Logic: The art of thinking and reasoning in strict accordance with the limitations and incapacities of the human misunderstanding... - Ambrose Bierce (1842-1914)
As a longtime executive, consultant, investor, and journalist in the gaming sector, I have been continually bemused by the weight of analytics applied to gaming stocks. While valuable to provide perspective, in a broader, historical sense, they are limited. As the old Texas expression goes, "Weighing cattle isn't raising 'em."
The only stat I look for in this current market that, in my view, provides a solidly accurate measure of a gaming company's value is EV/EBITDA. To this I add my own metrics built off my analysis of the actual on-the-ground performance of the company, and more critically, the effectiveness of its management.
This metric produces a number, which most accurately reflects the ultimate reality: What's it worth to an acquirer? If the ratio is 10 or below, the value is deemed strong. If the ratio is above, you measure just how high over the "standard" it is and decide whether it's toppy, balanced or over-valued. Then make your play. From my perspective, gaming, like few other businesses, is most likely to show a ratio well above 10 - and with good reason.
1. EV/EBITDA. Gaming companies are clearly disproportionately larger carriers of debt. EBITDA numbers will always be somewhat tamped down by the "I" in EBITDA, i.e., a high outlay for debt service. Even with long maturities and reasonable rates, price resistance on the upside is often based on a company's heavy debt load. You need to look at gaming debt with a wider lens.
Short-term borrowings often reflect capex for expansions or property improvements that will produce income. Long-term debt is usually incurred to finance new property development, construction, and acquisition of competitors and/or expansion. Together they contribute to an Enterprise Value number that can get many investors who use the metric antsy. Yet, it's the kind of debt that history shows, is usually a producer of EBITDA going forward.
In a well-managed gaming operation these are all good things. The EV/EBITDA ratio to me is the gold standard to judge valuation of a company's shares linked to my own key metrics.
2. Due to its status as one of the most highly regulated of all industries, gaming is naked to the investing public as to the amounts of s revenue produced down to the single slot machine. This is a plus for investors willing to sift through the numbers to arrive at smarter decision making. Regulatory bodies produce enormously detailed monthly statistics on the performance of casinos.
Company reports contain easily calculable numbers for investors to measure performance. Example: You'll find total slot win divided by the number of slots, which yields an average win per machine. You can then measure that against industry peers in that market to determine which company's marketing is a superior producer of revenue. This applies to casino as well as hotel, where you can measure RevPAR by property, food and beverage revenue, entertainment, etc. Performance by denomination in slots, for example, is also publicly available and is always an excellent measure of management performance, and by extension, valuation of its shares.
Free cash flow, another gold standard in casino valuations, is directly linked to margins - another freely available stat anyone can access.
Gaming operators in the same marketplace, with largely the same product mix, facing the same existential market factors, who consistently produce bigger margins, are doing something right. That should be reflected in share prices as well but often is not because the overall outlook of that market may be undergoing headwinds.
That's the case in Macau. And it's shortsighted.
Capacity to withstand headwinds
It's not as widely understood as I think it should be, that casinos as an industry have demonstrated remarkable long-term resiliency in surviving historic trends and technological revolutions. I don't just mean merely staying afloat through recessions, but far more important to me, the longevity of the business in human history. For how long and to what degree have successive generations of consumers been willing to spend their money on a product or service offered by a given industry is the key.
Let's take a wide-angle look at longevity for a moment.
The gambling business in one form or another dates back to artifacts discovered from 2,300 BCE or farther. Archaeologists have unearthed dice and early forms of cards from many civilizations in Europe and Asia. References to gaming for money are peppered through ancient history and they are always accompanied by comment from those who saw it as sin as well as those who loved it as a basic form of diversion.
The first modern casinos as we know them appeared in Venice in 1635. At the very least that makes it a business at least 380 years old. And during this long history, they've experienced legalization, expansion and contraction and have always been accompanied by shadow, illegal counterparts where governments have looked the other way. What this tells us is that gaming, as a diversion, springs from deep wellsprings in the human psyche, and while hardly immune to economic law, persists and grows.
The fact is that gaming, shrinking as a percentage of the whole or not, remains the engine that drives the Las Vegas Strip train and the trains of casinos globally. There's 2,300 years of history to back up that contention.
Most recent estimates by Global Betting & Gaming Consultants put the total world gaming revenue at $450 billion for 2015 despite the dramatic downdraft in Macau (For context, the combined 2015 revenues of Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL) and Alibaba (NYSE:BABA) totaled $421 billion). The same report projects that gaming will reach $525 billion in global revenues by 2019. A company spokesman told CNBC that higher taxes, and a sluggish global economy could shave 1% to 1.5% off the total-largely due to Macau. But overall we believe the resilience of the industry has never been sounder despite economic and regulatory headwinds. Using our EV/EBITDA, win per unit stats, online growth numbers and historical patterns in mature gaming markets, we believe the GBGC report number is a good one. Casinos, the total number of which are severely limited by legal and regulatory barriers, will remain a stable, incrementally growing business despite these constraints.
