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Gaming Stock Outlook: Long-term Prospects Flash Bright

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The gaming industry has been experiencing strong growth since the second half of 2016. The trend is likely to continue through 2018, with the recent Supreme Court decision allowing sports betting outside Nevada expected to give the industry a new lease of life. Scope for casino operators will grow if betting is legalized in other states as the activity could be worth a lot of money.

Despite the fact that demand in the space is relatively inelastic and a relatively fixed portion of consumers seek such services irrespective of market conditions, there are reasons to believe that the industry will see consistent growth over the long haul.

That said, recent numbers published by The Macau Gaming Inspection and Coordination Bureau have raised concerns for the short term. Though gaming revenues from Macau increased 12.1% in May, lagging analyst expectations and down 0.9% from April. Speculations over another crackdown on capital outflows by China have vexed investors as well.

Industry Performance Vs the S&P 500

A tough operating environment in Macau weighed on casino stocks from June 2014 to most part of 2016. However, the industry has come a long way since then. The Zacks Gaming Industry, which is a 21-stock group within the broader Zacks Consumer Discretionary Sector, has performed almost in line with the S&P 500 and its sector over the past year.

While stocks in this industry have collectively gained 12.3% over the past year, the Zacks S&P 500 Composite and the Zacks Consumer Discretionary Sector have rallied 13.4% each.

                              One-Year Price Performance


 
The gains have been supported by strength in the domestic market, turnaround in Macau business and international interest in the gaming space. Further, relaxed government regulations with respect to online casinos have also helped. Online gambling has been a primary growth driver as a wide range of customers has gained access to such portals. In fact, the scope for the gambling industry has widened as more than 80 countries have legalized online gambling. Notably, Europe is considered the world’s largest online gambling market.

Gaming Stocks Pretty Expensive

Since gaming companies are debt-laden, it makes sense to value them based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio. This is because the valuation metric takes into account not just equity but also the level of debt. For capital-intensive companies, the EV/EBITDA is a better valuation metric because it is not influenced by changing capital structures and it ignores the effect of noncash expenses.

Owing to the industry outperformance over the past year, the valuation is really expensive now. The industry currently has a trailing 12-month EV/EBITDA ratio of 22.9X, which is marginally below the high of 23.6X in the past year but well above the median level of 13.5X. Clearly, the aggregate valuation picture for the space appears rich.

The space looks quite pricey when compared to the market at large as the trailing 12-month EV/EBITDA ratio for the S&P 500 is 11.5X and the median level is 11.4X. 
                                Enterprise Value/EBITDA Ratio (TTM)

The premium to the broader market expanded materially in late 2017, as the chart above shows, and has remained at this elevated level ever since. The industry also trades at a premium to the broader market on other conventional valuation metrics like P/Es, though the premium level is more within historical ranges.  

Outperformance May Continue on Solid Earnings Outlook

Improving tourism in Las Vegas and rising demand for gaming and leisure will continue to drive the industry. Most of the companies are opting for alternative avenues to expand customer base and business. Additionally, casinos operators are increasingly making associations with the hospitality sector, setting up luxury hotels and taking initiatives toward improvement of the gaming businesses. Since these non-gaming services generate higher margins, companies are increasingly focusing on other streams to drive revenues.

But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. The earlier valuation discussion shows that market participants have been willing to pay up for these stocks already, potentially limiting further upside from current levels.

One reliable measure that can help investors understand the industry’s prospects for a solid price performance going forward is the industry's earnings outlook. Empirical research shows that earnings outlook for the industry, a reflection of the earnings revisions trend for the contituent companies, has a direct bearing on its stock market performance.

The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for the industry and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019, while the light blue line represents the same for 2018. 

 

                             Price and Consensus: Zacks Gaming industry


 
This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.

Please note that the $1.53 'EPS' estimate for the industry for 2018 is not the actual bottom-up dollar EPS estimate for every company in the Zacks Gaming industry, but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the dollar earnings of $1.53 'per share' of the industry for 2018, but how this dollar number has evolved recently.   

                         Current Fiscal Year EPS Estimate Revisions

As you can see here, the $1.53 'EPS' estimate for 2018 is up from $1.48 at the end of April and $1.42 at the end of the month period to that and $1.39 this time last year. In other words, the sell-side analysts covering the companies in the Zacks Gaming industry have been steadily raising their estimates. 

 
Zacks Industry Rank Indicates Prospects for Improvement

The group’s Zacks Industry Rank is basically the average of the Zacks Rank of all the member stocks.

The Zacks Gaming industry currently carries a Zacks Industry Rank #147, which places it at the bottom 42% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

However, our proprietary Heat Map shows that the industry’s rank was in the top 50% for the past six weeks and has slipped only modestly in the past two weeks.
 


 

Gaming Industry Promise Long-Term Growth

The long-term prospects for the industry are alluring. When compared with the broader Zacks S&P 500 composite, the long-term (3-5 years) EPS growth estimate for the Zacks Gaming industry appears promising. Though the group’s mean estimate of long-term EPS growth rate has declined sharply from the high of 28.22 achieved in August 2017, it has shown improvement since January 2018 to reach the current level of 17.31%. It also compares favorably with 9.8% for the Zacks S&P 500 composite.

                      Mean Estimate of Long-Term EPS Growth Rate


 
In fact, the basis of this long-terms EPS growth could be a steady top line that the Zacks Gaming industry has shown since 2016.


 
Bottom Line

A closer look at the gaming industry reveals its adherence to the advent of technology beyond the usual confines of casinos. With continued innovation and rampant use of smart phones as well as other electronic devices, online gambling is fast gaining popularity and is positioned for long-term growth. In order to capitalize on this booming trend of smartphone penetration, U.S. gaming big shots are consistently devising ways to upgrade their digital capabilities and expand service portfolios to online social gaming.

However, Macao's Gaming Inspection and Coordination Bureau (“DICJ”) is increasing its audits of the junket industry owing to worries of money laundering. Markedly, junkets are responsible for about half of gaming revenues in Macao. Thus, this crackdown may hamper Macao revenues. This, in turn, may weigh down on the company’s performance in the region.

Though the valuation looks a little pricey at the moment, keeping the long-term expectations in mind, investors may look for some good entry points in the stocks that will help them make the most of the momentum in the industry.

While we have only two stock from the Gaming industry with a Zacks Rank #1 (Strong Buy), there are few stocks that have been witnessing positive earnings estimate revisions and carry a Zacks Rank #2 (Buy).

Penn National Gaming, Inc. (PENN - Free Report) :  The consensus EPS estimate for this Wyoming-based company has moved 7.9% higher for the current year over the last 60 days. The Zacks Rank #1 stock has rallied 57.1% over the past year. You can see the complete list of today’s Zacks #1 Rank stocks here.
                              Price and Consensus – PENN


 
Melco Resorts & Entertainment Limited (MLCO - Free Report) has been seeing positive revisions in earnings estimates over the last 60 days. Analysts have revised estimates upward by 15.7% for the current year. Further, the Zacks Rank #1 stock has surged 30.1% in a year.

                              Price and Consensus – MLCO


 
The Stars Group Inc. (TSG - Free Report) is also witnessing a surge in current-year earnings estimates with the consensus mark being revised 3.4% upward over the last 60 days. The Zacks Rank #2 stock has rallied 106.1% in the past year.


                                    Price – TSG


 
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