What are the odds of an investor picking small-cap winners consistently in the stock market? The odds of outperformance may be unfavorable, but they can't be anywhere near as bad as the odds that one of the longshots in this year's Kentucky Derby faces.
Tincin, a horse that has never come close to winning a race and has earned a mere $390 in winnings over his short career, has a chance of sneaking into the field of the 127th Derby, which is less than two weeks away. The odds maker at Churchill Downs said in a Bloomberg News story that he will give Tincin 99-1 odds to win the Derby, which is as bad as horse racing odds get. "He ought to be 999-1," the odds maker said. So, the next time you think the stock market gods are out to get you, just think of the challenge Tincin faces.
While no one knows what will happen in this year's Kentucky Derby, there will be at least one near-certain payoff that day -- the track's operator will make a killing. Gambling in general can be a lucrative business in this country, even for a small-fry operator. However, the gambling industry consists of far more than betting on horses. The real growth area is in casino-style gambling, where the opportunities for small companies to make big money is growing as more areas of the country adopt provisions for legalized gambling facilities.
One small company that is playing both ends of the gaming spectrum is Penn National Gaming (Nasdaq: PENN). Up until a few years ago, Penn National was a pure-play horse racing company, operating two tracks in Pennsylvania and another in West Virginia. In 1997, the company started to transition toward other gaming activities when it installed slot machines at its Charles Town Races facility.
The machines have been a big hit with casual gamblers from the nearby Baltimore and Washington, D.C. metropolitan areas, and the company has since expanded the Charles Town racetrack into a full-blown entertainment complex, replete with 1,974 gaming machines. The complex accounted for nearly half of Penn National's total revenues in the recently reported Q1 and two-thirds of total EBITDA (earnings before interest, taxes, depreciation, and amortization.) Spurred on by its Charles Town success, the company has begun to pour more money into other non-equine growth opportunities by picking up a pair of barge casinos in the Gulf Coast last year.
As Penn National has expanded its gaming business, its growth rates have galloped ahead. In the most recent quarter, revenues more than doubled year-over-year while EPS jumped 25%. On a sequential basis, the company's topline grew 16% in Q1, EBITDA expanded by 30%, and EPS surged 50%. The results provide strong momentum for the company as it heads into the Q2 and Q3 homestretch, which are historically its best quarters.
There are plenty of firms in the gaming business, running the gamut from small-scale riverboat casino operators right up to the large companies that operate the giant casinos on The Strip in Las Vegas. But, the evolution of a slots-and-horses strategy is what makes the Penn National story interesting. If the company can get legislative approval to add slots to its other racing facilities in Harrisburg and Wilkes-Barre, Pa., it could potentially have another pair of Charles Towns on its hands. That would be a major league catalyst for the firm's margins and cash flow, and in turn its share price.
However, banking on future legislative green lights is a tricky way to build an investment case for a company like Penn National. The approval process for such a plan will be complicated and slow-going, not to mention fraught with uncertainty. It could happen, of course, providing Penn National with an easy way to boost the cash flows and returns from its two Pennsylvania tracks. Then again, Tincin could stun everybody and run away with the Derby, too.
Instead, Penn National is focusing on what is working business-wise right now. That means expanding and adding services to its Charles Town facility to handle capacity issues associated with its growing popularity and adding features to position its Gulf Coast properties as regional gambling destinations. The upgrades, along with planned casino acquisitions in other markets this year, provide decent prospects for future growth for the company, even if slots never make it to its other racetracks.
There are a number of small, niche gaming companies like Penn National out there, including a few that were listed in the Casinos/Gaming feature of The Motley Fool's Industry Focus 2001 research report. Most are valued along the same lines as Penn National, which is currently priced at about 11x trailing earnings and sports an enterprise value-to-EBITDA ratio of 6.8x. Based on the internal growth prospects alone, such a company may be worth a look for the interested small company investor, if only as a diversion before placing your bets for the upcoming "Run for the Roses."
Brian Graney plans to watch the Kentucky Derby, although he won't be placing bets on any of the horses. At the time of publishing, he did not own shares of any of the companies mentioned above. The Motley Fool is investors writing for investors.