So where's the growth coming from?
In the US, the American Gaming Association reports that in 2015 27% of all adult Americans visited a casino at least once, producing in total (commercial and tribal) $71 billion in revenues or 70 million visits. That number is produced by about 1,100 casino properties.
Project that number into China, for example. This year various estimates put the Macau GGR for 2016 coming in at anywhere between $28 and $31 billion. Over the next five years if transportation infrastructure improvements and a continuation of migrations to the middle class continue, Macau's penetration of China's 1.3 billion (est.) population even at 15% will have within their grasp a market of 300 million gaming customers or four times that of the US today. And that is why, despite the terrible, but narrowing declines yoy in Macau, developers there are taking a long view. The three new properties slated to add to supply by Wynn (NASDAQ:WYNN) in August, Las Vegas Sands (NYSE:LVS) in September and MGM (NYSE:MGM) early 2017 will bring the total casino number to 39 integrated resorts to share in that future.
Even given the vast disparity of average income and lack of transportation infrastructure still not on line, penetration of China's home market will continue to rise for Macau. We assume of course that the government will remain disinclined to legalize elsewhere. Governments like China can be unpredictable, as the industry learned to its woe since the great crackdown. So, in this world, there's no guarantee of anything. However, the odds are long. China wants to see a healthy, job-creating, well-regulated Macau continue as a special district as the mid-term report indicated. So betting on a recovery there appears to us to be a good long-term bet for investors. And given the valuations currently assigned to Macau's shares, we think they remain a strong play for long-term investors. The same applies to US-based gaming operators both regional and Las Vegas.
Here's how our key bundle of gaming shares have performed over the past six months factoring in pre-and post Brexit total market volatility:
Company price last six mos. EV/EBITDA (ttm)
Wynn 33.5% 16.95
Las Vegas Sands 0.7 11.32
MGM 2.4 12.36
Melco Crown (MPEL) -22.6 14.34
Boyd Gaming (NYSE:BYD) -3.7 10.25
Caesars (NASDAQ:CZR) -9.8 6.45
Clearly, there have been numerous individual factors impacting price movement and operating results of this basket of stocks. But one thing is clear: all of these companies share a common characteristic, their EV/EBITDA ratio is virtually a function of debt service cost worked into its EBITDA. Even though LVS and Boyd, for example, cling close to the 10 X standard, their debt loads are related to the same source: expansion and development. Both companies, particularly LVS are excellent margin producers.
At the same time, Wynn, which is the outlier in this example, commands the biggest premium despite a high ratio. That's driven by two factors: One, naturally the debt load directly associated with its soon-to-open Wynn Palace in Macau, and its commitments to its Wynn Everett property in Massachusetts scheduled to open late 2017, early 2018. This ratio will dramatically improve as we believe, when Wynn Palace opens and begins transforming debt into EBITDA.
The second, as we have often written on the pages of SA, is the "Steve Wynn premium", i.e. the value investors have historically placed on the unique creative propulsion given the shares by company Chairman Wynn. And it's been justified. Long-term believers in his companies have made tons of money on the shares and still are.
Caesars, as we know, is mired in the muddy waters of bankruptcy and litigation with its junior lenders and not likely to emerge as a clear, new entry any time soon. That's reflected in its EV/EBITDA ratio above. However, we must consider the circumstances that brought the company low were a combination of existential headwinds in the economy and mostly a string of bad decisions by the management and its private equity owners.
Conclusion: We believe investors and potential investors in gaming shares need to use a different mindset to value their decisions than that of most companies in other industries.
1. Apply the EV/EBITDA measure as the single most valuable tool you may have taking into consideration that if it is very high over the generally accepted standard, it most often is due to investment in brick and mortar assets that sooner or later will produce earnings.
2. Judge management by sets of data easily accessed from public sources. These are core operational statistics that reveal great clarity about the productivity of a gaming company's properties, marketing heft, competitiveness, margins and management quality.
3. Take a long-term view. This is an industry as we have pointed out with at least a 2,300 year history as part of basic human drives that has tended to withstand powerful headwinds from its opponents, regulators and the economic landscape. Yet, here it is, 2,000 years after Roman emperors like Augustus, were shooting craps to divert themselves from the woes of the empire, still generating revenue and in fact, growing.
Without doubt, this is not a business without warts. But its primary challenges do not, as many believe, an overhang of manageable debt, or a shrinking inclination among millennials to gamble. Pew Research has told us that demo tends to acquire the same leisure patterns as their elders as they mature. The single greatest challenge is saturation. This is because as we have seen in Atlantic City and other jurisdictions, when the scale of available gaming positions to available bodies gets out of whack, casinos suffer, decline, and go bankrupt, like any other business.
Yet, what tends to be overlooked in declining markets like AC is not so much who was forced to close, but who is still open. And here we are, almost nine years after the deluge of 2007 onward, and we still have a market where five casinos can generate $2b+ in revenue in spite of the flood tide of competition from nearby states.
