Sports betting could be gargantuan. Last year, the Supreme Court overturned a ban on sports betting outside Nevada. Within six months after the ruling, New Jersey saw close to $1 billion flow through its new betting channels -- half of what flowed through Las Vegas' sportsbooks, with all of Vegas' infrastructure, in the same time.
In this week's episode of Industry Focus: Consumer Goods, host Nick Sciple and Motley Fool contributor Asit Sharma take a deep dive into the huge changes sports betting could bring, from state taxes to Vegas traffic to the fate of the traditional heavyweights and more. Also, find out what's still up in the air, how states might push back against the ruling, and what it could mean for the industry. Plus, the hosts hit on the financials for MGM Resorts (NYSE: MGM) and Caesars Entertainment (NASDAQ: CZR), what U.S.-China trade tensions could mean for Macau, Japan's growing gambling market; and more.
A full transcript follows the video.
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This video was recorded on Jan. 15, 2019.
Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Tuesday, Jan. 15, and we're talking about casino gambling. I'm your host, Nick Sciple, and today I'm joined by Motley Fool senior contributor Asit Sharma via Skype. How are you doing, Asit?
Asit Sharma: Great! Nick, how are you doing?
Sciple: I'm doing well, Asit. We're talking about casinos today, so off the bat, I just want to ask you, do you gamble at all? What's your favorite game? You do any of that sort of thing?
Sharma: When I was a younger guy, I used to gamble a little bit with my friends playing cards. I've never been much of a gambler, but I do want to put in that I'm fascinated by gambling and its relationship to markets. I think I talked one time on the show about Victor Niederhoffer, a fantastic speculator who's made and lost many fortunes. He's got an interest in racehorses and professional games, betting on them, and how that relates to speculation in the market. So I have sort of an academic interest. I'm so bad at gambling, that's the problem. I lose too much whenever I do try my hand at it. How about you, Nick?
Sciple: I like to play a little blackjack every now and again. I've placed a sports bet every now and again in my day. Went to Vegas for the first time last year, had a good time with my girlfriend. Saw the Britney Spears show down there, which was like a live, in-person music video. That was a good time. I have a good time with gambling as a pastime. Of course, always happy to enjoy it responsibly, just like they say in the beer commercials.
We picked a good week to talk about casinos, Asit. We hadn't planned this, but just in the past week, some news as we've seen some activists taking stakes in the major U.S. casinos. We have activist firm Starboard Value reportedly building a stake in MGM Resorts, and Carl Icahn -- everybody knows Carl Icahn, one of the largest activist investors out there -- has reportedly taken a stake in Caesars. Icahn does have some casino experience. He sold a $1.5 billion stake in Tropicana Entertainment in 2018, and also sold the Trump Taj Mahal in Atlantic City to the Hard Rock last year.
This isn't the first interest we've seen in Caesars. Earlier this year, Tilman Fertitta, the owner of the Houston Rockets and Landry's, which also owns the Golden Nugget Casino and Morton's Steakhouses, he offered $13 a share in cash and stock for Caesars in October, but that offer was turned down.
We've got a lot of sharks circling around these major U.S. casino businesses, Asit. What's your take on all this activist interest coming out recently?
Sharma: Well, first of all, I want to say that I think all these activist investors got wind that you and I were going to do a podcast episode. That's why their interest suddenly picked up, and that's why we're hearing this in the news cycle. [laughs]
Let's start with MGM. Apparently, this stake was built in the last three months. I took a look at Starboard's most recent 13-F filing, that's a filing that big hedge funds and private equity groups have to do for disclosure, it shows their institutional holdings. They didn't have an appreciable stake as of their last reporting period, which ended 9/30 of 2018. In a few weeks, we'll see what their holdings were as at the end of the year.
Interestingly, as Starboard was putting this position together, MGM management was probably polishing off the final touches on a plan to free up about $300 million in EBITDA -- earnings before interest, taxes, depreciation, and amortization -- out of coincidence or management having the feeling that it's possible, if they don't prove their profitability and earnings structure soon, there could be some activist interest.
Starboard Value, as its name implies, is a value investor. They tend to acquire companies which are beaten down in some ways. This is not one of the activist investors that tries to have an adversarial relationship with management teams, but it often has big plans for companies that it takes significant stakes in.
One that I wanted to talk about, which was also announced after the year turned, was Starboard's stake in Dollar Tree, which owns Family Dollar. Just to give you an example of how this hedge fund operates, they want Dollar Tree to sell off Family Dollar, which it only acquired three years ago, because it's been a money-losing proposition for that company, and it wants the Dollar Tree brand to expand its price points from $1 to multiple price points. So, big changes. That gives you the flavor of how this company might tack on as it tries to influence management at MGM.
Basically, going forward, there's not a lot for MGM left to do. Many times, these companies want management to buy back shares. That should increase stock value. But MGM is highly leveraged, so I don't see much that can go on in that manner.
On this next idea, which is Carl Icahn's interest in Caesars, that's also interesting. It should be fun to watch. Carl Icahn of Trian Partners is famous for producing these voluminous white papers, 80-page, 100-page white papers which argue for a big change in the companies that he takes stakes in. I don't know if we'll see that with Caesars. But Caesars, again, is another company which has a lot of leverage on its balance sheet. It just came out of bankruptcy recently. Icahn is a master at finding every last penny of value. I'm going to be interested to see how this one unfolds. Any thoughts from you on either of these?
Sciple: It's hard to tell. The big catalyst that we saw in the last year, at least in the gaming space, is sports betting. Part of what's going to happen there is going to depend on what we get from a regulatory point of view. The Justice Department came out with a new stance on how the Wire Act should be applied to online gambling just yesterday, Monday afternoon. That's going to affect the ability for some of these casinos to roll out casino-like games through their apps and things like that. There are some regulatory hurdles that look like they're creating a little bit of a special situation for these businesses. Maybe the activists see something in the tea leaves they are that they can pull the thread on.
