Anyone who thinks the recent run up of the shares of Penn National Gaming (PENN) is attributable to anything but the overheated sports betting gold rush needs an adjustment from the neck up. It’s sad in the sense because taken apart as a pure casino play, Penn belongs in any well-balanced gaming portfolio. And it’s also a head scratcher that investors and analysts alike who see sports betting as lifting the company into the nose bleed ranks have overvalued the sports betting sector for the moment. Some think Penn’s Barstoolies will propel it into to the price targets some analysts have pegged in the 70s. We’re not so certain.

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An overheated Barstool debut in Pennsylvania

The PA September sports betting numbers are in. On the surface they show a record-setting monthly handle of $463m up from $355m in August. Online betting’s share was 89%. During the first week of action, Barstool-related downloads seemed buoyant. The “Stoolies” app took in $29m in bets, ~7.2% of the monthly total. The Roundhill ETF (BETZ) estimated that rolled out to a 30-day stretch. Barstool could generate gross handle somewhere in the mid-teens share. At the same time, market leaders moved as follows:

(Above Penn’s diverse geographic footprint: Source Penn archives)

Fan Duel (OTCPK:PDYPY) led with $171.2m in handle.

Next was DraftKings (NASDAQ:DKNG) at $11.6m, and rounding out the top three, Rush Street Interactive chalking up $64m. Was this as sparkling a debut for the Penn National Gaming Barstool app as some pomp pom twirlers among analysts have opined? PTs roaring back up in the 70s seem to us excessively bullish at this time.

We took a quick look behind the Pennsylvania numbers as reported by Legal Sports. They tell something of a different story. PA is the only state that officially reports total handle numbers, but also shows what the apps have spent in promotions. It’s an eye opener. As we have cautioned in several of our SA articles on sports betting stocks, the performance is more than explosive handle numbers, but just how much the apps spend to achieve them?

Free bets and bonuses has proven the voracious eater of revenue potential. Operator revenue reached $13.1m of the total handle. However, they spent $12m of that number on promotional credits. That equaled 92% of online revenue. No need to adjust your contacts, folks. That’s 92% given away. PA has the highest online gaming tax rate in the nation, so the taxable revenue was actually $1.1m using its 36% effective tax rate.

Penn’s Barstool app was live only two weeks, but gave out nearly $2.2m in credits. That was in spite of booking a ($656,000) loss on the action taken even before credits were taken down.

DKNG produced $1.1m in online revenue, but poured out $2.3m in promotional credits. FanDuel appeared to have a something of a better sense of the moment. It generated $6.6m in revenue, and poured out $4.2m in credits.

New kid on the block, Malta-based Unibet, made $1.28m in revenue but gave out $1.47m in credits. There are 10 aggressive competitors in PA, all of whom, to one extent or another, gave away anywhere between a low of 53.7% of revenue that month, to a high of 328.8% for Barstool. So yes, put it off to the cost of acquiring first-time bettors with the hope that as they continue in action, the giveaway gusher could begin to ameliorate and turn the revenue flow to profitability.

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To bring some perspective into this puzzle, we note that this was early in the NFL season and revenue was yet to rev up to where it might have been expected to churn. So the giveaways subsequently were higher percentage wise than they might have been. But it should at least be chilling for the street’s pom pom wavers in the sector hat even in this small sample size savvy old operators like Unibet gave away 93% of its lifetime online revenue in the state. DKNG has given away 58% of its to-date revenue stream and BetRivers is at 41%.

Barstool’s entry cannibalized some PA market share from the leaders and will probably continue to do so. So it’s again a test in time to determine just how much the total market will expand to absorb the perils of both more competitors coming online and a stabilizing total sports betting spend.

Contrast these numbers to a mature market like the U.K. There, operators told Legal Sports that their average bonusing cost is at around 10%. So that tells us that the US apps, hungry to acquire new customers, will spend whatever they can to build market share. But there’s a wrinkle here. PA operators are taxed on net gaming revenue after promotional credits. So take DKNG. On this basis they actually lost $920,000 in net revenue in September. But the loss can be carried forward to offset future liabilities, according to the PA Gaming Control board. At the same time however, DKNG can report gross revenue at $1.4M to investors. Looking ahead DKNG management has pro-forma projection of Q3 revenues of $133m against a $205m outlay for “sales and marketing.” Our point: The massive bonusing by Penn and others to build market share begs the question for investors in the space as we have noted in our SA coverage.

Do we investors really understand how much of the sector revenues are the result of promotions that simply can’t be sustained? As those of us who have lived inside the gaming industry for decades have learned: Once you initiate a customer into excessive promotional expectations, the chances that a given percentage of them will not stay put, but migrate eternally to whatever property or site that offers the best deal.

Time will tell whether Penn’s Barstool app becomes a one-way ticket to the top tier of sports betting sites, or just another, nice, viable als-ran.

We like Penn’s casino business a lot

Penn has one of the best regional casino businesses in the sector but its price movement this year has been entirely built on the overheated prospects for its sports betting app, Barstool. It’s to be remembered that Penn has paid $165m for 36% of Barstool, and says it will pay another $62m within three years to achieve a 50% equity in the company. That will value Barstool at $450m. It’s far too early and unfair at this point to lay down a judgment that either a) Penn made a great deal, or b) they totally misread the potential of the site and overpaid.

