Gambling is defined as wagering money (or something else of value) on an event with an uncertain outcome. The primary aim of gambling is to win more than the amount wagered. To place a gambling bet, you need to have three things: consideration, chance, and a prize. Casinos are the most obvious venue for gambling but not the only place gambling takes place. There are online poker sites and sports betting sites, Super Bowl office pools, Lotto, and quite a few other non-site specific ways in which to place wagers.
Insurance is a very specific type of gambling. Yes, it is a means of protecting the insured party from some kind of financial loss. And yes, it is also a risk management tool used to hedge against a contingent, uncertain loss. But insurance is also very clearly gambling. Two parties agree on the consideration (by calling that wager a premium instead), the type of chance (by using expectations of when the insured might die, for example), and a prize (by referring to the winnings as a death benefit). It's a consolation prize for the beneficiaries but a prize nonetheless.
I am by no means the first person to make this connection - some already consider it such common wisdom at this point that it's become a cliché to them. But if you are one of those folks who don't see it that way, the notion that insurance is gambling would be more obvious to you if, the next time you bought an insurance policy, you paid for it in a setting more representative of the transaction. For example, it would help if you bought your policy at an insurance parlor which included drinks brought to you by a semi-clad waitress, amidst the faint odor of stale Lucky cigarette smoke, with a pirate show outside for the kids, more R-rated entertainment inside, and a luxury hotel room upstairs where you can crash at 4 a.m. Your insurance agent should be staring at you indifferently, rake in hand, and shuffling insurance documents for you to execute. After signing, you could leave town with several secrets to keep from your spouse. Any of this beats getting cornered at a cocktail party by an insurance rep who won't stop yammering at you about how important it is to protect your home, life, limbs, kids, and future compensation.
I understand that may be asking too much from insurance companies, a financial services specialty group which very much wants its customers never to make those kinds of comparisons. Yet, if you thought that the connection between these two gambling businesses would lead to cross coverage by sell-side analysts, well, dear friend, you thought wrong. I've compared company research coverage lists within both sectors and not run across a single senior analyst at any reputable Wall Street firm legitimately covering both types of companies.
Then, it dawned on me. What would happen if securities analysts really took the gambling connection between casino operators and insurance companies seriously? How would they compare the different types of gambling operations these two types of companies manage? On what basis would they compare their operations, profitability, or the quality of their respective managements? What about the relative returns to their equity and debt investors? What would they conclude? At the risk of being the pioneer with all sorts of arrows in his back, I am going to attempt to do just that. Someday, you may proudly say 'I was there at the creation' - I'd rather not specify what the alternative comment might be as I am sure I'll be seeing it in the comment thread below.
Comparing Operating Metrics and Returns. From an operational and profitability perspective, leading gaming and insurance companies couldn't be more different, despite the bets they're accepting. Putting it in gambling terms, casino companies are more like high rollers, and insurance companies are more similar to those grandmas you see in Vegas spending all Tuesday at a one-armed bandit with a bucket of chips. Let's make some explicit financial comparisons. To do this, I've taken a representative group of gaming companies and a representative group of insurance companies and looked at their financial statements and key metrics.
I started by pulling together summary consolidated financial data from seven leading global gaming companies - Caesars (CZR), Galaxy Entertainment (OTCPK:GXYEF), Las Vegas Sands (LVS), Melco Resorts (MLCO), MGM Resorts International (MGM), SJM Holdings (OTCPK:SJMHF), and Wynn Resorts (WYNN). What matters is not the absolute size of these companies' consolidated revenue, operating income, EBITDA, or cash from operations. It's the year-over-year growth rate of revenue, comparative levels for Adjusted EBITDA margin, cash from operations as a percentage of revenue, ROA, ROE, leverage, and interest coverage statistics. I've italicized those items within the table.