I do think, when you look at the leverage of these companies, there's got to be something to address those issues. You've seen some interesting things with the real estate arms of both MGM and Caesars. We're going to talk about that later. I'm interested to see what role, maybe unlocking some value out of the real estate might play in what goes on there. It's going to be an interesting thing to follow. There's a lot of moving parts.
As I mentioned, one of the biggest news items in 2018 surrounding gambling was what went on with sports betting. Back on May 14th, the Supreme Court overturned the Professional and Amateur Sports Protection Act. Basically, what that act had done was banned sports betting outside of Nevada, and I think there was one other state that was carved out that hadn't used their carve-out. That happened back in May. We've seen some states move to legalize, about nine states are currently legal. But there hasn't been quite as much movement as maybe some had hoped for. Part of that has to do with the way the legislative calendars line up with a lot of these states. Because that federal ban on sports betting through PASPA was lifted by the Supreme Court, we still have to have legalization come at the state level, and most state legislative calendars tend to wind down at the end of May. It takes a little bit of a process to work through the bill-making machinery. With state legislature starting to come back into session here at the end of January, beginning of February, we might see some movement on continued legalization.
To give you some context on the size of the sports betting market, $4.9 billion was bet at Las Vegas sportsbooks in 2017. Some estimates on the size of the illegal gambling market are as high as $150 billion, although, based on what I've seen, I think around $70 billion is probably more reasonable.
Asit, what are your thoughts on these early days of how sports betting has emerged and the regulatory environment we're looking at?
Sharma: As we go forward, some of the states which traditionally have gambling operations have been the first to pass through their legislators the mechanisms for gambling. Mississippi is one, which you'll be very familiar with, obviously. New Jersey very quickly moved in 2018 to allow sports betting.
One of the things I'm looking at is this possibility of a federal bill coming up. The Sports Wagering Market Integrity Act of 2018 was sponsored by Sens. Orrin Hatch and Chuck Schumer. Of course, Senator Hatch retired in December, so the bill has to be reintroduced in Congress. What I've read is, many people in the industry don't think that the federal regulations are going to amount to much after the SCOTUS decision. But two of the big online betting outfits, DraftKings and FanDuel, are certainly monitoring this very carefully. DraftKings is making preparations just in case. A recent filing shows that they have engaged two lobbying firms to "educate policymakers on issues related to fantasy sports and sports wagering." So as far as the daily fantasy sports getting into this sports betting, they're already moving in. I think they'll work with influencing the policy debate if there is any. But to me, it seems that this is moving forward, and more states will adopt this year.
Sciple: Yeah, that seems to be the case. It's a battle that's going to continue to play out. Something to call out there is, Sheldon Adelson, the leader of Las Vegas Sands (NYSE: LVS), which is another casino operator, he's also a heavy political donor and a heavy supporter of the coalition to stop internet gaming. He has a lobbying special interest organization there. It's going to be interesting to see the battle between the folks on his side of the debate wanting to put a wall around how large internet gaming can be, along with these new upstarts like you mentioned, DraftKings and FanDuel.
As we look to how sports betting has played out in this first year, our best data is really coming out of New Jersey. As you mentioned, they had some existing gaming operations. New Jersey was the force behind this Supreme Court case. The original name of this Supreme Court case was Christie vs. NCAA, Christie being Chris Christie, the governor of New Jersey at the time when that case was brought. So New Jersey was really Johnny on the spot with bringing this online. Just in the first six months of sports wagering in New Jersey, we've seen $928 million of wagers placed. To give that some context, that's about half of what Nevada puts together, $1.8 billion, in the first six months. That's about half of the amount of sports bets placed in Nevada. Considering this is coming only six months, with infrastructure not being in place until after May, it really has ramped up in a very, very speedy fashion, and it looks like there could be some more upside.
You mentioned DraftKings and FanDuel. This is an important thing to call out. Of the amount of bets placed on sports in New Jersey, of the revenue collected, about two-thirds of that sports betting revenue has accrued to sportsbooks affiliated with DraftKings and FanDuel. These have been very influential players in driving traffic there. There are a few reasons behind that. Of course, they have an existing user base of folks who are comfortable putting money on the line to make decisions surrounding sports that are sports fans, and they already have an app in place.
Asit, what are your thoughts here so far on how DraftKings and FanDuel and these other online operators have been able to capture a larger share of the market than your existing legacy casino players?
Sharma: I think the brand familiarity that you mentioned is a big one. Both of these companies have loyal followings who've made deposits with the company, has been able to withdraw money on their winnings. That's very important to the online wagerer, if I can use an antiquated term. This kind of familiarity with your sportsbook, the place where you go and place your bets, collect your winnings, and your trust in that, be a retailer, physical location, or online, is extremely important in the industry, as you can imagine. I think they've got this edge.
I want to call out a stat that you brought to my attention. This is amazing. More than 72% of money wagered on sports in New Jersey in November came via mobile and online platforms. Nick, I've got your numbers right here, $21.2 million in overall revenue, $14.4 million of that was online revenue vs. $6.8 million in retail. So, like we see with many other industries that we discuss, if you make it easy for someone to do something online, it doesn't matter what it is, people are going to come. It's very easy to move money, and it's one of the more compulsive industries. I usually talk about compulsive industries in terms of Starbucks and coffee, but this is that amplified many magnitudes. As you say, be responsible if you try out online wagering. Do it as a hobby.
One thing that I'm very interested in in the coming months and years, also, is what I call capabilities crossover. So far, Draft Kings, FanDuel, and a couple of smaller competitors don't have physical presences. We've seen since the SCOTUS ruling that FanDuel has opened a sportsbook in Meadowlands Racetrack in New Jersey, and DraftKings has opened one in Resorts Casino Hotel in New Jersey and also at Scarlet Pearl Casino Resort in Mississippi. As these companies decide that a physical presence will enhance their offerings, by the same token, some of the larger traditional casino players like MGM and Caesars are looking to partner up with smaller companies and also extend their own online capabilities and cross over the other way -- that is, to go from a capital-intensive economic structure to something that's capital-light. I think both of these types of wagering facilities are going to learn from each other. We'll see lots of partnering, we'll see lots of M&A.
