“We think it is broadly safe to say, within our gaming coverage universe, [Penn Enertainment] is the most debated name, given what is perceived to be a wide range of outcomes for the stock.”
So wrote Deutsche Bank analyst Carlo Santarelli, launching a breakdown of the bull- and bear-market cases for Penn.
Santarelli maintained at the time of his note a “hold” rating on the stock, with a target price of $29 per share. The stock traded a $21.40 at the time of his report on Thursday.
Santarelli described Penn’s risk/reward outlook as “fairly balanced,” allowing for two key catalysts. One is the jettisoning of Barstool Sportsbook in favor of the new ESPNBet. The other is the not-unrelated reboot of Penn’s interactive segment, including rebranding its online casinos under the Hollywood moniker.
The analyst expects “healthy market-share gains associated with the ESPNBet launch against the backdrop of an undaunting valuation, one in which we, finally, believe provides a free option on the Interactive segment.” That being said, “Interactive will represent a relatively small portion of Company EBITDAR (<15%) and as such, the core [casino] business will likely continue to serve as the primary basis for the longer-term valuation.”
Santarelli identified five “primary drivers” for the bull-market scenario. First was that Penn’s core business — brick-and-mortar casinos — is stable and historically resistant to economic downturns. While allowing that casino customers are as recession vulnerable as any, Santarelli opined, “The nature of the gaming customer, the geographic diversity of the asset portfolios, and the trade-down benefit for drive to casinos, relative to travel destinations, make it less susceptible than many consumer discretionary arenas.”
To bolster his point, he cited regional markets that experienced “relatively muted” effects from the Great Recession of 2007 to 2009. These included Iowa (up 1.3 percent) and Indiana (up 6.6 percent). Overall, the net “peak-to-trough decline” was eight percent across the markets served by Penn.
The second factor was the probable response of the sports-betting market to the dumping of controversial Barstool in favor of ESPN, expected to bring share gains. Santarelli predicted, “ESPNBet will experience a notable handle and GGR market-share increase post launch,” triggering a runup in Penn’s stock.
Santarelli did allow that “it will take at least a year from launch to determine whether the customer-acquisition strategy has been successful or whether the early promotional spend simply rented customers who were lured by free money.”
Thirdly, he felt expectations for the interactive division were too low. “While there are most likely risks associated with the ESPN launch,” he noted, “we believe a worst-case scenario would be an eventual retreat from the digital business, leaving PENN’s exposure to Digital solely related to the $60 mm to $100 mm of skin fee EBITDAR annually, which we believe, on its own, is worth $3-$4 per share.”
Fourth, Santarelli cited Penn’s “largely disregarded” pipeline of brick-and-mortar projects totaling $850 million, of which Penn is shouldering only $225 million. These initiatives include the relocation of Hollywood Joliet and Hollywood Aurora to new more heavily trafficked locations, as well as the addition of a second hotel tower at M Resort in Las Vegas and the development of a first hotel tower for Hollywood Columbus.
“While some of this capital expenditure, notably the Illinois project, is defensive in nature, we don’t believe valuation currently reflects what we expect will be double-digit returns on invested capital,” Santarelli offered. He projected that they would add incrementally to property-level cash flow by 2026, although he conceded that such growth was not “easily identifiable.”
Finally, Penn’s balance sheet “provides flexibility,” thanks to a traditional debt-to-cash-flow ration of 1.6. The company has $1.3 billion in cash on hand and another $900 million in undrawn borrowing capacity. No debt matures until 2026. Santarelli also expected Penn to “remain active” in terms of share repurchases.
Leading the fourfold bear case was an influx of new competition into hitherto Penn-dominated markets, including Council Bluffs, Iowa, and Chicagoland. “These competitive impacts are in conjunction with what we believe to be a slowing domestic regional gaming consumer and rising operator costs.” Santarelli said this manifested with same-store revenue declines in four of the last five quarters, a “top-line malaise” he expects to continue into next year.
Furthermore, Santarelli opined that Penn would be saddled by rent payments in any economic downturn, having sold most of its real estate to Gaming & Leisure Properties. Thus, “a 10% decline in revenue would result in a 43% decline in discretionary free cash flow.”
Thirdly, the ESPN deal could be “a coin flip.” The analyst contended that “in the absence of demonstrated share gains, shares will be penalized, and given operators can broadly control their own destiny, with respect to market share gains, we don’t see many paths that lead to share remaining broadly static … Given the competitive nature of the industry and the limited success of the foray with Barstool, we aren’t entirely sure the equity market will be willing to give PENN the benefit of the doubt.”
Given an “already saturated market” for online sports betting, it is argued by Deutsche Bank that Penn will have to up its marketing spend to promote EPSNBet and increase its promotional outlays, two factors that would cut into the bottom line and retard profitability.
Adding that Penn has “no choice but to open the promotional wallet,” Santarelli wrote, “We remain hesitant to ascribe too much value to the power of the ESPN brand as it pertains to customer acquisition and more important, retention within this space, especially given how late the partnership already is to the competition.”
He also noted that Penn would need to more than double its sports betting and igaming revenue to $940 million to hit the breakeven point. Santarelli observed that Penn is presently outside the $12 billion-plus online-sports-betting market of New York state, requiring it to overcompensate elsewhere.
Lastly, “We believe PENN has had a disappointing experience in the icasino space.” Santarelli estimates its market share of igaming at 2.7 percent.
Evidently, the analyst preferred the bull case, as later in the day he issued a short-term “buy” recommendation for Penn. He argued that “a catalyst stack of events, coupled with an inexpensive valuation, relatively elevated short interest, and limited investor interest on the long side create a favorable setup for shares.” Santarelli added that buyers could have Penn’s interactive segment “for free.”
He was also a buyer of the ESPN alliance, contending, “We expect the launch to drive healthy handle and [gross gaming revenue in online sports betting] market share gains, while also garnering considerable attention from mainstream financial media outlets. While the longer-term success of the customer acquisition spend will remain ambiguous throughout 2023, we expect the burden to rest with the Bear in the early stages of market share gains, and, as such, we expect shares to respond well to the gains we anticipate in November and December.”
