Description

Overview

I believe PENN is currently positioned as a heads I win, tails I don’t lose much. 

PENN (the “Company”) is a regional casino operator (the “Land-Based Business”), with a nascent Online Sports Betting (“OSB”) and iCasino business (collectively “Interactive”). The Company has grown revenue 20% since pre-pandemic, with margins increasing substantially, and has turned their interactive segment breakeven, yet the enterprise value is essentially the same as it was in February 2020.

The Land-Based Business, which operates 43 regional casino properties in 20 states, produces all the income of the Company. With 85% of gaming revenue derived from slots, the traditional casino operation can be viewed as an annuity, and it has traditionally been seen this way hence all the PE activity in the space.

On top of this business, there’s option value embedded into the stock as PENN is one of the seven remaining viable providers in the OSB/iCasino industry which despite having dozens of companies with licenses in certain states, has coalesced around just a handful of true national players with the size to support the required infrastructure. 

And in 2022, the Board authorized the repurchase of $1.5B of shares ($600mm has been used to date), and the total market cap of the company is $5.0B.

I believe this opportunity exists due to 1) near term fears of a recession, 2) a misperception of the current state of the OSB market in the US, and 3) confusing capital structure decisions made over the past two years pursued, largely correctly, to maximize liquidity which have not only ceased, but are currently being reversed. The current market is presenting a low-risk opportunity to buy into what I believe will be a long-term compounder taking advantage of a fundamental paradigm shift in the highly lucrative industry of gambling spearheaded by a management team heavily compensated based on share price appreciation over the next three years. 

I believe, the Land-Based Business can produce over $700mm of levered FCF by 2025 (~$5.00 per share), assuming the same EV/LFCF multiple as today results in a market value for the Land-Based Business of $55 per share. In addition to the Land-Based Business I believe the OSB/iGaming business, on a normalized earnings basis, can be worth close to $30 per share, and its value will start to become apparent in 2023 as early markets mature and start-up costs become less of a percentage of the interactive segment’s revenues.

Taken together I believe PENN will be worth $85 per share by the end of 2025, when near term fears of a recession recede and the Interactive Segment/industry matures, that represents ~160% upside from today and a 40% IRR.

Business Description

Since COVID, the Company has significantly increased their property level margins, now targeting 37.0% property-level EBITDAR margins. Many operators are seeing improvement in margins as customers have come back but not all of the pre-COVID perqs have come back. There is a lot of debate right now about where margins will settle and whether or not operators are over-earning. 

However, I think there are legitimate reasons that the industry may sustain higher margins. Management has cited antiquated costs that went away with COVID that will not ever come back (the ubiquitous buffets), as well as smarter, more targeted approaches such as thinking differently about whether maxing out hotel occupancy through comp’ed rooms is really the best approach. Prior to COVID PENN was spending $20mm annually on direct mail, with increased digital adoption PENN can reach many of those same older customers for pennies on what they used to be paying. Reading through the last few years of earnings calls, management reminds me a lot of Houghton Mifflin, HMHC, who cut a lot of costs during COVID and realized that they could operate much leaner, leading to permanently increased margins (and was since bought out by Veritas). Additionally, there are structural elements that should help profitability. PENN frequently talks about their conversion to cashless experiences, where customers don’t need to go ATMs but instead can load money on to a digital wallet from their mobile apps. This would eliminate the myriad costs associated with transferring large amounts of money as well as some of the labor requirement for converting cash to chips and back again. 

The Land-Based Business has a lot of longer-term momentum:

On the OSB/iGaming side, PENN goes to market with a media first approach. In 2020, they acquired US-based media company Barstool Sports, and in 2021 they acquired Canadian-based theScore. This owned-media approach is unique amongst North American operators and is differentiated from the leasing of media companies through aggressive ad buys (FanDuel/DKNG) or a partnership style approach (NBC-PointsBet/Fox Bet). PENN’s strategy in acquiring the media brands was to leverage them through an omnichannel approach, leading to Barstool branded retail sportsbooks being developed at many of their properties and the Barstool/theScore brand leading their OSB and iCasino offerings.