I'm curious, your thoughts on how that will fold out?
Sciple: For me, at the end of the day, in the states where mobile wagering is legal, it's going to capture an outsize share of the market as we saw in New Jersey. The question I have on my mind is, how many states are going to legalize mobile and online betting? You're going to have concerns of, how do we verify the age of the gambler, do we really want everyone being able to place bets on sports anywhere in the world, or do we want to confine it to a smaller arena? In Mississippi, you have sports betting, for example, confined only to on-site locations. It's going to be interesting to see how the regulatory framework plays out from state to state. It's a little bit of a wait-and-see here. I do think in the states that allow online and mobile betting will probably have a quicker uptake on the amount wagered there.
I do think for sure what we're going to see is sports betting become a larger subset of how people consume sports. You're already seeing on ESPN, for example, Scott Van Pelt on his SportsCenter show has the Bad Beats segment that he'll do every night, and things like that. We're having that come into more of how sports are covered. Deloitte had some numbers out, I sent these out on our end-of-the-year show. Deloitte's expecting that sports betting will drive 40% of all TV watched by men ages 25 to 34 years old, which of course is a very important demographic particularly when it comes to sports. So, definitely can drive engagement there.
Another question that we have to ask is, how profitable is sports betting going to be? Based on data we have from Vegas, historically, the house edge on sports bets is about 4.6%. Out of every $100 that gets bet at a casino or sportsbook, $4.60 of that comes down as actual revenue to the casino. Then, in Las Vegas, when you net out the taxes you have to pay to the state of Nevada, about 3.3% of that comes down as net to the casino. So, another thing that we're going to have to follow from a regulatory perspective is not only how many states allow mobile and online wagering, but also, what is that tax hook that the states are going to have on the casinos when it comes to their revenues?
For example, New Jersey actually just raised theirs another 1.25%. New Jersey taxes brick and mortar sportsbooks at 9.75%, and they tax mobile and online sports betting at 13%. It's not that casinos haven't really gotten up and running quickly, but if you look at a state like Pennsylvania, where they're putting their tax rate at 36%, you've really seen a much slower uptake from businesses there. It's just a lot harder to make money.
Those are the two questions that I'm going to have. We know for sure that we're going to get increased engagement out of sports betting being legalized. But, how profitable it's going to be and how large it's going to be is going to vary on a state-by-state basis, both on whether mobile wagering is allowed and on how the tax rates are set by the state. What do you think, Asit?
Sharma: I think that the states that become very savvy in attracting business. We start from a global perspective, the fight to win business in the corporate world has driven more of the use of analytics in recent years that states will use when they compete. To pull an example of the air, for Amazon coming to a particular city. There's much more data that's being crunched now than ever was before. I think the states are going to make calculations, each state that's interested in this market will try to figure out how much of sports total market they can draw from other competing jurisdictions, looking at how likely their citizens are to gamble. In other words, if you're a retail gambler and you live in my state, North Carolina, you may have to physically travel to another state to gamble. Though, we have in the mountains a couple of places where you can gamble. So if North Carolina were to follow through and legalize, I think they would look at that market and then make a tax calculation as well. You can fiddle with both ends of the equation. You can incentivize gambling in your state, but you can also push these tax rates up or down depending on that demand flow. And maybe Pennsylvania is trying to disincentivize what they've allowed. I don't know. It would seem to me that the best equation is somewhere in the middle. You want to optimize your state's revenue. And there's some nuance to that. But I think now, with the computational power that states have at their disposal, which was not the case 10, 20 years ago, we're going to see some nuance in these tax rates. It's another thing I'm fascinated by for this year, to see how that pans out.
Sciple: I agree with you, Asit. One major influencer is going to be looking across the border. If you see dollars from your state going across the border for sports betting or any other reason, that's probably going to be a little bit of a nudge to states that are more reticent to legalize to get on their game and start moving up. It's going to be interesting to see how things play out. Again, for our listeners, it's going to be a state-by-state, law-by-law dichotomy over time. I do think the market's going to grow, it's just going to be a question as to how this regulation comes down, what it's going to look like. Definitely something important to follow. It's going to drive engagement, both for sports and probably for these casino and gambling companies.
Let's talk a little bit about Las Vegas. That's another market that folks think is going to be influenced by the sports betting change. Obviously, for the longest time, you could only gamble on sports in Las Vegas by federal statute. Now, as it opens up more nationwide, is less traffic going to move out to Vegas? Vegas had 38 million visitors last year. What are your thoughts on that trend and what's going on in Vegas generally?
Sharma: I think Vegas has done much in the past decade or so to get ahead of a potential trend like this, although I'm not sure that 10 years ago, this was on their radar screen. As a destination, it's really changed the way it markets itself. It's gone after corporate business in a huge way. Also, Las Vegas has presented itself as a family oriented destination. You don't necessarily have to treat Las Vegas as Sin City, you can go there just for a fun weekend. If you like to gamble, you can gamble. If you just like to stroll around what I think of as food-tray architecture with a drink in your hand, you can do that. It's a fun place. I've been once and enjoyed my time there. Gambled a little bit, was there for a conference.
I think that the flow of traffic into Las Vegas won't necessarily be impacted. It's a very adaptable city, as well. Nick, you tweeted out for questions on the show yesterday. Actually, a friend of mine who's an avid listener, Brandon Stokes, who supplies me with millennial stock ideas -- I've mentioned that before -- he asked about e-sports in this whole equation of legalized sports betting. He pointed out that MGM actually has an arena for e-sports betting, which I was able to briefly look at before the show. There you go. There's one way that the location of Las Vegas can compete with evolving trends and technologies.
