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There was a bubble in online gambling stocks. There’s no doubt about it. We’ll shortly look at the fall of many of the names in the space, but the insanity in the sector — and across the market — is best highlighted by a stock that, had all gone to plan, should no longer exist.

On May 10 of last year, Wynn Interactive (74% owned by Wynn Resorts (WYNN)) agreed to merge with special purpose acquisition company Austerlitz Acquisition Corporation I (AUS). Austerlitz was headed by William P. ‘Bill’ Foley II, a legendary (and somewhat underrated) investor who has created tens of billions of dollars in shareholder value through Fidelity National Financial (FNF) and its various spin-offs. (I personally am long shares of Cannae Holdings (CNNE), one of FNF’s more recent creations.)

The tie-up valued Wynn Interactive at $3.2 billion. Six months later, the merger was terminated. Two months after that, Wynn was reportedly asking for just $500 million in a sale (that news came from the New York Post, whose M&A reporting admittedly can be somewhat hit-or-miss). In February, Wynn said on its Q4 conference call that, as planned, it had avoided “engaging in the unsustainable user acquisition blitz that has emerged” in the online sports betting space. Despite that strategy, per figures from the Wynn 10-K, the Interactive business posted a full-year Adjusted EBITDA loss of $267.4 million — four and a half times its revenue of $59.4 million.

Less than a year ago, one of the greatest investors ever valued Wynn Interactive at over $3 billion. Right now, with tiny market share and over $200 million in cash burn last year, that business might well be worthless or close to it. Even given the perverse incentives of SPAC sponsorship (where getting a bad deal done is far better than no deal at all), that’s a shocking change in a little over eleven months. AUS closed Monday at $9.79, and seems likely headed for a liquidation.

The Bubble Bursts — For Investors And Gamblers

Meanwhile, many of the sports gambling stocks that do exist as planned have come down markedly from their highs, as a not-quite-exhaustive list shows:

Again, it was a bubble. And the core reason these stocks have collapsed is the sudden realization that online sports betting, in particular, really isn’t that great of a business. (I wrote as much nearly four years ago, but like so many investors in the market of the past few years missed being long on the way up for fundamental reasons, and missed shorting at the top for, well, cowardly reasons. To be fair, tops are always much clearer in retrospect.)

Hold — the percentage of bets made kept by the book as revenue— seems to be running at under 7%. Legalized books in 2021 did nearly $58 billion in handle — and generated less than $4 billion in actual revenue.

That $58 billion figure is pretty large. It’s about $450 for every household in the US (including the majority that still live outside of regulated markets). It does not seem like bettor action has disappointed at all.

Rather, many investors simply didn’t understand that even a ‘huge’ online sports betting business is not that profitable. In their defense, many executives in the sector don’t appear to have understood that either. Legalized books in the US spent billions of dollars on customer acquisition, offering sign-up bonuses, free bets, odds boosts, and other promotions. Billions more were spent on advertising.

For investors outside of those markets, or those not paying close enough attention, it might not be clear exactly how much money was being thrown around. Here’s a personal example. Since Aug. 30, 2020, I’ve made nearly $68,000 betting sports online despite never living in a regulated market1.

I don’t bring up that $68,000 figure to brag. There’s not much to brag about. I didn’t really do anything to earn that money. The profits were not generated by particularly hard work, or any real intelligence. The majority of it — I’d guess in the range of $40K — came simply from taking advantage of the various promotions offered by the varying sites2.

During the last NFL season, in particular, the ten or eleven sites (PointsBet (PBTHF) went live in December) operating in Virginia offered promotions that combined offered several hundred dollars worth of expected value — a good chunk of it from the Caesars site in the state. (Caesars went particularly nuts last year, both in terms of promotions and advertising.) Ahead of a planned trip to Colorado roughly a year ago, I calculated that I needed just shy of $30,000 — thirty thousand @#$(&! dollars! — to take full advantage of the sign-up bonuses from the ~20 different platforms in that state. Expected value from those bonuses alone was probably in the high four figures. (Sadly, the trip never happened, and many of those bonuses since have been reduced.)

Any dope with basic math skills and Internet access in a regulated market had five figures, maybe six figures, of value to create over the course of the past two years. It really wasn’t that difficult to do.

A Change In Strategy

And so Wynn posted an EBITDA loss more than four times revenue, and Caesars Digital ~1.4x revenue. Even DraftKings generated EBITDA margins worse than -50% (on a revenue base of over $1.2 billion.)

But here’s the thing: the days of that kind of hemorrhaging are over. Promos have been slashed in terms of EV and (in the case of Caesars) in size. I made a nearly two-hour round-trip to Virginia once or twice in a week in 2021; I haven’t gone in a couple of months here in 2022. It’s literally no longer worth the time.

