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End of the World As We Know It

How long can the casino industry grow, and where?

End of the World As We Know It

Question: Are we nearing the end of growth in the casino industry?

If so, what are the investment implications?

The end of growth seems to be divided into two mass geographies: the United States and the rest of the world.

It has become common to discuss whether certain regions of the U.S. have reached saturation, always with the proviso that some veins of gold remain untapped, such as Georgia, the city of Chicago, or the motherlode of Texas.

That thesis appears likely. Certainly, nobody’s going to open half a dozen casinos in Atlantic City, and while New York state could add several casinos around the Big Apple, they’re likely to get much of their business by cannibalizing casinos in New Jersey, Pennsylvania and Connecticut.

This new environment is already playing out in many jurisdictions, with new properties often doing more cannibalizing than growing of their markets.

Even adding a new casino here or there just adds earnings in increments. It’s hard to find needle-movers in the U.S.

So where is the growth, and growing returns, for casino investors? As with other mature industries, growth is coming in nibbles, from mergers, by financial engineering, and in returning capital to shareholders.

Here are some of the areas:

• Modifying the business model. Casinos are evolving into entertainment centers where people increasingly can spend money on lots of forms of entertainment outside the gaming floor—shopping, dining and shows are old standbys. They long ago evolved along the Las Vegas Strip into becoming profit centers. Now that focus is moving to regional casinos.

More elaborate variations on this theme include uber-nightclubs, gaming lounges within casinos, and even virtual reality.

As an aside, it was interesting during a tour of IGT’s booth at the recent G2E that an investor asked how a person can bet on the virtual reality game being demonstrated. You can’t bet yet, but it is an amenity for the casino, was the response. Move over, Dave & Buster’s.

• Acquisitions, the classic path to growth in a mature industry.

The pace of acquisitions has accelerated in both the casino and supplier sides of the industry. One reason is that, absent growth, companies can squeeze out higher profits by reducing costs.

• Opening new revenue streams. In addition to more stores and restaurants, casinos increasingly are going online to attract social gamers, and hope to cross-market them into brick-and-mortar casinos.

Add to this new forms of betting, or spectating, such as eSports.

• Financial engineering. In gaming, this is taking the shape of companies selling or spinning off their real estate to real estate investment trusts.

The idea is to unlock the value inherent in the real estate and to give shareholders a recurring return in the form of dividends.

So far, three different models are being tried:

—The spinoff of real estate into an entirely new company, such as Gaming & Leisure Properties created from Penn National.

—Selling properties to a REIT in a lease buyback, such as Pinnacle with, in its case, the added wrinkle of shareholders also getting stock in the REIT.

—MGM creating a REIT for some, but not all, of its properties, at least initially.

One issue for the surviving operating companies in the REIT model is whether their new lease obligations so reduce EBITDA as calculated by lenders that future borrowing, thus growth, is dampened.

However, in the near term, REITs do unlock value.

• Dividends and share repurchases. At present, few casino companies pay dividends, but dividends are growing—including indirectly as casino shareholders also become shareholders of REITs, which are required to pay out 90 percent of their profits in dividends.

To date, buying back shares has been the preferred way to return capital to shareholders. Share repurchases are not recurring as dividends tend to be, can be made opportunistically, and do not generate income tax obligations for shareholders.

However, share repurchases can prove inefficient, as many companies dilute their effect by generously awarding stock options to management, and by the tendency of companies to buy high in a kind of perverse, upside-down cost-dollar averaging.

In short, we expect to see more dividend payers as growth options narrow.

Growth opportunities seem to be greater outside the U.S., as gaming participation is so low almost everywhere else.

This opportunity has not gone unrecognized as casino operators try to rush into emerging markets, especially those attempting to tap into China—Philippines, Korea, Australia, Cambodia, Russian Far East, even the tiny American territory of the Northern Mariana Islands in the remote South Pacific.

The problem with these markets is that they are nibbling at the corners of China. And that, as the early underperformance in the Philippines might reveal, is not going to be a needle-mover for the big international operators who have basically chosen to stay away.

What would move the needle for them are big and wealthy countries such as Japan and Brazil embracing the Singapore model of a limited number of integrated resorts. As of this writing, there is hope that Japan will do just that before this year is out, though that’s been a perennial hope, and Brazil might also act soon.

So, where does that leave investors? From our perspective, in the U.S. it means trying to find companies with credible and significant growth stories, perhaps made more attractive by dividend programs.

Internationally, it means going elephant hunting. If a handful of Singapore-like licenses come up, it will be big game to pursue for the likes of Las Vegas Sands, Genting, Wynn and MGM Resorts. But it’s a risky bet, and as Singapore also showed, not everyone bags an elephant.

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