My thought is, probably, there's the potential for a little bit of a dip in traffic near-term, but that resolves over time as it plays to traditional strengths. It's not going to lose huge traffic anytime soon. What do you think?
Sciple: I agree with you, Asit. Vegas is one of the most popular convention destinations in the United States, and it continues to be so. It had a little bit of a weaker year this year, but it's expecting things to come on strong next year. About one-sixth of Vegas' annual visitors come via convention attendance.
Another thing to think about is, there's new attractions coming there. Next year, the Raiders are coming to Vegas. That's going to increase some traffic. If you want to go to a road game for your favorite football team, Vegas is going to be one of the top destinations you like to go see your team play. You saw the same thing happen this past year with the Golden Knights. You have tons of folks come down to Vegas to see their team play. That's going to be an attraction, as well.
One thing to mention, when we're talking about Vegas, who are we talking about? Really, the two main players in Vegas are going to be MGM and Caesars. They own about half The Strip. There are some other smaller players there as well. Las Vegas Sands we mentioned earlier. They're predominantly located in Macau, but they do have a couple of casinos in Vegas. Same thing with Wynn.
As we're talking about Las Vegas Sands and Wynn, let's talk about Macau and what's going on there. You mentioned Vegas is the biggest gambling market in the U.S. domestically, but Macau is the largest in the world. It's the only place in China where folks are allowed to gamble, and about 70% of their visitors came from China, at least according to data back in October. There are 41 casinos there, several different Chinese operators. Major U.S. companies are Las Vegas Sands, as I mentioned, Wynn Resorts and MGM Resorts.
What are your thoughts about what's going on there in Macau and that market in general? It's the largest market in the world. It's most certainly the largest market in Asia. It's been a place where folks have flocked in because there's not a lot of other alternatives.
Sharma: An example of a great long-term market. It's ideally situated. Here you go again, regulation has ensured that Macau has its own built-in cash cow because there's so few places to gamble in Asia. Looking at some stats, you mentioned the Chinese market, 70% of Macau visitors came from China in October. Visitors grew 15.3% year over year. I find it fascinating that, even though we've got more international players now, it's still dominated by SJM, a Chinese company which has 20 casinos.
As this trade discussion has really turned hot over the last six months, turned from a trade discussion into a full-blown trade war, you have to really factor that in when you look at the Macau market going forward. We have several casinos with concessions expirations coming up in 2020. SJM Holdings is up for renewal. MGM China is up for renewal. In 2022, we've got Galaxy Entertainment, Wynn Macau, Melco Resorts and Sands China. We talked a little bit about this before the show in our back-and-forth, our notes. Nick, you had mentioned that a very well-known short seller, James Chanos, is short on the American players in Macau, and this has something to do with the regulation. Can you give us a brief overview of his opinion of Las Vegas Sands and Wynn and betting on them in China?
Sciple: Sure. I'll give you his thesis, and then add a little editorial of my own. Chanos' opinion here is that over the long term, we've seen the U.S. casino operators in China trade at a premium to their Chinese counterparts. But his position is that with the kind of trade tensions we've had between the U.S. and China, those companies should at least not be trading at a premium to those Chinese operators. The risk to them is that if China were to decide to pull their concessions at any time, their business falls apart. If you can't offer your key service to that market, which is gambling, then you don't really have a business. The companies that he is short are Wynn and Las Vegas Sands. Politically, it might make sense to them to retaliate against U.S. operators if trade tensions were to continue. As I mentioned earlier, Sheldon Adelson is the top dog at Las Vegas Sands Corporation. He's a heavy donor to the Trump administration and to Republican politicians in general. You layer on top of, there's trade tensions in the U.S. and China, and the head of one of these companies that it is very heavily involved in Macau and that has concessions coming up is also heavily connected to the administration which China would be retaliating against, it doesn't shock me that those sorts of things would come to pass. What do you think, Asit?
Sharma: There's a reason that these companies trade at a premium to their Chinese counterparts, and that's because, if you're centered in Macau, that's your only real operation. You have a concentrated market. Primarily Chinese economy, but other South Asian economies, if they start to decelerate, let's say, in a global recession, if you're only based in Macau, then you're going to get hit proportionately harder. Some of these other international companies, U.S. companies in particular, are a little bit more diversified. So, there are some underlying reasons why, historically, the U.S. companies have traded at a discount.
I think, personal opinion, that at the end of the day, the trade disputes will have to resolve because China and the U.S. are just too important to each other not to resolve them. In Macau, my expectation is that Las Vegas Sands and Wynn are going to have their licenses renewed. I wouldn't be short these two companies just for this reason, for their operations in Macau. But, I think it is an interesting thesis. It's certainly a risk. And who knows? Jim Chanos may be right and make a pool of money off it.
One last thing I'll say about Macau is the outlook for 2019. Because of all this uncertainty, J.P. Morgan analysts predict that gross gaming revenue is going to increase by only single digits this year. Macau, if you look around the world, it's the go-go place for gambling. It's got high revenue increases almost every year, in the double-digits. So, we're going to have a relatively slower year in 2019. But, the same analysts, among others, expect that after we get past this period of renewals, and even sooner, the growth is going to pick up again.
Sciple: I want to follow up on what you're saying about Jim Chanos. It's always dangerous when your investment thesis hinges upon government action of any kind, whether you have to have a law passed or some policy change. Building a thesis around that sort of thing is a very high-level type of bet to make. There are a lot of various outcomes. I wouldn't recommend anybody take a position in any company or any market that is dependent solely upon a government intervention to make that thesis come true. We'll see how it plays out for Mr. Chanos. He's a very sophisticated investor. But, for our listeners, typically at least for me, that's a no-go type of thesis on a business.