Conclusion: I think a good hard look at the casino sector now is warranted using the metrics and caveats laid out here. If there's a recession, the companies have proven resilient and the ones who have used debt wisely and manage to good margins will prosper.
For all its presumed volatility, and knee jerk trading patterns, gaming stocks, shock shock, operate in the most stable of all entertainment related industries. We'd like to suggest a new paradigm for investors regarding casino stocks: Weigh standard valuation metrics in the light of a long history of the business, not quarter-to-quarter earnings, or even a single year's EBITDA. Decide to invest in gaming shares or sell them by employing a little extra research and self-education to satisfy yourself by concluding:
- The company's EV/EBITDA ratio is healthy or not.
- Understand that publicly-traded casino companies are not only required to report their operating results by the SEC and its equivalent bodies globally, but also to regulatory agencies. This makes available a rich lode of metric ore for investors because:
- Information by casino by state, by market is public, showing win per unit per day from slot machines and table games in comparison to peers. It's the best measure of management competence I know.
- Total drop/handle as an indicator of amounts wagered is likewise publicly available.
- Revenues from non-gaming service lines such as RevPAR are available in many jurisdictions were public gaming companies operate.
- Total visitation to a jurisdiction's casinos by month, year is likewise easily accessed.
- Evaluate levels of saturation in markets in which a company operates. The simplest way I know is to measure the rate of revenue growth in a market against the total number of gaming positions over time. Historically, capacity additions are generally absorbed growing the entire pie in underserved markets. When growth rates go flat as the number of gaming positions increase, you are looking at saturation taking its initial toll. More casinos are sharing the same pie. If a recession comes, discretionary income takes a hit as is all too obvious. If the economy rebounds, so will revenues as is also all too obvious.
But the often overlooked balance of gaming population to total available gaming positions in each market in which a company operates is key. Then I always average that by property against its peer group and have, what I believe, is a great metric to evaluate management's performance.
You derive that metric based on the percentage of the adult population that visits casinos in that market (available from the American Gaming Association's data base) laid against total aggregated revenue and come out with an average casino visit spend per head per year in that market.
What you are looking for is a balance. If supply and demand in a gaming market is in balance, you have a great, sustainable investment. If you see average spend decline and dilute over five years due to new supply, you have a market out of balance. Remember, like no other business, casino capacity is constrained by law and geography. You can't just stick casinos anywhere you like the demos as you would scatter thousands of Starbucks (NASDAQ:SBUX).
This is the case in Macau, for example. When measured by the revenue per head against feeder market population only, Macau takes a big hit from government crackdowns and regulations. But we know that the percentage of total China population with easy access to Macau is limited. By comparison, take the current penetration percentage of US casinos to population and apply it to Macau, i.e., over 90% of the population living within reasonable travel distance to a total of around 1,100 casinos.
Factor in the American Gaming Association's research showing that around 34% of the US adult population visited a casino at least once last year. The total China labor force is over 800 million as compared with 152 million in the US - this does not include retirees. This means the current scale of population to supply confined to Macau is nowhere near saturation if in theory the same 34% US participation rate was applied. And we know in China, it's much higher.
Even given the vast gap in average incomes between the US and China, that still yields a potential market of 272 million working adults plus retirees, let's call it a round 300 million. Of these, the middle class is the fastest-growing segment. In comparison, over 70 million Americans visited casinos last year generating about $71 billion in total win. So in theory, if and when transportation infrastructure improvements arrive in China, it's quite easy to conclude that Macau at present is undersupplied with 33 casinos and three more in the pipeline.
That's why despite the constantly picked over metrics many analysts sift through during this downdraft in Macau is severely limited in guiding investment decisions on its casino shares. On the surface, facing more supply in a weakened market translates to Macau share prices sitting where they are, trending lower or spiking now and then only on short-term news. That situation evokes puzzlement by many observers who can't understand how the three pipeline projects of Wynn, Las Vegas Sands and MGM are going to make money. Their conclusion is that Macau is facing oversupply. WRONG.
That view has short-run merit, but in terms of the long-term position, it's pure nonsense. And that explains why the three new entries mentioned are placing their bigger bets. The hard fact is that in the context of population, transportation and cultural inclination, they see an eventual active market base of a fat chunk of the 300 million souls with a choice of a single gaming venue.
It's highly unlikely at this stage for us to envision China legalizing gaming elsewhere. It could happen but it's a reach. That means Macau will enjoy a monopoly on gaming in a growth market for decades to come. Supply and demand will produce impressive EV/EBITDA numbers for participants in that market. Take that to the bank now.
So you should not buy casino shares entirely based on standard Wall Street performance metrics alone. Casino stocks are not like any other traded security. And casinos are not like any other business.
About the author: Howard Jay Klein is a former c-level casino executive, a consultant to that industry and is the author of Mastering the Art of Casino Management. He is the publisher of the SA marketplace site The House Edge. His own gaming portfolio is held in a blind trust to avoid conflict of interest with clients past, present and future.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.