When A License To Print Money Doesn’t Make You Rich

Imagine you lived in St. Louis, Missouri, had a $100 in your pocket, and wanted to go spend $100 at a casino one weekend. Where should you go? As far as payouts, your worst bet is the Harrah’s in Maryland Heights. There, the slot machines only pay out $0.89 for every dollar that is spent gambling. Your best bet is the Casino Queen in East St. Louis if you want the higher payouts, as you stand to collect $0.93 on every dollar.

If you look at the structure of casino payouts, and use that as a proxy for the business model as a whole, you would think that casino stocks would be a goldmine. And yet, it is the most disastrously performing sector of the sin stock category, with only 5.8% annual returns since 1992. What gives?

Sometimes, the casino itself does not even own the slot machine software. They contract with a manufacturer to operate a multi-site progressive jackpot system. The manufacturer acts like an insurance agent, spreading the risk out across gas stations, hotels, bars, and casinos throughout the state. The system is maintained to share the wealth proportionately based on the level of play, and the users collaborate with the manufacturer to create a revenue sharing arrangement.

Statistically, that is why a gas station in the Bootheels of Missouri is not scheduled to pay out $1,000,000 until 2450, but when it happens, the current arrangement is that the manufacturer and the gas station shares the payment obligations with other gas stations, hotels, bars, and casinos.

Across the nation, the payout ratio tends to fall between $0.83 and $0.97 per dollar wagered, and it just happens that Missouri casinos fall into the tighter $0.89 to $0.93 range.

Back in the 1980s, Charlie Munger used to criticize casino company executives for being corrupt–alleging that they do not care about the stockholders and enrich themselves through high salaries rather than ownership of company stock that appreciates for the long term.

And this moral quandary does exist. Casinos engage in lavish perpetual construction, and there are often incentives offered (e.g. complimentary gifts) to entice potential high-rollers to the casino.

The balance sheet of casinos is terrible. The toll of high construction and maintenace costs, mixed with this complimentary gifts, low foot traffic, and only 7% returns on machines once the manufacturer costs and shared risk pools are taken into account, makes this an industry where shareholders do not get nearly as rich as you might intuitively expect.

Look at MGM Resorts, which runs casinos in Vegas, Michigan, and Mississippi. It has $13.7 billion in debt from construction costs and years in which it loses money (it lost $2 billion during the financial crisis.) Well, 2015, which is a healthy year for the firm, will only see $400 million in annual profits. That debt is crushing–over $1 billion will flow to banks in the next five years in interest alone. That doesn’t even take into account the return of the principal. Shareholders can’t get rich when creditors are owed that kind of money.

Caesar’s Entertainment, which runs 39 riverboat casinos in the United States, is merely biding time until bankruptcy. It has $7 billion in debt, owes $2 billion in interest, and is losing $1 billion per year. It has never been profitable in its history. The stock is almost $9 per share. Who are the people who own this? If you buy this stock, and tuck it away in your portfolio, you will eventually see the holding go bankrupt. It is just mountain debt and high interest upon itself, and there have never been any profits. There aren’t any profits. There will never be any profits. The whole firm is a mess–why would you want to touch this?

Even Wynn Resorts, with CEO Stephen Wynn owning 20% of the stock, only makes $500 million in good years. It makes this money against a backdrop of $8 billion in debt. There is no platform for the shareholders to really get rich on a 25+ year basis because the interest payments choke off too much of the profit (and this will only exacerbate once interest rates rise.)

It’s not a coincidence that casino stocks are never covered on my site. With the other sin stocks–alcohol, tobacco, prisons, and weapon production–the shareholders are getting rich. Often, they are doing so at a rate that greatly exceeds the S&P 500. But that does not exist in the casino industry. Even though the industry is intuitively appealing–hey, the house always win–the management within the industry has never put the shareholders first. The debt from construction is so enormous that it almost guarantees shareholders will never do well even if the operating performance across the casino portfolios proves sound. There is extraordinary debt levels compared to operating income.