One last thing before we start talking about these major U.S. casino operators on the back side of the show, we mentioned how Macau has been for the longest time the center of the Asian gaming market. There are some signs that we might have some new markets opening up over in that region. In 2019, Japan is expected to approve three new casino licenses. We've seen several operators circling around them, trying to go after those licenses. Among them, you see Las Vegas Sands, you're also seeing Caesars circle for that. Caesars doesn't have any presence in Macau, so there is a little bit of a want for them to get some exposure over there. And then, we're starting to see some pushes for casinos in Vietnam. Las Vegas Sands had some interest over there. What are your thoughts on those markets as opportunities for casino operators, as well as any second-order effects they might have when it comes to Macau?
Sharma: Primarily, Japan is the market to look at. The population there is extremely hard-working, as everyone knows, and the Japanese love their diversions, whether it's, in the youth, dressing up in crazy ways, or playing Pachinko. You pointed out to me, five million Japanese people are addicted to Pachinko, this pinball-like game. I've had the opportunity to go to Japan, and I've seen these Pachinko parlors. They're incredible. Very noisy, frenetic. But you can see how that's maybe a relaxing enterprise after you spent like a 12- or 15-hour work day.
I think that there's a huge potential there both because Japan is one of the wealthiest countries in the world, has a very dense population. And as I've said, that population is always looking for an outlet. It's an extremely attractive market for any of the major players and the ones, as you mentioned, like Caesars who aren't in Macau. I think that's the one to look at. Vietnam, I'm also very interested in.
As for the effects for Macau, I think that as time goes on, as we've seen with the greater Chinese economy, there will be some loss of revenue as other players and other countries come in, and their regulations change, and they allow more gambling. But, to do that, you do need to have a relatively wealthy investment base. You need capital to make it happen. It won't be overnight. Macau long-term, like Las Vegas, will have staying power. It has a first-mover advantage in that region.
I'm keeping my eye on Japan. I just think that's a fascinating market. It's going to be highly regulated. These changes won't happen overnight. The Japanese will be very careful in how their population responds to gambling, and also how they regulate foreign countries coming in.
Any thoughts from you on how Japan or Vietnam might affect Macau?
Sciple: I think, obviously, when you have different alternatives, it's going to reduce the amount of need for someone to go out of their way to travel to Macau, particularly among the Japanese market. I don't have any data on what segment of the market in Macau comes from Japan, but I wouldn't be surprised if it's a meaningful amount.
To give a little bit of extra color on what you're talking about with Japan from an opportunity perspective, some estimates have the Japan casino market at being $15.8 billion a year. Compare that to Nevada, it's $11.1 billion. That's a significant market. You also mentioned efforts to keep under wraps how big casinos can get, and the societal problems that can come along. There have been talks on putting caps on how many visits a Japanese citizen can give to a casino in a month, limiting the size of the casino to only 3% of the total area of the resort, really confining how much gaming space you can have, and then putting a 30% tax on gaming. It's a huge opportunity that all these casino operators want to get a bite out of, but it's still to be determined how big that opportunity is going to be. And again, as we mentioned for sports betting, that's all going to come down to what the exact regulations look like and how these operators can navigate them.
All right, Asit, let's swing into talking about some of these major U.S. casino companies. There are an innumerable number of operators out there, and sub-operators. Let's talk about Caesars and MGM. First off, let's talk about Caesars.
We mentioned at the top of the show, Caesars came out of bankruptcy in late 2017. There's been a lot of questions around the company. Their CEO, Mark Frissora, announced a couple of months ago back in November that he was going to leave the company effective February 8th. Looking at my calendar, that's only a couple of weeks away, and we don't know who the heir apparent is going to be. Their balance sheet is still showing side effects from their bankruptcy. To give some background on the bankruptcy, it was an $18 billion Chapter 11 filing. It took two years from the start to finish. They shed $10 billion of debt, then totally reorganized their business into a realty operation, which now trades publicly as the Vici Properties (NYSE: VICI) REIT, ticker VICI. Then, we have Caesars Holdings, which is the casino operations, the hospitality part of the business.
You called out to me, Asit, an interesting phenomenon with their balance sheet. It's a little-known area of accounting when it comes to the failed to sale leaseback transaction which governs those real estate assets that Caesars spun off to VICI Properties in the bankruptcy. Can you walk us through what that means and what difficulties it provides to investors trying to analyze Caesars' books?
Sharma: Sure. Listeners, I'm going to take a little bit of time with this because there are some of you out there today that probably own Caesars or are interested in owning it, and I wanted to commiserate with you. I happen to be a CPA, and I had trouble figuring out what the heck is going on with this balance sheet. Let's break it down. I'll try to tweet a link that'll summarize what I'm going to talk about if I lose you.
Basically, Nick mentioned that Caesars had created a separate entity which holds its real estate, Vici Properties. It's a real estate investment trust. It was able to take basically the $10 billion of debt and put that into the trust along with the properties. When the company first envisioned this, they envisioned that this would work as a sales leaseback transaction. That simply means that I own a property, I sell it to you, Nick, but I still want to stay in the property, so I start paying you rent. It's a very common type of transaction. You see it a lot with professional services. Doctor's offices will do this to unleash equity in their buildings once they've paid off their buildings.
But what happened was, after the transaction, Caesars realized that because of certain covenants within the lease terms, they could not account for it as a sale leaseback transaction. So they account for the real estate now as a failed sales leaseback transaction. Just what it sounds like, it's an actual accounting term that they used in their filings. In this failed leaseback transaction, Caesars is actually required to keep the sold real estate assets on its own books at the originally booked value. If you look at both balance sheets, it looks like the properties never moved. Sort of an accounting quirk, but because the payment stream didn't fulfill certain accounting requirements under GAAP -- generally accepted accounting principles -- it has to be done this way.
Looking at that balance sheet as of this latest balance sheet date, there's roughly $10 billion of what's called a financing obligation and $8.9 billion of long-term debt. That $10 billion of financing obligation is exactly the same number that Nick mentioned earlier that they supposedly shed and put over into the other company. They have to account for all of their lease payments going forward for the real estate as a so-called financing obligation. But, simply, you can think of it as more long-term debt.