PENN correctly identified that the media companies had fiercely loyal customer bases that have thus far led to by far the lowest customer acquisition costs (“CAC”) in the industry. In the Q4 2020 earnings call, speaking about the PA and MI launches, Jay Snowden, the PENN CEO, cited that most analysts had forecast that CAC was anywhere from $300 to $800 per customer for the industry, and that PENN was “well below the bottom end of that range”. He then later said that in Michigan their CAC was less than $200 (on a later call he mentioned that CAC was running sub $100). In lieu of absurd promos and advertising, PENN’s promotions often entail being able to win exclusive merchandise from Barstool, offering a differentiated benefit for betting on the site that cannot be replicated by other brands and creating organic marketing from their loyal customers. 

Too much of the narrative in the OSB space has been about scale and tech stacks, there is a certain amount of scale required for the investment, but each of the national players will achieve that in 2023. Tech stacks will become table stakes, there may even be a second mover advantage. Just look at land-based casinos, how many have meaningful differentiators in their table games/sports books. PENN has the scarce resource, a brand people care about and it is materializing in lower CAC.

Just look at advertising spend the past three years from DKNG (no land-based business), CZR and RSI:

In comparison to the sub-$200 CACs for PENN, DKNG and RSI report Average Revenue Per Monthly Unique Payer (“ARPMUP”). DKNG with their large base of DFS casual players reported in Q4 an ARPMUP of $109 (up from $77 in Q$ 2021). And RSI reported in Q3 ARPMUP of $311. 

Many expected that the OSB/iCasino would cannibalize some of the Land-Based Business. But this has not been the case for PENN (or the other providers, notably MGM and CZR, who have been able to leverage an omnichannel approach). PENN’s initial assessment in 2020 was that customers who bet across channels are 12x more valuable to the Company than customers who simply bet at one of their casinos.  

The Sports Business Journal had a very good article about the state of OSB in September 2022. The takeaway was that despite dozens of different entities possessing licenses in different states the market has coalesced around seven main providers (these are the national players). Those providers, and their relevant market share by handle, which is a very misleading way to judge market share because it doesn’t account for promotional credits, are: FanDuel (38%), DraftKings (27%), BetMGM (11%), Caesars (9%), BetRivers (5%), PENN/Barstool (4%) and PointsBet (3%).  Depending on state, PENN has seen as high as mid-teens percentage of overall handle to zero handle (they did not receive a license in NY; however, NY is completely uneconomic for operators, between exorbitant advertising spend – potentially temporary – and the highest tax rates in the country – 51% off of gross revenue, not even allowing the impact of promos, the NY market despite its largess is not attractive for OSB operators). But critically this is based off of handle. As PENN’s management has continuously highlighted, they are the most profitable OSB operator and their share based off of Gross Gaming Revenue (“GGR”) or Net Gaming Revenue (“NGR”) is significantly higher; that is not apparent at the moment because while all states report handle figures, only a handful (notably PA and MI) report GGR/NGR figures. From PENN’s earnings presentations over the past two years:

So, while PENN only has mid-single digits market share by handle nationally, it has significantly more share by revenue. And this number is likely to increase as advertising markets normalize and competitors continue to burn cash. Rationalization is coming. And this final point is that PENN, largely due to the strategy outlined above, has managed to establish itself as a national competitor while still producing substantial cash:

PENN’s cash production is largely why I view them to be a low risk way to get exposure to the OSB/iCasino industry. It is also allowing them to change their capital allocation strategy.

Capital Allocation 

The Company has issued a lot of shares since the beginning of 2020, shares outstanding have gone from 116 at year-end 2019 to 169 at year-end 2022, essentially increasing fully-diluted shares outstanding by 50%. Much of this dilution came in 2020 through two public equity offerings and a convertible debt offering pursued in the name of survival. In addition to this capital raising, the Company also paid a hefty premium for theScore in 2021 which involved issuing 12mm shares. 