Here are a few takeaways from the summary table below. First, during the past five years, revenue growth at the major casino operators dropped off a cliff and only began a recovery last year. Second, Adjusted EBITDA margin trended upward within a range of 21.5% to 25.6%. Frankly, part of that is due to an increasing emphasis by the gaming companies on non-gaming, higher margin entertainment (and food). Third, the major operators increased capex in response to drooping top lines, yet they were still able to improve cash flow from operations. Fourth, while Return on Assets faltered (lower net income, higher asset bases), Return on Equity began to bounce back by the end of FY'16. Fifth, total debt as a percentage of total capital also spiked back up in FY'16. Last, I excluded the non-US listed gaming companies for purposes of the interest coverage calculation as the numbers from Galaxy and SJM would distort the ratio significantly upward - the major U.S. gaming companies are basically flat over the five-year period at about 5x leverage:
Note that the metrics used for judging the casino operators are the more general metrics used in sector reports rather than more granular metrics like casino win, table drop, slot machine count, room revenue, etc. Those are all highly useful in analyzing individual casino companies and comparing them to other casino companies. In this case, what's needed are the kind of metrics that will permit comparison between casino companies and non-casino companies. You have to go one level up. You swap many nuanced details for a chunk of comparability.
I ran a similar five-year analysis of the operating metrics and returns for four leading life insurance companies: Lincoln Financial (LNC), MetLife (MET), Principal Financial Group (PFG), and Prudential Financial (PRU), In this case, I used insurance sector metrics that are not so sector-specific that they would prevent me from making comparisons to non-insurance sector companies. So, while they are not exactly the same as those used for the casino companies in the table above, most of them are analogous to those metrics as they provide a means to assess the growth rate of revenues, stability of margins, and the relative size of returns, leverage, and coverage.
I took two different looks at operating margin at the insurance companies using two different metrics. First, the ratio of Operating Income to Net Premiums Earned where the Operating Income in the numerator is equal to total revenue - insurance claims - underwriting costs - other operating expenses. The other operating margin metric I show in the table is Operating ROE. This measures a company's operating profits in relation to the money its shareholders invested in the firm. It's just the annual operating income - realized gain or loss in the investment portfolio divided by the average amount of common equity during the period. The result, multiplied by 100, provides the percentage Operating ROE.
The results are summarized in the table below. As in the case of the leading casino companies, there are several observations to take away from this sample group of leading insurance companies' metrics and trends. First, after a roaring start, net premiums earned - the main component of total revenue - has dwindled toward 1-2% type year-over-year growth. In addition, net investment income at the insurance companies has scarcely kept pace with either debt or equity markets. By way of comparison, the Bloomberg Barclays U.S. Universal Total Return Index for bonds averaged 2.1% each year while the S&P 500 was up 14.3% per annum. Here, you are looking at an average annual increase in NII of 1.5%. Total revenue growth at the insurance companies beats the pattern at the casino operators, most of whom would like to forget the outright revenue declines they experienced in 2015. On the other hand, neither set of companies would want to continue running at low single digit growth rates:
With respect to margins at the insurers, as shown in the preceding table, Operating Income to Net Premiums Earned rose above 30% and then fell back just below it during the period. One might compare that trend to the generally rising operating margins at the casino operators, even if the calculation of the specific metrics is not directly comparable. More directly comparable are the ROA and ROE figures. In general, the insurance companies have much lower ROA and ROE because of the huge amount of capital needed to fund the business. More striking is the pattern: ROA and ROE for the insurance group ran up and then down while the casino companies' ROA and ROE has bounced around quite a bit more, albeit at higher levels. Much of that volatility has to do with the reorganization of CZR, but even without that, returns at the casino companies would be more volatile. There's a huge difference in returns from steadily hiring more insurance reps versus opening up a new entertainment complex every other year.
Last, there's no doubt which of these two groups is less leveraged. The insurance companies' total debt runs about 30% of total capital while the gaming companies average about 55%. In addition, interest coverage is generally higher at the selected insurance companies (6.2x fixed charge coverage on average) than at the leading gaming companies (5.5x EBITDA to interest coverage on average). Again, it's the pattern I'm mostly interested in for purposes of this comparison, and what I see is declining leverage and increasing coverage at the insurance carriers versus a more variable but level pattern in those two metrics at the casino operators.
Comparing Managements. Candidly, I didn't start out thinking I would write up a report comparing insurance companies to gaming companies. I was initially looking to find out which CEOs receive the most compensation while their companies have produced the worst operating results. It was only by happenstance that I noticed and then connected two things. What I first saw was that the worst pay for performance offenders are in the insurance sector. After observing this, I wanted to know whether there were any other sectors with similar characteristics that might also demonstrate that pattern, namely, high CEO pay combined with poor operating performance. It was only after making that second inquiry that I began to think about the connection between running an insurance company and running a gaming company. Would gaming company CEOs also be consistently overpaid based on the operating results for their companies? I wondered whether companies within either sector had stock prices or bond prices that were either under-performing or out-performing their relevant securities markets. In other words, has the effectiveness of management mattered to investors any more than operating performance or return metrics?