(Above: The Las Vegas Trop, a problematical buy now lateraled to the REIT owners in a barter deal. Source: Topicana Archives)

Barstool brings Penn its 62m stoolies, which naturally produces a considerable ease of entry into the millennial sports loving base. It will take time, and obviously, a ton of promotional dollars to find out whether the sports betting aspirations of the deal will be validated. As one after another new states legalize and Penn gets its share of the ever growing pie. However, no matter the expansion of the total market. What’s fairly certain is that the Barstool app will encounter plenty of competition along the way. And the jury is very much out.

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Penn shares have had quite a run this year posting a 52-week range from the initial pandemic shock collapse to $3.75 a share to a heady $76.62 at its recent high. The stock has since eased off to $62.35 at writing.

Penn has a market cap of $9.68b, which is very yeasty in our view. But compared to DKNG’s $16.2b, its begins to look like crazy bargain. Its EPS (ttm) sits at -$7.36, clearly still choked, as is the entire regional sector, by pandemic woes.

Despite all this, analyst consensus PT runs to $74.14, a number we think is far too heavy with as yet to be proved assumptions about Penn’s forward growth in sports betting through the Barstool app. I remain skeptical of that assumption. Yet, I do put myself among the fans of Penn’s day job as it were. I think taken alone, as a casino operator, it’s a solidly managed, real contender in the regional space. The big three of US regional casino operators are well poised, post pandemic for a heady rise. Penn’s casino recovery is reason alone to be in the stock.

The sports betting map of the US: Source AGA

Because we appear to be in the early stages of a second wave of the virus, it’s in my view, somewhat futile to attempt to forecast a reasonable forward earnings, revenue and sensible EBITDA for Penn. Regional casinos have been inching north as a slow to growing trickle of customers has begun to return to action. As most of these properties are drive-in or bus-in customer carriers, air arrivals mean little. That’s a plus. But I do believe the pent-up demand factor is a lot bigger than many observers are forecasting because the nature of gamblers I have come to learn after all my years in the business is that there’s a genuine itch that needs periodic scratching. Forced to stay away too long builds anticipation and preserved bankroll.

And that’s very bullish for the regionals like Penn.

The three big US regionals have varying strengths apart from sports betting which without doubt will evolve into a very respectable contributor to accretive EBITDA over time. That is what you bet on now, not the still nascent arc of sports betting now.

Penn’s two prime competitors are the newly-minted Caesars Entertainment Inc. (CZR) with 55 properties in 16 states and Boyd Gaming Corporation (BYD) with 29 properties in 10 states. (Note: BYD’s core strength is the Las Vegas locals market with 10 properties). As CZR is in very early stages of its transition with El Dorado Resorts as well as its rapidly closing in acquisition of the William Hill plc UK betting giant (OTCPK:WIMHY) we don’t think an apples to apples comparison to CZR works just yet. It will by 1Q21.

All three companies combine the key elements in management culture and quality of execution at the customer level we like best. As such we are fans of all three at their current trading ranges – pre-pandemic. We see looming upsides for all threewith sports betting playing a role of course, but not the central one in EBITDA recovery.

The US casino market is comprised of 1,000 casinos generating around $71b in annual revenue. Of that number, the tribal casinos represent ~$26b. So just focusing on commercial casinos post pandemic with a return of a better economy, and loosened travel restrictions due to an abatement of the pandemic, we see good things for all three. What we like above all about Penn is its excellent geographic footprint and the depth of its management team going forward.

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Strengths: Among the best geographic footprints in the sector with properties in every region of the US. While they vary in market share, exposure to cannibalization from adjacent states (Ex: Its West Virginia property absorbed blows from the huge MGM (MGM) National Harbor property in Maryland) they are by in large well run and kept competitive.

Weaknesses: Pursuit of a Vegas flagship produced a bad buy in the Tropicana, a long-time dog. It recently sold the realty to its REIT, Gaming & Leisure Properties Inc. (GLPI) in a non-cash barter deal for rent credits on its portfolio. Penn needs a Las Vegas flagship as a loyalty program destination. Its Plainridge Park slot operation in Massachusetts sits within breathing distance of the Wynn Resorts Ltd (WYNN) Encore integrated resort in Boston. Its decision to put a token property there was problematical as it’s not performing up to forecast. (Neither is the Wynn property). Also sports betting prospects for Massachusetts recently believed to be very close got a blow. It now appears it will not happen anytime soon, as it is buried in the legislature.

The takeaway: We think some analysts have been so mesmerized by the prospects of sports betting that they have taken Penn shares up to untenable heights to date. The robinhooders and Barstool dreamers have dived into the stock big time and had a great run to date. Good for them, never look back, just take the money off the table when you feel the time is right and shove those chips into the cashier’s cage.

But going forward there may be a piper to be paid when reality begins to sink in. Sports betting will evolve into a great adjunctive business for casinos as well as online app operators. But it may not be the bonanza envisioned by some observers. The pity is, in my view, is that the real story for Penn is the casino story, the big data base story, the geographic strength and fine management going forward.

The post pandemic casino business is the real Penn steak here and the sports betting business the nice side of fries. We are seeing the reverse in the trade going forward. Don’t stuff yourself with the fries and leave that great porterhouse sitting there getting cold.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.