However, in February 2022 the Board authorized a $750mm share buyback. Over the course of the year the Company bought back 18mm shares at an average price of $34.23, which they repeatedly stated they felt was well below intrinsic value. Despite still having over $100mm authorized as part of the buyback program, the Board doubled down and approved an additional $750mm of share buyback authorization in December 2022. The full share count story is below:

Further supporting the idea that the Company has seen Jesus in regards to its capital allocation, on April 12, 2021 the Board approved a two-phased performance-based supplemental equity award for CEO Snowden. The first prong of the completely conditional bonus is that prior to year-end 2025 the stock price must be above $132 and maintain that price for 60 consecutive trading days, if achieved the $19.4mm “Stock Price Hurdle Award” is then vested over the next three years. And the second prong of the bonus, contingent on achieving the first, is a $29.3mm bonus if the five-year total shareholders return measured at the end of 2026 and 2027 equals or exceeds the 75th percentile of the S&P 500 index. The awards will be in the form of RSUs.

Valuation

First off, a note on the leases. As mentioned in prior PENN write ups on this site, in 2013 the company completed a PropCo/OpCo spin out of their real estate into GLPI. The CEO of GLPI is Peter Carlino, who was previously the CEO of PENN taking the reins in 1994, succeeding his father who had been the CEO of PENN before him. Carlino still owns 2mm shares of PENN. The leases have decades remaining on them (the weighted-average remaining lease term is ~25 years). They are subject to small escalators, but are otherwise largely fixed rate. Due to the extremely long tenor of the leases, the history of strong operations from PENN, and the economic incentives from GLPI I tend to look at the lease obligations as more of quasi-equity than a traditional debt item (albeit with annual required rent payments, but with no real bullet payment), hence the layout of the valuation table below. 

All of the profits of the business are currently generated by the traditional land-based portion of the business. 

Right now the Land-Based Business is being valued very cheaply, even considering a potential recession:

Above I have modeled the business assuming a ten percent decline on top line in 2023 and EBITDAR margins falling ~150 bps over the next three years. In addition, I assume the effective interest rate on their debt increases another 150 bps. Under those scenarios the Land-Based Business value takes a hit in 2023 but regains its value by 2025. Offsetting a near term decline is the value of the interactive segment, under conservative market share and margin estimates, but excluding upstart costs of new market entry, campaign financing, early promotions, etc. - this is how I think of the value of the steady-state business (which should become apparent to the market as essentially all OSB providers begin to turn profitable in 2023).

Alternatively, I have modeled a non-recession case where the Company is permanently able to take advantage of higher margins on their Land-Based Business, interest rates do not continue to hike and the Interactive business is able to take HSD share of a faster growing marketplace. I do not view this as a bull case, I think this is the most likely outcome.

Again, these earnings are assuming a steady state, currently the Company sees no earnings from the online portion of the business due to investing in infrastructure and states continuously coming online. 

There is a lot of long-term growth on the OSB and iCasino side. Just look at the Daily Fantasy Sports (“DFS”) market, DKNG reports that it is still growing for them HSD, LDD more than a decade in, and well after market shares have been settled. Let alone the growth to new markets as even DKNG (as of Q3) was only live on OSB in states representing 37% of the population (8% more has legalized OSB but not yet launched operations), and 11% for iGaming.

So, in a downside scenario in 2023 I think a reasonable valuation would be $21.50 for land-based, with $6.50 of additional value from the Interactive Segment, for a total target of $28.00, or essentially 15% below today’s levels. 

Whereas I think the far more likely scenario is that the Land-Based Business continues to perform, value per share is boosted through approximately $1.0B of share buyback dry powder, and the market becomes re-excited about the Interactive side as it becomes clear that an oligopoly has been established and the business will be pursued profitably. In that scenario I believe the $85 target by the end of 2025 is extremely achievable.

Risks/Mitigants

Risk: Larger players take dominant market position in online sports betting/iGaming, PENN never achieves critical mass in the space and is washed out.

Mitigant: PENN Interactive is already breakeven on a standalone basis (inclusive of start-up costs), but even more so when looked at from an omni-channel perspective. In this case, I do not believe interactive will be value destructive, but it may not achieve the upside contemplated. You’re left with an improving regional casino operator with a double digits FCF yield, purchasing back $1.0B of stock and a management team heavily incentivized to increase the share price over the next 3 years.