Now, the quirk comes when Caesars makes a rental payment. Every time it makes a rental payment over to Vici Properties for, let's say, a casino that it's operating and occupying, it actually does it a little bit like you or I would for a mortgage payment. It writes a check, it books part of it to a principal payment and part of it to interest expense. The only problem is, as this failed leaseback transaction is highly technical, the values of the properties on both the entities' books -- that is, Vici Properties and Caesars -- is sort of different, so they have to book excess interest and excess depreciation expense they normally would.
And what all this means is that, if you look at the interest expense on Caesars' books, it's through the roof. I looked at the first three quarters of this year, they've booked $1 billion in interest expense in nine months. Not all of that is actually true cash paid for interest.
So, how do you figure out how leveraged this company is? I have a simple formula. I'm going to walk through it. Again, if you're still awake and still interested after the show, I'll tweet it out so you can follow this if you're a shareholder. Basically, I think the easiest way to figure out how to look at this debt is to take the company's EBITDA, that's earnings before interest taxes depreciation and amortization, reduce that by the actual cash paid for interest that Caesars has incurred over a given time period, and then reduce that by the actual rental payments they're making over to Vici, plus any principal payments on their other debt. That gets you closer to figuring out how the company is burning its cash.
The net of that so far this year, Caesars had $1.7 billion in adjusted EBITDA. After you remove all those items that I just walked through, they're left with about $444 million of capital to operate with in the nine months.
Looking at the big picture, the good news is that Caesars is generating enough to meet its interest and also its principal payment obligations and its rental payments to Vici Properties. The not-so-good news is, there's not much left in the kitty for this capital-intensive expenditure that a casino operator has to make in terms of opening up new properties and constantly refurbishing, renovating existing properties. Give them props for being able to come out of bankruptcy and pull this structure and pull it off. But, be watchful and be wary if you own shares. Hopefully, we'll revisit this later in the year, we'll see how they're doing.
What are your thoughts on all that that I just walked through? If you're still awake, Nick, what are your thoughts?
Sciple: Thoughts are, these books are just a mess when it comes to trying to understand them as an individual investor. You look at Caesars on paper, and some of their assets, if you take the position that over the longer term, we're going to see regulation that moves more toward on-site betting, Caesars does have the most robust regional casino footprint of everybody else. But, that's the big question with all of these casino operators, Caesars and MGM at the very least. How do they navigate their leverage situation? It's going to be to be determined.
Caesars has used that Vici Properties arm to finance some additional acquisitions and moves in the past year. They acquired Centaur Gaming, which is a racetrack and some casino facilities in Indiana. They did that using a sale leaseback to Vici Properties. If they can get out of this whole morass coming out of bankruptcy, it's an interesting financing vehicle, the Vici business. MGM has a similar operation there. Any additional thoughts there, Asit?
Sharma: Some of the things that we'll talk about with MGM are applicable to Caesars, too. Looking at higher-margin revenue streams the company can get, that may be related to the Supreme Court regulation that changed and allowed casino operators to move into sports betting and implications for online betting. I think that Caesars does have potential, it's just a little tenuous. I see it as a value play, and I think anyone who invests in Caesars is investing in a value company. Over the past 12 months -- I might correct this later, but I believe the stock lost about 66% of its value over the last two years. It has potential. It has a mobile betting app centered in New Jersey. That's one of the opportunities it has to increase the revenue streams that are coming in. You mentioned the presence of more sports teams in Las Vegas. That's obviously going to help, the partnerships with the Las Vegas Raiders and Golden Knights that it has, also the New Jersey Devils and the Philadelphia 76ers and Baltimore Ravens.
Caesars is an ongoing story. If you're interested in taking a position, I would take small bites and monitor it from quarter to quarter. There's so much of the industry that's in flux since last year that there's positive potential, as well, so I don't want to mislead anyone with the explanation I had before to say that because of this complex transaction that they undertook, they won't be able to come out of their hole. At the same time, watch that cash flow. We'll see in a few quarters how they're doing.
Sciple: I own a few shares of Caesar myself. I'm not looking to add a significant stake here. As I mentioned earlier, I think the addition of sports betting will make some of those regional casinos a little bit more valuable. This is one extra reason to come there. We'll just have to see.
We've also seen them do a couple of non-casino-oriented moves. They're opening Caesars-affiliated resorts that do not have casino operations in both Cabo and Dubai. That's an opportunity to grow their presence. Their Total Rewards loyalty program has about 55 million members worldwide.
You can tell yourself a story of sports betting driving more people to the regional casinos, increasing engagement with the loyalty program, and pushing people to Vegas. But it's a story that we're just going to have to follow. There are a lot of moving parts that we just don't control, and the business doesn't control, either, from a regulatory point of view. Definitely something to revisit later on in the year as things develop.
I will say, not having a CEO named is definitely very concerning to me. It's been several months since that announcement came out. We're a couple of weeks away from when he's going to step down, and there hasn't been any clear communication of who that heir apparent is going to be. There's a lot of questions around the company right now. I wouldn't be rushing out to buy shares. But, I do agree with you, there could be an opportunity, particularly from a value point of view right now as the shares are really beaten down.
Sharma: I want to jump in with one really quick last thought that occurred to me. Mark Frissora, the outgoing CEO, led the company out of bankruptcy, and successfully, too. So, one would think that there'd be a tighter succession plan or, after all that hard work and successful work, that it would be more transparent and clear to investors what the next step in terms of the CEO succession is. But, we'll just have to wait.
Sciple: Yes, we will, Asit. Let's talk about MGM for a little bit. MGM is similar to Caesars in that it's a major U.S. operator. Them and Caesars are kind of a duopoly when it comes to the Vegas Strip. They have less regional presence than Caesars does, but their regional casinos are very powerful. For example, I've been to the Beau Rivage in Biloxi. When you go to Biloxi, Mississippi, that's the nicest casino there. I live in the D.C. area right now. At Motley Fool HQ, they have the MGM National Harbor. There ain't anything as close to D.C. as the MGM National Harbor. It's a nice casino. And, they have exposure in Dubai, with two casinos there.