It’s not just promos. Caesars has pretty much pulled its advertising. Other operators are following suit. The business changed dramatically in a matter of weeks, following fourth quarter earnings and the epic amount of money given away during the launch in New York State.

Those changes as of yet haven’t done anything for online gambling stocks, most of which (including DKNG, CZR, and PENN) are close to 52-week lows. Fears of a recession may be a factor, admittedly (particularly for leveraged brick-and-mortar plays like Penn and Caesars), but there’s at least the possibility that investors aren’t really accounting for the current changes in the industry.

That might create some opportunities. It’s hard not to be at least a bit intrigued by the combination of plunging share prices and an improving near- to mid-term outlook for profits losses. Amid that environment, some quick thoughts (which, to be clear, are not the result of deep enough dives) on some of the sector’s key players:

DraftKings

In last week’s review of de-SPACs, I wrote:

…there’s going to be a quarter when DraftKings posts bottom-line numbers that shock a lot of investors who have written the company off. I don’t think that quarter is that far away.

In 2021, DraftKings posted a pro forma Adjusted EBITDA loss of $676 million. Combined, it and Golden Nugget Online Gaming (GNOG) spent over $1 billion on sales and marketing — and that doesn’t include promotions (which are netted out of revenue, rather than broken out as costs.)

If promotions and marketing come down, presumably that does wonders for DraftKings’ margins. The company said after Q4 that existing states would be positive in terms of contribution profit (gross profit less external marketing) this year. That’s still a long way from positive consolidated EBITDA, and guidance doesn’t suggest that much in the way of margin expansion.

Still, there is at least a path to hitting to getting in the black from an EBITDA standpoint, a necessary first step, and that path might be shorter than it now seems. Could DraftKings turn out to be something like Snap (SNAP) — a business that in the early going looked structurally unprofitable but within a few years was generating decent cash flow?

It’s possible. There are a couple of concerns, however. The first is management. I know DraftKings bulls will defend chief executive officer Jason Robins, but I’m not terribly impressed. The reason venture capitalists pumped money into DraftKings’ daily fantasy business before its own SPAC merger last year was not because DFS was a good business; DFS pretty clearly is structurally unprofitable. (The take rate is too high to keep casual players fully engaged; lowering the take rate means the business can’t cover costs.)

Rather, the point was that a dominant DFS business could become a customer acquisition engine for a dominant OSB business. That hasn’t happened. DraftKings crushed FanDuel in DFS share, but in OSB, DraftKings trails FanDuel by a reasonably large margin. Execution is at least one of the reasons why.

Meanwhile, it might just be that CEOs have to pump their stocks on social media now, but Robins’ activity there seems a bit of a red flag. Warning sellers who have sold the stock is not that much different from warning traders who have sold the stock short. Both are a much better way to inspire confidence from bears than bulls.

Valuation and capital are add to the concerns. (Capital is an issue across the space, given how much cash has headed out the door over the last two years.) At the 2021 cash burn rate, DraftKings has less than two years’ worth of cash left. Even assuming that burn rate moderates, if any unforeseen problem (including macro pressure) occurs, dilution almost certainly has to follow.

That aside, DKNG stock is cheaper after the sell-off, but a $7.2 billion market cap is still almost 4x 2022 revenue guidance. Given peak EBITDA margins probably in the 20% range (maybe 25%), I’m not sure that P/S multiple is quite where it needs to be.

But we are getting closer, and I’d bet at thin odds that there’s a quarter this year where DKNG stock is up 10%-plus after earnings. The biggest risk right now is that those gains come off a far lower base than the current ~$13.

Rush Street Interactive

Rush Street really has done a decent job so far. An Adjusted EBITDA loss of $65 million in 2021 hardly seems like a success, but margins of -13.5% are quite good in comparison to larger peers.

RSI does get some brand help in Illinois and Pennsylvania (where its former parent operates under the Rivers Casino nameplate), but it’s managed to carve out a decent amount of market share without spending itself into bankruptcy. The focus on the more profitable iGaming side of the business makes some sense as well.

That said, it’s still tough to turn terribly bullish at an enterprise value of ~$1.3 billion. Larger peers are probably going to improve their execution going forward. In theory, RSI makes sense as a takeover target (a la DraftKings/Golden Nugget) amid expected industry consolidation. It’s going to be tough to make that deal soon, however: RSI would be selling at a ~50% discount to past highs and an acquirer needs convince likely-skeptical shareholders.

But if RSI can keep holding high-single-digit share and move toward profitability without a big rally in the stock, the name starts to get interesting. I’ve generally been a skeptic here, but it’s worth at least keeping an open mind.