To get at the first question about CEO compensation and operational performance, I used a Bloomberg pay-for-performance comparison study. The study measures the ratio of an executive's awarded pay last year to his or her company's three-year average Economic Profit. The lower an executive's awarded pay is as a fraction of operating performance, the higher that executive ranks. Without lulling you to sleep, here are a few more details you'll need to better understand how this ranking system works. First, the Awarded Pay in the numerator consists of the executive's total compensation (salary, bonus, stocks, options, pension awards - basically, all the cash and non-cash remuneration paid to the CEO). Second, the denominator uses the subject company's three-year average Economic Profit (if positive). Economic Profit in a given year is Net Operating Profit After Tax (or NOPAT) minus a Capital Charge based on the Investment Capital used to fund the company. Investment Capital includes all equity and debt and off-balance sheet sources of funding the company's operations, and the Capital Charge is just the Investment Capital multiplied by the company's Weighted Average Cost of Capital. Third, the executive's Reported Pay is added back to Economic Profit to arrive at an Adjusted Economic Profit. Reported Pay for an executive is disclosed in the "Total" column of a company's summary compensation table, which lists awards at the grant-date fair value. The SEC mandates its disclosure from most U.S. companies, and it's a standardized calculation. Finally, if average Economic Profit was negative for the past three years, the executive's ranking in the study is based on how negative the average Adjusted Economic Profit was for the past three years.
An example always helps. In this case, we'll start with the lowest ranked CEO in the study, and given the topic areas covered by this report, you should not be surprised that an insurance company executive wins the dubious distinction of being worst on the pay-for-performance scale. Last year, MetLife Inc. awarded its CEO Steven Kandarian $21.5 million. Of that figure, $5.5 million was cash and the $15.0 million balance was non-cash. On the other hand, with respect to operating performance, while MET's NOPAT improved over the last three years under Kandarian, the Investment Capital it needed to fund its business stayed high, and that kept the implied WACC-related Capital Charges up. Hence, the calculated denominator stayed deeply negative. MET's three-year average Adjusted Economic Profit less Kandarian's $21.5 million pay package results in a negative $62,197 million. And, that places Kandarian at the very bottom of the pay-for-performance pile:
MetLife is far from the only insurance company which appears to have a grossly overpaid CEO. In fact, insurance company CEOs dominate the bottom of the survey results, occupying seven of the 10 worst CEO pay-for-performance slots. The other six are the CEOs of Hartford Financial Services (HIG), PRU, American International Group (AIG), Voya Financial (VOYA), LNC, and PFG. Again, much of that is a function of the survey's emphasis on implied Capital Charges. CEOs of companies engaged in the more entertaining version of gambling don't generally require billions of Investment Capital and, therefore, don't incur high Capital Charges, even if their WACC tends to be higher.
The worst pay-for-performance in the casino space belongs to Mitch Garber at Caesars Acquisition Co. (CACQ). Technically, Garber received much higher compensation than Kandarian, telling Bloomberg News, "I looked at my tax stub, the number even surprised me" - but, of the $91 million awarded to Garber in 2016, $89 million came from cashing out an equity stake in Caesar's Interactive Entertainment. Garber worked on a deal to sell CACQ's Playtika online games unit to a Chinese consortium led by Alibaba Group Holding Ltd. (BABA) chairman Jack Ma for $4.4 billion. The deal was announced in July 2016 but took until September 23 to finalize. The sale of Playtika also helped Caesars Entertainment Corp. avoid bankruptcy. Caesars Interactive Entertainment is owned by Caesars Growth Partners LLC, a JV between Caesars Entertainment's main operating unit, Caesars Entertainment Operating Co. Inc., and Garber's company CACQ. CZR has been shifting good assets into CACQ and debt into Caesars Entertainment Operating Co. In January 2015, Caesars Entertainment Operating Co. filed for bankruptcy with $18 billion of debt. Days after the Playtika deal closed, CZR settled its bankruptcy with creditors, avoiding more expensive and lengthier litigation.
