier are Las Vegas Sands, Wynn, Caesars (who may refile for an IPO in 2012) and MGM. Growth possibilities in Asia and the possibility of online gaming give it a chance at significant near-term earnings expansion. Granted, current valuations seem a bit high -- Wynn has a P/E of 26, and LVS over 30, while MGM is struggling under a heavy debt load -- for value investors. Yet the potential in Macau and online makes the three stocks at least worth a look for risk-tolerant and/or growth-seeking investors.

In the second tier are the regional operators: Penn National, Pinnacle, Ameristar Casinos (NASDAQ:ASCA) and Isle of Capri. Facing economic headwinds and potential market competition, if not saturation in certain locations, the possibility of top-line growth seems slim. Given the sometimes onerous tax requirements negotiated by state legislators before approving casino projects, and the political difficulty -- if not impossibility -- of layoffs and cost-cutting, margin improvements to shore up the bottom line seem challenging as well. Given those issues, none of three stocks look like solid investments, and all three are definite short possibilities.

Penn National, in particular, could see significant pressure as its Pennsylvania, Illinois, and West Virginia properties face new competition from newly approved projects in Chicago, and Baltimore. The stock is trading at 17 times forward adjusted earnings yet has shown no revenue growth and weak cash flow over the last four years. Granted, the company has improved its cash generation this year -- levered cash flow (defined as free cash flow less interest payments) is $150 million through three quarters -- but between 2007 and 2009 the company did not generate enough cash to cover capital expenditures and the interest on its debt. In 2010, Penn cleared just $10 million. Even this year's improvement seems hardly impressive enough to justify a $3 billion market capitalization. The stock has been on a strong surge as of late, but potential resistance around the $40/share point may make an interesting entry point for PENN bears.

Pinnacle Entertainment's properties in Louisiana, and St. Louis, would seem to face lesser competition worries, at least in the near-term, yet its debt load -- 2.4 times equity -- could cause problems should broader economic troubles persist here in the US. The company has posted negative free cash flow every year from 2007-2010, and has funded its operations and expansion through the issuance of over $400 million in debt during the last five years. Capital expenditures should ease going forward, as the company's Baton Rouge project comes online next summer, but operating cash flow has decreased and revenue grown slowly, despite the company's acquisitions, developments, and expansions at existing properties. The company's current ratio of 0.95 as of the third quarter shows the slim margin for error at PNK. The stock is already down 26% year-to-date, and, like PENN, on an upswing, which may provide an entry point in the near-term for a short.

Ameristar's seven properties, like Pinnacle's, appear to sit in established, and stable, markets. Its heavy debt load -- nearly $2 billion, for a leverage ratio of 5.15:1 -- seems unwieldy, at best. Yet the company pays a dividend -- currently yielding 2.3% -- and is repurchasing some 12% of its common stock outstanding. The company has cut capital expenditures dramatically, creating $330 million -- over half of its market capitalization -- in free cash flow over the last seven quarters, and is coming off a record-breaking third quarter. In addition, the stock is trading at just 10 times consensus 2011 adjusted earnings.

But while ASCA looks stronger than its second-tier competitors, the debt burden remains a difficult hurdle. Free cash flow has been impressive -- but half of its has gone to pay off interest on debt, which has grown another $400 million year-to-date. The decisions to return capital to shareholders through dividends and buybacks -- totaling over $90 million this year -- seems curious given the capital-intensive nature of the business. As capex slows going forward, Ameristar should be profitable. Yet shareholders must wonder how much cash will be left for them once the company begins to deleverage. And any further weakness in the economy -- especially in the company's still-fragile markets such as St. Louis, Kansas City, and Mississippi -- could hurt the bottom lines and cause debt covenant issues. Ameristar has some promise, but the high debt load may cause some problems.

Isle of Capri may be the weakest stock of the group, as it will struggle with both sets of problems facing its regional competitors. The company's three Mississippi properties are facing one of the nation's most stagnant casino markets. Its casinos in Natchez and Lake Charles, Louisiana, will soon face competition from Pinnacle's new venture in Baton Rouge. And three of its four Iowa locations sit on the Mississippi River across from Illinois, where existing casinos are already facing cannibalization worries, and awaiting the aforementioned development in central Chicago. (The company mentioned the new casino in Des Plaines, IL, as a factor in weakness at its Davenport property in its most recent earnings report.) All told, 8 of the company's 15 casinos face significant near-term challenges to their revenue stream.

In addition, the company's balance sheet is precarious, at best. Total debt is $1.2 billion, nearly four times shareholder equity and over six times the company's market capitalization of $184 billion. Free cash flow from fiscal years 2009 through 2011 (ending April) were barely enough to cover interest payments on the debt, while capital expenditures will continue on pace through at least the current year, as new projects outside St. Louis, and in southwestern Pennsylvania, are developed. Earnings were negative for the first half of FY2012, and revenue was down slightly year over year. (Flooding in Mississippi did impact the company's take in several casinos, but revenue growth in the unaffected locations was still just over 2%.)

The stock has dropped over 50% year to date (though it has stabilized over the last couple of months), so the trade may have been missed. Yet the challenges facing the company and its onerous debt load mean more downside may be yet to come. The combination of economic weakness in its Southern properties and expanding competition up North would seem to spell trouble for ISLE. Its shareholders can at least take solace in the fact that it's not alone.

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