A Closer Look at Casino Stocks: Part 3

So far, we have spent considerable time discussing how the revenue picture for most casino companies has brightened over the past few years. Naturally, though, when analyzing casino stocks, odds are good you will also be interested in how things look a little further down the income statement. Undoubtedly, it won't take long to run across the term EBITDA -- a key measure of profitability in the industry.

Essentially, EBITDA is a simple non-GAAP calculation that usually starts with operating income (earnings), then adds back items like depreciation & amortization, interest expenses, and pre-opening costs. (In all fairness, stripping out these charges can often yield a truer picture of a company's operating performance.)

Taking a property's EBITDA as a percentage of net revenues will yield another important metric -- property-level EBITDA margins. For a quick example, let's look at Pinnacle's (NYSE:PNK) new L'Auberge Du Lac resort in Lake Charles, La.

Last quarter, the property posted operating income of $11.1 million. After adding depreciation and amortization charges of $6.3 million, the resort earned an EBITDA profit of $17.4 million. With revenues of $79.7 million, that equates to an EBITDA margin of around 22%.

The following chart, which comes courtesy of a recent article written by my Foolish colleague and fellow gaming enthusiast Jeff Hwang, shows the current margins of some of the industry's most prominent players.

As with any other business, companies with level or expanding profit margins are preferable, while those in a downtrend might have some explaining to do.

No such thing as a sure bet
With leisure travelers and business convention attendees descending on Las Vegas in record numbers (around 40 million annually), the red-hot Strip has profited from exorbitant room rates and packed casinos. And with most other markets around the country also enjoying robust demand, gaming companies have churned out one record quarterly earnings report after another over the past couple years.

Against that backdrop, the casino group has returned outsized gains of 26.4% annually over the last five years -- and almost 40% annually over the past three. Despite -- and perhaps because of -- this tremendous advance, betting on gaming stocks is by no means a sure thing. Yes, the sharp run-up has led to some pretty stretched valuations, but there are other potential concerns as well.

As might be expected, building a portfolio of top-notch resorts and keeping them up and running is not exactly cheap. MGM Mirage alone reported $380 million in capital expenditures last quarter, most of which went to help rebuild the Beau Rivage and spruce up a few of the firm's other properties. Meanwhile, rival Harrah's just unveiled plans to spend $550 million for expansion in Atlantic City, as well as $485 million on a new riverboat in Hammond, Ind.

Not surprisingly, the capital-intensive nature of the business means that many companies are excessively leveraged, operate with high fixed costs, and carry significant debt on the balance sheet. Of course, a large debt load by itself is not necessarily a reason to panic, and strong cash flows generated by a new property can quickly de-leverage a company.

For example, Las Vegas Sands spent $265 million to construct the Sands Macau resort. However, it didn't take the company long to recoup that money, since the property generated impressive EBITDA of $285 million within the first twelve months after opening its doors.

Yes, the capital requirements are high, but so are the potential returns on investment. Why else would companies fight to spend upwards of $30 million per acre to develop the strip real estate owned by Tropicana owner Aztar?

Still, there are other factors that could cause problems: decelerating growth rates, unstable regulatory environments, competition from tribal casinos (and online gaming outlets), and short-sighted politicians who view casino companies as ATMs rather than legitimate businesses. Some of these same concerns were commonly cited a decade ago, however, and the industry has still grown by leaps and bounds.

A look ahead
So, what does the future hold for casino companies? For one thing, considerable technology upgrades are on tap for a business that really hasn't changed much since the days of Bugsy Siegel. Within the next few years, expect to see companies benefit from innovations like RFID chips, smart cards, sophisticated player-tracking systems, and server-based slots that can switch an entire bank of machines from penny slots to nickel slots within minutes.

Going forward, there will be a premium placed on information-gathering, as companies build vast databases of player information: their favorite slot machines, their average wager at the baccarat tables, what they ate for dinner, etc. By accurately tracking player preferences and behavior, companies like Harrah's will have a distinct edge when it comes to marketing.

It also seems likely that despite claims of overcapacity, the growth engine of Las Vegas will accommodate even more growth in the years ahead -- occupancy rates greater than 95% have become the norm. Beginning with the introduction of the Mirage (the first casino to be financed with junk bonds) in 1989, a wave of development has virtually reinvented the strip. And given the massive projects currently on the drawing board, the gaming and entertainment Mecca has plenty to look forward to in the near future.

With the bar continually being raised, the costs to develop a top-tier casino resort have spiraled ever higher. The new Wynn Las Vegas cost an astounding $2.7 billion to build, or approximately one million for each of its 2,716 rooms. This is the highest price tag of any hotel ever built, and around double the per-room cost to develop other luxury resorts like Bellagio ($533,000), Borgata ($550,000), and Venetian ($415,000).

On the other hand, though, the escalating costs to ante-up are an effective barrier to entry, and the generous cash flows generated by these properties have climbed to levels that might have seemed unattainable in years past. (As a side note, it will be curious to see what happens when investors place a more accurate price on the value of the undeveloped land owned by giants like Harrah's and MGM Mirage.)

All things considered, gaming stocks might need some time to cool off, but the long-term fundamentals underpinning the industry's explosive growth are more attractive than ever. Betting on the players' side of the table is fun, but adding some exposure to the house's side might not hurt either.

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Fool contributor Nathan Slaughter has a score to settle with the Sahara blackjack tables. He owns shares of Boyd Gaming, but none of the other companies mentioned. The Fool has a disclosure policy.