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The House Always Wins – Investors, Not So Much

The House Always Wins – Investors, Not So Much

September 06, 2023

Casinos tend to bring out the animal spirits in people – Ferraris in the front drive, bright lights and bells going off, George Clooney and Brad Pitt walking past security, the list goes on. Considering the house always wins, investing in the house seems like a can’t lose endeavor. Unfortunately, operating a casino is considerably less sexy than what’s portrayed on TV and in movies – and less profitable. Let’s explore why.

The sobering truth is that casinos are effectively insurance agencies with lights, cocktails and a hotel attached to them. The house can lose on any wager made by a player, just as an insurance company can be subject to a claim from any policyholder. Both entities also set the odds. Casino oddsmakers set slot machine payout percentages, sportsbook lines, you name it. Insurance company actuaries set premiums based on the risk characteristics of policyholders. The more players the casino has the more the distribution of results falls to the average spread for each game. Given that this is profitable, the house always has an edge. Let’s check the performance of the larger operators to see how the chips stack up.1

Over time, casinos tend to lag the performance of the S&P 500. Penn Entertainment spiked during the pandemic by becoming a “meme” stock on internet message boards and subsequently fell after the fervor subsided. Notably, Caesars Entertainment is not on this list as they filed for bankruptcy in 2015 and have since recapitalized and realigned their business. Let’s turn to my preferred measure – Return on Invested Capital (ROIC) – to see if long-term returns on capital can explain this lag.2

Helpful as always, the ROIC’s of the casinos fluctuate around the 3-7 % range with cyclicality in the business that accentuates losses. In general, the inability to keep up with a required return of equity in the high single digits means that incremental financing is required from debt that has a lower cost of capital. Let’s see if debt levels from these firms have increased over the years.3

 Almost like clockwork, these companies have utilized leverage over the years to fund additional capital expenditures and buoy themselves in times of economic stress since it’s a more cyclical industry segment. As I’ve mentioned in previous posts, debt use isn’t necessarily bad, but if it doesn’t provide stable economic returns, it will be disastrous when the company needs capital in the future. Operating without a suitable spread to the cost of capital could be perilous if the business needs to roll that debt over at higher rates.

Odds Are a Pure Commodity

Traditionally, the main competitive advantage for any casino was location and other amenities. Due to the increasing ability to gamble online, those advantages are slowly fading in importance. Casinos must increasingly compete and offer more favorable bets to players, which lowers the edge for the casino and the margin they can earn on each bet.

For example, in online sports betting, if one casino offers +300 on the Bears winning and another offers +350 on the same bet, a player would obviously choose the +350, all else equal. This lowers margins for casinos over a wide pool of bets since they must match other offerings. Casinos can offer higher payout parlays that have more of a house edge, but the principle remains the same for other casinos that can simply mirror that odds offering if they wish. There are no sustaining differentiators in this regard which eliminate the possibility of sustained economic returns.

A Relative Bet

All of this isn’t to say that an investment in a casino stock is never warranted. There may be times in cyclical lows that make a casino stock’s price relatively attractive on a rebound in travel or broader economic activity. The leverage that casinos also tend to employ would further boost this comeback return. Industry changes such as the proliferation of online betting may lower relative ongoing capital expenditure needs as well. The jury is still out on these shifts, however.

Summary

This exercise illustrates my view that over a prolonged period, casinos as an industry haven’t demonstrated an ability to offer above average returns on capital and as a result have lagged in performance. A company’s ROIC is the investor’s “house edge” (though I abhor the comparison of Wall Street to a casino), and casino equities have historically offered investors nearly the same edge as their table games.

Postscript – A Real Longshot

Most people know that craps and blackjack have the best player odds in the casino with a house edge of roughly 0.5-1%. Keno has the worst odds with a house edge of 25-30%. Even more astounding, the odds of selecting all 20 Keno numbers perfectly (pick 20 random numbers from 1 to 80, and then 20 numbers are randomly selected) are 1 in 3.5 quintillion. You would win the Mega Millions about 11 times before you ever hit a pick all 20 Keno bet!

Dean Schwefel, CFA®
Senior Investment Analyst

SOURCES:
1. YCharts. Total Returns of SPY, LVS, WYNN, PENN, MGM (Jan. 2005-8/10/23)
2. YCharts. ROIC of LVS, WYNN, PENN, & MGM (Jan. 2005-8/10/23)
3. YCharts. Total Long-Term Debt of LVS, WYNN, PENN & MGM (Jan. 2005-8/11/23)

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