Caesars Entertainment

I mean this sincerely: Caesars Entertainment is one of the greatest stories in finance of the 21st century. In 2013, Eldorado Resorts was a private, family-owned map-dot with two and a half properties (Reno, Shreveport, and a JV in downtown Reno with MGM). Seven years later, after a string of wildly successful acquisitions, Eldorado closed its merger with Caesars (taking the name in the process) and became the largest gaming company in the U.S.

It is a staggering achievement. And it was enough to put ERI/CZR on the list of stocks to buy on a dip simply because management was good enough to bet on.

But the company’s foray into iGaming has been rough. The William Hill acquisition looks like an overpay, particularly with the recently renegotiated price for the sale of the non-US assets and ongoing technical problems stateside. The staggering amount of promotional and advertising spend in 2021 seems a result of vastly overestimating the lifetime value of acquired customers.

The rollout in Illinois (an important state!) of a bizarrely poor, low-functionality app — an error which was only fixed last month — still makes no sense. Chief executive officer Tom Reeg seemed to brag on the Q4 call about the number of customer support inquiries that came in after this year’s launch in New York state — ignoring the fact that the demand was due in large part to numerous outages on the site.

The power of the Total Rewards loyalty program and the Caesars brand means that being a distant fourth in market share is not anywhere close to good enough. That positioning also explains, at least in part, why the stock is 40%-plus below its highs.

A key question for investors thus might be: are the missteps in iGaming enough to drive broader concerns about management in the new era?

Penn National

I’ve been at best early on PENN stock so far. I wrote last May, with PENN at $76, that the stock was a buy for online gambling bulls. (That take might actually not have been that wrong; those bulls could have done worse elsewhere in the sector!) I recommended the stock more generally last month at $46, while arguing more forcefully for a $40 entry point. PENN now sits at $36.

There are two core problems in being bullish. The first, which is true for all of the brick-and-mortar plays, is trying to understand what, precisely, “normalized” earnings look like. Are we at the top of the cycle? Closer to the bottom? The beginning? The end? Given operating and financial leverage, it’s a hugely important question — and two-plus years after the start of the novel coronavirus pandemic, still pretty much impossible to answer.

The second is that Barstool Sportsbook seems to have disappointed. Of late, I’ve seen some commentary on social media and in industry coverage throwing shade at the Penn/Barstool tie-up, given the book’s minimal share (something like 4% nationally). But Penn and Barstool also (for the most part) avoided the promo/marketing race to the bottom, a decision that impacts that share.

Yes, market share is minimal, but it does seem like it’s growing. And Barstool looks like it will be cash flow-positive next year, with this year’s EBITDA target in the range of -$50 million.

There is hope for, and value in, the interactive business. Yet at $36, a smart investor can build a case that the market is assigning a zero, or something close, to that interactive business. (To reiterate, “can build a case.” A smart investor can make a lot of cases for PENN and the entire sector right now.)

Again, I’ve been early. The chart is ugly with a capital U-G-L-Y. But I’d add a key point: clearly, a lot of investors bought PENN last year without doing the proper due diligence. I wonder if a lot of investors are selling PENN, or avoiding it, this year in the same manner.

The ‘Picks and Shovels’ Plays

The intensely volatile market environment of the last two-plus years has created plenty of regrets for pretty much every investor. Selling too late, buying too early, missing out on short opportunities…most of us, myself included, have done it all since the beginning of 2020.

Reviewing the performance of suppliers like GAN and Genius Sports, however, catalyzed what might be my biggest regret. The case for those stocks, and others like KAMBI, was that they were ‘picks and shovels’ play. The term comes from the gold rush, when supposedly the only people who made money were those selling the picks and shovels to the miners, most of whom wound up busted.

It’s a common term in investing, particularly in retail-focused coverage. And it might be the dumbest concept in investing.

Here’s the thing: if the end market is a bubble, it doesn’t matter whether your exposure is direct or indirect. When the gold rush dries up, the picks and shovels store closes too. In fact, the whole bleeping town collapses.

And we have learned this lesson so many times. As we wrote in our first post here, the cumulative losses in telecom and fiber plays — the “picks and shovels” of the dot-com boom/bubble — vastly exceeded those of actual “dot-com” stocks. We’ve seen the same trend more recently in the electric vehicle sector (think lidar sensor manufacturers, charging plays, etc.)

To be fair, GAN and GENI from a distance look cheap enough to at least merit a closer look. But not because they’re “picks and shovels“ plays — only because maybe the sector as a whole is getting in range of a more reasonable valuation.

Disclaimer: As of this writing, Vince Martin is long shares of Cannae Holdings.

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