Should You Gamble on This Stock?

Dan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Penn National Gaming (NASDAQ: PENN) has been known by investors as the best casino stock available for many years. However, not as many investors are as optimistic today as they were in the past, which is evidenced by the relatively large 10.20% short position.

We’ll take a look at why Penn National has developed such a strong reputation through the years, as well as why shorts are in attack mode.

Penn National is different

Most casino companies carry enormous debt loads. While Penn National owns its fair share of long-term debt at $2.63 billion, that’s nothing compared to some peers. It also isn’t enough debt to dissuade the company from expanding. Actually, Penn National is aggressively looking to add locations throughout the United States.

Currently, it owns and operates 29 facilities across 18 states (and Ontario). This broad geographic diversification is what separates it from other players in the industry. Most casino companies rely heavily on Las Vegas visitors for revenue. Penn National doesn’t have to fret about Las Vegas traffic numbers. Rather, Penn National’s strategy is to simply build casinos where demand is high and supply is low.

Penn National desperately wanted to win a location in Springfield, Massachusetts, but it lost the vote. Instead of giving up, Penn National opted for Tewksbury, which is north of Boston and off Interstate 495. Penn National aims to spend more than $200 million on the property. Of course, having a location near Boston has enormous potential, and if done correctly, it has the potential to steal enormous market share from nearby Connecticut casinos, Mohegan Sun and Foxwoods.

Another example of Penn National’s location strategy is Mahoning Township, which is in Western Pennsylvania, only 60 miles north of Pittsburgh. This location might not have as much potential as Tewksbury, because Pittsburgh is more of a blue-collar town with a lower average income than Boston, but for Penn National, it’s simply a matter of building a presence near as many big cities as possible. Penn National aims to spend $225 million on the Mahoning Township property.

Yet another location Penn National would like to add to its portfolio is San Diego. Penn National will really dig into its pockets for this one and aims to spend $360 million. Considering the many high-income consumers as well as nearby competition, this kind of investment might be necessary. Expectations here will be much higher than in most areas. While San Diego could be a big boon for the company, it should be noted that many local residents strictly oppose this plan and are fighting against it.

Looking back, Penn National has opened six casinos over the past five years. As you can see from the information above, Penn National doesn’t plan on slowing down. And with more states looking for revenue streams, Penn National’s growth potential seems high.

On the other hand…

A company that is opening locations opposed to closing them often indicates strength. But it’s possible that Penn National is moving too far too fast. The biggest concern is the health of the consumer. While there will always be the die-hard gambler (a nice way of referring to a degenerate gambler), most gamblers are of the casual variety. In other words, they go to gamble at casinos as a form of entertainment every once in a while, or while on vacation.

The consumer is up against it at the moment, with increased payroll taxes, declining wages, spiking oil prices, and steadily increasing mortgage rates. It’s difficult to imagine a scenario where the consumer will somehow become healthier over the next several years. While stock and real estate investments are performing well, the average consumer doesn't have those kinds of investments. 

Penn National vs. peers

Penn National’s revenue has consistently increased over the past three years, and despite a slight setback in 2012, earnings have improved. After three years of losses, Penn National delivered profits in 2011 and 2012. The top line should continue to grow, but the bottom line could be cause for concern in the near term due to cost increases.

Caesars Entertainment (NASDAQ: CZR) revenue has declined for four consecutive years, and it has posted big losses over the past three years. The company’s margins are weak, and long-term debt stands about $21.56 billion. The short position is very high at 28.50%, which likely relates to the company’s inability to grow when Las Vegas visitation levels are at an all-time high. If real-money online gambling becomes a hit, then Caesar's will have a chance to turn the corner, but it would be a risky bet.

One company that few investors look at is Churchill Downs (NASDAQ: CHDN). Churchill Downs is best known for horseracing, and rightfully so, but it also offers slots, video poker, poker, and other forms of entertainment. Most importantly, the company’s revenue and earnings have consistently improved on an annual basis, and it even managed to deliver big profits in 2008 and 2009, when the economy was in disarray. It's also important to note that an insider aggressively bought shares between $65.92 and $67 in March, and the stock is now trading just north of $84. This insider hasn’t sold any shares yet, which could be a positive sign. Furthermore, Churchill Downs sports healthy margins, and it yields 0.90%.

Conclusion

If the economic recovery is real, then Penn National’s expansion plans should pay off in a big way. If the economic recovery turns out to be nothing more than smoke and mirrors, then Penn National would be a poor investment, as it strictly relies on consumer discretionary income. Churchill Downs looks to be the steadiest and most resilient play of the three companies included in this article. 

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Dan Moskowitz has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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