Portfolio Allocation

Is PENN Gaming Still a Good Short?

PENN is now down $25 (21%) from when I presented the idea in the February 14th issue at $118. After wrestling with its 100 dma since March 29th, it closed a bit below it on Friday and decidedly below it today.

PENN’s Chairman Emeritus sold 3,000,000 shares on February 8th worth $371mm. It represented 66% of his holdings. Three other directors sold 1.7mm shares that day. The CEO on March 15th exercised $13 stock options on 71,450 shares and immediately turned around and dumped them for $140, netting $11 million. Insiders are voting with their wallet on their view of the prospects for the Company.

PENN owns, manages or has ownership interests in 41 gaming and racing properties in 19 States. In February 2020 Penn completed the acquisition of a 36% interest in Barstool Sports, the online sports betting company, for $136 million in cash and convertible preferred stock. In 2023, Penn has the option to take its ownership interest in Barstool up to 50%. When I was a junk bond trader in the 1990’s I traded the gaming sector bonds. And Penn was a junk bond company building out a riverboat gaming business in the States that had legalized it back then. It also operated horse racing tracks.

As you can imagine, PENN’s business has been hit hard by the virus crisis. For the full-year 2020, Penn’s revenues declined 32.6%. It’s Q4 revenues were down 23.4% vs Q4 2019, indicating that its casino business improved vs the first nine months of 2020 as the public became more comfortable venturing into venues like casinos. Adding back the non-cash impairment charge in Q4 2019, Penn’s operating income fell 35.2% YoY for the quarter.

Interestingly, the management asserts that it was able to cut costs quite a bit in response to the disruption in operations caused by Covid. However, in Q4 its operating costs were 88.3% of revenues vs 85.8% of revenues in Q4 2019 (after subtracting the impairment charge from expenses). It looks to me like management is blowing smoke about expenses.

The rationale behind shorting Penn is that, on a price/sales basis, PENN is valued at nearly twice most of its competition. The casino companies like MGM or Boyd Gaming trade around 2.5x trailing revenues, whereas PENN trades at 4.7x trailing revenues. I suppose if Penn were able to generate high revenue growth, 4.7x might not be inappropriate. But its revenues took a 30%+ hit in 2020. It’s not clear that the revenues will ever bounce back to pre-Covid levels, let alone generate the type of growth that justifies the 4.7x revenue multiple.

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PENN started 2020 at $25. While several analysts attribute PENN’s absurd rise in price to its affiliation with Barstool, the deal was announced on January 29, 2020 and the stock rose from $27 to $38 over the next two weeks. While the deal might have been responsible for the $11 rise in PENN, there is absolutely no fundamental basis in PENN’s operations plus its 36% interest in Barstool to justify the current market cap.

Penn’s interest in Barstool is accounted for as a Variable Interest Entity. As such, it’s not consolidated into Penn’s financials and is treated using the equity method of accounting. Penn records its share of Barstool’s earnings as revenue from investment on the income statement. Well guess what? In Q4 Penn recorded $1.6 million in net income “attributable to non-controlling interest.”  This may or may not include some positive income from Barstool, but the Company has other VIE’s which may have produced that non-cash accretion to net income.  Given the numbers available from Draft Kings, it’s more likely that Barstool loses money.

Since the Barstool investment, Penn’s market cap has shot up $12.5 billion to as high as $22 billion on March 15th this year.  And since the time of the Barstool investment, And several gaming companies are rolling out digital sports betting apps. This will affect Barstool’s market share and value adversely.

Yes digital sports betting is a lot of fun (I use Draft Kings and BetMGM) and there will be more States that legalize sports betting in the future, but PENN’s valuation is beyond absurd. PENN earned $43.9 million for the full year in 2019, pre-Covid. On that basis, PENN is trading at a 345x p/e.

With or without Barstool Sports included, PENN is ridiculously overvalued. Gaming is hyper-sensitive to economic cycles. Given my assessment of the current economy, and my belief that the U.S. economy will be at best sluggish for the foreseeable future (Jay Powell in so many words admitted that in a speech recently), I do not see Penn’s revenues or net income recovering from Covid anytime soon.

 

 

Originally Posted By Investment Research Dynamics