Do you want to talk a little bit about MGM's REIT arm? They have MGM Growth Properties (NYSE: MGP). That IPO-ed in 2016. It probably was the model behind what Caesars did with Vici and their bankruptcy proceeding. What do you think about that vehicle and what MGM might be trying to do with that in the coming years? They own a significant portion, but they're looking to sell down some of that stake.
Sharma: MGM, being a little bit better off financially than Caesars, I think the real estate holding company is working out a little bit better for them. They're looking to pull that stake down to under 50% in the next three years. That should get them about $1.5 billion of cash. MGM, having this in its pocket, also has maybe more potential to develop and acquire.
But, it also has a little bit of a cash flow... I won't call it a problem, it's more of an issue that's native to these large casino operators. It has to expand its profitability. We talked in the beginning about the activist interest. One of the reasons that activists are interested in MGM is that it doesn't generate quite enough cash flow to do everything you need as a casino. What I mean is, everyone has to take their operating cash flow and then pay any shareholders for repurchase or dividends if you issue one. I don't think MGM actually issues a dividend. But, first, you have to generate positive cash flow, then you have to cover your capital expenditures, and then there's money left over. And the problem is, again, as I said earlier in the show, casino operators are continuously acquiring new properties. They're building out additional square footage into properties. They're putting new events and exhibits in. It's such a capital-intensive business that you have to have high margins. The cash flow begins with high margins. As I said, coincidence that they announced this $300 million plan to improve profitability? Or, was management feeling the heat that activists might step in?
But let's talk about that plan. $200 million out of the $300 million in savings annually in adjusted EBITDA -- again, earnings before interest, taxes, depreciation and amortization -- $200 million will come from operating efficiencies, half of that from labor reductions, i.e. layoffs. Then, this last $100 million will come from EBITDA expansion that's tied to digital revenue growth. The company has an idea to perform a digital transformation. It's going to reallocate some of its annual capital expenditure each year to specific technology advancements. That should increase its top line and grow its market share. This is a mix of elevating guest experience through data and pricing, the digital loyalty programs that you mentioned, Nick, and then optimizing its business mix -- who it sells to, how much of it is corporate business, how much of it is leisure business.
I think this is important. I just took a brief look at the company's cash flow the first nine months of the year. This is a very typical example. MGM generated about $1.4 billion roughly in operating cash. Capital expenditures were about $1.2 billion and change. Again, very little left over there.
I'm intrigued by this idea of a digital transformation because it's not tied to high fixed costs. If you can increase that top line just through digital channels, if you can get more into the online sports betting game -- which I'll ask you to talk about, Nick -- that's free money for a casino operator, which is operating, again, off of a few things. Bringing in that total take into a house, but also acting as a hotel operator, also acting as an operator of restaurants. To me, there's some opportunity here if management can execute.
I should point out that they did a similar plan that just ended last year in which they freed up about $500 million over a few years in EBITDA. The potential is there for them to improve this.
What are your thoughts, Nick, on this digital transformation, and maybe how that relates to sports betting that can go online for MGM?
Sciple: MGM, probably of all the casino operators, has pushed the hardest to make some partnerships in the arena of sports betting. I think they've announced partnerships with every major sports league with the exception of the NFL, which hasn't partnered with anyone yet. They've really pushed hard into that arena. You pointed out management's emphasis on moving toward a more digital strategy. They entered into a market access deal with Boyd Gaming. Boyd Gaming is a regional gaming provider in the U.S. They're going to share infrastructure to promote sports betting between their two businesses. What that gives GM is an increase in distribution without having to pay for a more physical presence.
I mentioned that their regional casinos, while they don't have as many as Caesars, they really are some crown jewel facilities. Like I said, the National Harbor is probably the closest casino to the D.C. area there. They've got one of the only casinos in the Detroit area. They have a good physical presence. And as we mentioned earlier in the show, digital looks like where you want to be for the sports market. We saw that data out of New Jersey, saying that the folks affiliated with DraftKings and FanDuel have really captured an outsized portion of the market. I really like what MGM is doing here. I like the assets that they have to leverage around this sort of thing. I like the partnerships that they've made. I think it's really a nice-looking business.
The question, just like with Caesars, is how do they navigate their debt situation? But, as you mentioned, what's attractive about this opportunity is that you can grow your business without having to grow your hard assets on the balance sheet, which I think is attractive. Any last words on MGM?
Sharma: Again, if you're choosing between the two, both of these companies have underperformed the broader market over the last year in what's been a cyclically strong era. So, just an idea, you could take positions in both. Both could be poised for an upswing -- unless we get a recession, of course, which hurts discretionary spending. Again, eager to see all the changes both companies are instituting. If they're able to increase those profit margins, investors will finally award them that higher premium that's been missing for the last few years. Again, the point of this entire show is to pinpoint the changes that are nascent in the industry. It's going to look so much different with sports betting, online betting, with these digital plays in the next few years.
I'm getting interested in them. I don't own either. Maybe after the show, I'll take a position in one or both.
Sciple: I tell you, if I had to choose between these two major U.S. operator, Caesars and MGM, I think MGM has to be the choice here. You don't have the management questions, you don't have nearly as many questions when it comes to the balance sheet. They have some value they can unlock from their REIT business. There seems to be a little bit more value there for them than what Caesars is having to deal with. I really like what they're doing in the partnership space. Definitely something to watch.
As we mentioned earlier, and I'm going to mention it as many times as I possibly can, a lot of the thesis here for growth is going to be dependent on what the states decide to do. If states take a tack where their taxes are too high, or if they constrict the ability to do business online, that can impact the thesis behind these companies. But I think it's a trend that we're going to see continue to play out. I think MGM is, of the two, the better position and the one I'd be more comfortable putting new cash into today.