Back to pay-for-performance. Since CACQ doesn't require $800 billion or more Invested Capital every year to stay in business, even though NOPAT ran negative, Garber ranks well above Kandarian in terms of pay-for-performance. In fact, of the 1,032 executives in the survey, Garber ranks 258 steps away from Kandarian's position at the bottom of the list. There's a big difference between a pay-for-performance ranking where a CEO has a rolling three-year Adjusted Economic Profit of -$62.1 billion (Kandarian) and a rolling three-year Adjusted Economic Profit of -$267 million (Garber):
'So What,' You Say. Well, let's put it this way. By looking at the operating, profitability and CEO pay-for-performance metrics for two sets of companies with a similar underlying business but different success factors, we've learned a number of interesting things. For example, we can see that the insurers are relatively stodgy operators with low growth rates and margins. On the other hand, while the casino operators have generally provided higher rates of return on assets and equity, their leverage tends to be higher, their interest coverage tends to be thinner and, every now and again, they go bankrupt. In addition, while insurance company CEOs may run more financially docile entities, they look way overpaid relative to their companies' operating performance, mostly because they can't seem to use the vast amount of capital needed to fund their operations in an above average way. Both sets of companies share a common threat to their operations, namely, online gambling. The insurance companies would, in theory, be much more vulnerable to disruption via internet based competition than major casino companies with destination entertainment complexes.
Given these metrics and trends, if I was going to invest in a leading insurance company or a leading gaming company, on balance, I'd likely opt for the debt of the former and the equity of the latter. That doesn't mean I want to play in either space. It just means that in terms of the comparative analysis, that would be my initial inclination. From a credit perspective, the insurance companies we've looked at are simply more stable. When you compare spreads on their mostly investment grade rated bonds to the largely high yield rated gaming company bonds, you just don't get that much more by taking on higher turns of leverage and lesser interest coverage on gaming paper.
Let me give you an example, I selected the most widely traded senior unsecured notes issued by the four insurance companies discussed above and looked at their Z-spreads. The graph below shows that over the past six months, these Z-spreads have generally ranged between 100 and 150 basis points. The average for the four securities is 130 basis points, but keep in mind, this is just a small sample of securities drawn from leading global casino operators as opposed to regional, smaller gaming company bond issues:
I then took a look at certain selected gaming company loans and bonds syndicated or issued by LVS, MGM, and WYNN. I excluded the defaulted bonds of CZR (e.g., the Caesars Entertainment Operating Company 10 Second Lien Notes due 2018 trade flat with 178 days of unpaid accrued interest as of this writing). Instead, I used the LVS L+200 basis points Senior Secured 1st Lien Term Loan B due 2024 and the two of the larger, more frequently trade senior unsecured notes issued by MGM and WYNN. In the graph below, you can see that Z-spreads on these instruments are about 100 basis points wider than what you saw in the insurance company graph above, but they are also a good deal less stable than the sample insurance company Z-spreads.
If you absolutely, positively must have an extra 100 basis points, you can still get there by moving down the insurance companies' debt capital structures. For example, there are hybrid fixed-to-floating rate junior subordinated notes that have been issued by the insurance companies which are still investment grade rated and provide Z-spreads of around 200 basis points (or more). For example, the MET 5¼ Junior Subordinated Perpetuals flip from their fixed coupon to a floating rate in June 2020 and the PRU 5⅜ flip from their fixed coupon to a floating rate in May 2025.
From an equity perspective, regardless of the inclination to favor gaming equities over insurance equities based on the metrics discussed previously, it's hard to make a case for these particular casino stocks right now. They trade at an average blended forward P/E multiple of 25.1x and an average blended forward Enterprise Value to EBITDA multiple of 12.3x. By comparison, the S&P 500 Index is priced at blended forward P/E and EV/EBITDA multiples of 16.7x and 10.4x, respectively. However, over the past two years and five years, the casino group's multiples have been about the same as they are now (i.e., at a premium to the S&P 500).
Would I reverse course and buy into the common stocks of the insurance companies mentioned above? Hardly. And not just because there's little in the way of growth expectations or margin expansion. True, those equities are trading at an average blended forward P/E of 10.1x, and that's certainly below the S&P Index level, but it's spot on with the average P/E multiple for the group over the past two years and five years. In other words, if you think that gap in P/E valuations between the insurers and the broader equity market will close, you might want to rethink that assumption. Equity investors in the space haven't historically been willing to pay up for the kind of performance metrics - or CEO pay - that the insurance companies generate.
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This article was written by
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.