Risk: A recession may substantially decrease revenue, especially since historically regional operators have been mostly affected by the price of gas and regional home prices, both of which seem particularly precarious at present.

Mitigant: Based on LTM valuations the Company is trading at a double digit FCF yield in an industry that is one of the oldest in the world. The long-term demand for gambling is certain. Also, there is the secular tailwind of regulation coming to the industry, converting billions of dollars from the black market to the legal market. Furthermore, this is a management team that has just gone through the pandemic, where they were hyper-focused on achieving break-even results at lower revenue levels. The Company has arguably never been better prepared for a downturn. And lastly, regional operators fared much better than Las Vegas operators in the GFC. Below is one of management’s favorite slides that they have been including in earnings presentations:

Risk: The Company has significant debt and high fixed charges, the inherent negative operating leverage means a reduction in revenue will have a multiplying effect on equity values.

Mitigant: The business has de-levered since pre-COVID and has re-financed. Approximately 85% of their obligations are fixed so they have minimal exposure to interest rate risk and their nearest debt maturity is in 2026. CFO, Felicia Hendrix, is a former equity research analyst that is extremely competent and she has repeatedly cited that share buybacks will be balanced with a need to maintain liquidity and a rock-solid balance sheet.

Addendum

Things I currently do not explicitly assign any value to, but could add value over my target hold period:

• Media: PENN bought Barstool in early 2020 for $550mm (paid in installments over three years). Since then there has been an explosion of interest in similar media companies (Dan Le Betard got $50mm from DKNG for three years of advertising, Pat Mcafee – a former Barstool employee – signed a similar deal with FanDuel for $120mm for four years, Spotify purchased Bill Simmon’s the Ringer for $200mm+). Since PENN acquired the business Barstool has grown its audience 194% (in January 2020 Barstool said it had 66mm monthly uniques) and increased ad sales by 160%, even without that growth in early 2020 Barstool was much larger than any of the three comps. I have looked at Barstool as a customer acquisition vehicle for PENN, but there could be standalone value.

• Further Share Buyback Authorizations:  The Board approved $1.5B of buybacks in 2022 and the CEO is heavily incentivized to increase per share value. The Company produces loads of cash and they have established that they believe $35 per share is well below intrinsic value.

• Conversion to own Player Account Management (“PAM”): PENN will be converting to its own PAM system during 2023, it has historically used an outsourced provider. With their own PAM they will be better able to understand their risk exposures to individual players and will be able to offer same-game parlays and additional in-game betting. These two types of bets generate higher Hold %’s for operators. This would lead you to assume that revenue as a percentage of handle should increase in the future.

• Calming Advertising Environment: In 2020, there was a mad rush to enter the online gambling space (just look at the OSB stocks in the 2020-2021 period, also aided by stay at home/government stimulus). As exemplified by the SBJ article from September and DKNG’s Q4 earnings call, the market has rationalized. In accordance with that, and supported by all the management teams on earnings calls and separate channel checks with agencies I’ve done, the costs for digital (and linear to some extent) advertising have come down substantially. As noted, PENN has done minimal advertising to date, but the CEO has mentioned this could be a growth avenue for them now that costs have come down and their platform is more ready-for-primetime.

• Labor Market: Obviously it has been a very tight labor market for casino personnel and that looks like it is alleviating. But these companies have also been aggressively hiring software engineers. PENN employees over 300 highly sophisticated engineers (DKNG has over 1,200). With recent tech layoffs this could be an opportunity for the industry.

• State Budget Deficits from COVID Could Expedite OSB/iCasino Adoption: Pretty simple, gambling could be a source of income for states, economic challenges created by COVID or a potential slowdown in the economy could make states that were previously disinclined to approve gambling be more receptive.

• Float: Traditionally, gambling customers went to Casinos, took cash from an ATM, went to the cashier to get chips, played, went to the cashier to get their cash back, left. With the adoption of digital wallets ($80mm of deposits from PENN customers in its first year) customers may leave funds with operators. Not only does this alleviate the direct costs associated with handling large amounts of cash, but it creates a potentially valuable liability. 

Catalyst

OSB Industry Profitability in 2023

Continued Share Buybacks

Recession Fears Recede