I do want to call out before we go away that there are a few businesses that you can invest in that are more of the pure-play on the gambling software, online sports betting side of the business. Scientific Games is a partner with Caesars, they have Caesars partnered with them to help do their app and run their online sports betting platform. Paddy Power Betfair acquired FanDuel. We mentioned FanDuel a bunch today. They acquired that back in May, right before or right after the Supreme Court decision, for $1 billion. They're a major betting operator in the U.K. That gives them some U.S. presence. DraftKings is still private. The analogy I would say is, you can invest in FanDuel on the market, but you can't invest in DraftKings, it's like if Lyft were publicly available and Uber wasn't.
What are your thoughts on this, Asit? Do you think any of these major casino operators are going to come hunting for DraftKings anytime soon to get that extra juice they've seen in New Jersey so far? Is anybody going to come after these guys, and what might that look like?
Sharma: Paddy Power Betfair picking up FanDuel, they snatched that at a good time. The question for major operators is going to be, what is the valuation for DraftKings? It's a pretty profitable company already. It has access to capital if it wants to stay private. I think we may see someone try to snap it up within the next one to two years while it's still something that's within reason to purchase.
If you're looking at this sort of direct play, you brought up Paddy Power Betfair. Not as well-known here in the States. They're from the U.K. and have a really solid European presence. I think they're in the Australian market, as well. Seasoned operators, opportunistic. PDYPY is a symbol to look into if you're interested in the direct plays.
Going back to your question, it is possible that DraftKings could at some point have their own IPO if they feel that there's not too much of a regulatory burden for them. But, because they have a first-mover advantage, along with FanDuel, they've been able to scale across the industry, have great margins, very little infrastructure. So why would they want to be acquired? If I were running the company, I'd probably want to keep it private for as long as possible. What do you think, Nick?
Sciple: I agree with you, Asit. I feel like if DraftKings wanted to sell, they would. If you remember, a couple of years ago, every ad you saw on ESPN was a DraftKings ad. It doesn't look like they're hurting for cash, if they were able to pay for that much in advertising. I think they have a good opportunity here when it comes to the online betting market. Again, it's going to depend on what regulations come down the line.
Given the liquidity situation, the balance sheet situation of the potential acquirers that we might be talking about, I don't know how they would come up with the cash. It's definitely an interesting thing to think about.
I want to want to mention one other pure-play that I think is interesting to keep an eye on. It's The Stars Group (NASDAQ: TSG). The Stars Group is really diversified. Probably the most common thing you'll know them for is the PokerStars brand. They're really heavy in online poker in Europe. They also have some online betting operations in Australia as well. What's interesting about them is they acquired Sky Betting back in April. It was a $4.7 billion acquisition, a very large acquisition. That gave them some exposure to the sports betting market. They're also partnered with the Resorts Casino Hotel, which DraftKings is partnered with. Dipping a toe in the U.S., but they have that legacy business over there with poker that gives them some cash.
I think there's some growth opportunities there. Definitely one to wait and see what happens. I mentioned the question marks around the latest guidance the DOJ gave on the Wire Act yesterday. We'll have to wait and see how that plays out. I imagine that's going to be in some litigation. I wouldn't go so far as to say any of these pure-plays -- Stars Group, Paddy Power, Scientific Games -- is something I'd be throwing cash into today. There's a lot of variables up in the air on what's going to happen. But I think the opportunity there is significant. We'll just have to see how the regulatory things fall and how everything plays out.
Sharma: Yeah. Only comment I'll make on Stars Group is, this acquisition of Sky Betting gives them the largest active online player base in the U.K. When you're interested in these pure-play companies, that's important. As I said at the beginning of the show, if you acquired or have that base of players, it's not simply a list or a database that you've got possession of. It's a really important asset. Since time immemorial, there's been an element of trust embedding between the better and the person or entity that takes the bet. These tend to be the assets that drive future revenue growth for anyone. So, I'm intrigued by that.
To break down the revenue by segment, curbing from Nick's notes here, Poker makes up 60% of revenues. Gaming is 30%. Betting is 6%. The rest is Miscellaneous. This is another one that's interesting to me. I'm not as familiar with it, but we'll certainly look at it a little bit more after the show.
Sciple: I want to call out, 90% of their revenue is Poker and Gaming. However, those are pretty stable revenue bases. The betting subset, I want to say it was up 85% in the past year. Don't quote me on that. I want you to fact check. But that's where the source of growth in that business is. You've got some opportunities there.
Again, I can't overstress how important it is that we're going to see how the regulatory environment plays out. We're going to see what the tax rates are. We're going to see how open mobile and online betting is. But, definitely something to watch in the future. Definitely going to drive engagement with these gambling enterprises, casino businesses. It's definitely going to influence how sports are consumed going forward. Regardless, it's something we should keep track of. Asit, I hope to have you on here in six months or so as we have more information to continue to break it down and follow up on it.
Sharma: Absolutely! Thanks a lot, Nick! I must say, after this show, I'm feeling sort of lucky! [laughs]
Sciple: Me too! I need to go down and pick up a lotto ticket or something like that. I will say, I like the Saints on Sunday. They're playing in the Superdome, it's real tough to beat them there. If I was feeling really lucky, maybe I'd be thinking about the Saints. What do you think, Austin?
Austin Morgan: I'm all in on a Rams-Chiefs Super Bowl. Rematch of Monday Night Football game, there was like a combined 120 points.
Sciple: I'm all for it. We'll revisit next week and see how it plays out. Folks, there's Austin's blood bank guarantee lock of the week on what's going to happen in the conference championship games. Asit, loved having you on. Let's do it again sometime!
Sharma: Absolutely! Thanks! And, thanks everyone!
Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass! For Asit Sharma, I'm Nick Sciple. Thanks for listening and Fool on!
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Asit Sharma has no position in any of the stocks mentioned. Nick Sciple owns shares of Caesars Entertainment. The Motley Fool owns shares of and recommends Amazon and Starbucks. The Motley Fool has a disclosure policy.