Motley Fool Hidden Gems Investing - Why Do Casinos Lose Money?

Episode Date: February 6, 2023

If the house always wins, why are gambling companies having trouble turning a profit?  (0:21) Jason Moser discusses: - Privately-owned restaurant companies Cava Group and Panera Brands mulling a return to the public markets - How Panera has evolved since its last time as a public company - A key metric he's watching when Chipotle reports earnings on Tuesday afternoon (9:40) Ricky Mulvey and Matt Frankel discuss the struggles gambling businesses having making money and one business breaking the trend.  Stocks discussed: CMG, PDYPY, MGM, DKNG, CHDN Host: Chris Hill Guest: Jason Moser, Matt Frankel Producer: Ricky Mulvey Engineers: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

Chris Hill. If the house always wins, how come gambling businesses are having trouble making money? Motley Fool Money starts now. I'm Chris Hill. Joining me today, Motley Fool Senior Analyst, Jason Moser. Happy Monday. Jason Moser. Happy Monday indeed. 2022 was the weakest year for traditional IPOs since the dot-com bubble burst, but the IPO market may finally be heating up again. It looks like restaurants are leading the way. This morning, Kava Group, which is the parent company of the growing Mediterranean-style restaurant chain Kava, filed paperwork confidentially with the SEC to go public.

The Wall Street Journal is reporting that Panera is working on a return to the public markets. So, what is your reaction to either or both? Well, I'm not terribly surprised, I guess. You certainly see this happen from time to time, particularly if you see a business like Panera, for example, acquired by JAB several years back. Panera was a pretty good investment for a while. I think a lot of people did very well with it. Ron Shaikh seemed to feel like living life as a publicly traded company was just far more difficult than it really needed to be. I understand that. You have a lot of accountability and you're always under the microscope. I think it was a nice move for him to be able to step back and let

JAB take hold of that. But now you've got Panera in a bit of a different position than it was when it went private. It's not just Panera anymore. JAB has taken Panera and they've combined it with Caribou and with Einstein Bagels to create Panera Brands. It's more than what it used to be. Kava, very similarly, actually acquired a publicly traded company in Zoe's Kitchen. It took Zoe's Private, ultimately converting most of, if not all of those Zoe's Kitchens over to Kava models. But that was a way for them to be able to get access to a lot of growth at once. Restaurants are always tricky. On the one hand, everybody's going to eat. You got to love the recurring nature of sales, but there's a lot of competition that comes with it.

There's a lot that can go wrong. I think at least with these businesses, Panera more so than Kava, at least Panera has more than one way to succeed with three different brands under that umbrella. Kava is going to be a little bit more specific, and so there is a little bit of a risk there in how well it translates to ultimately what I would think would be a global opportunity that they're seeking. But yeah, I mean, it remains to be seen, but I certainly understand the desire to get back into the public markets. Yeah. I haven't looked at a map to see where Kava locations are. I know they're in the greater Washington, D.C. area where you and I live. For those listening who may not be familiar, just think Chipotle, but instead

of Mexican food, it's Mediterranean food. The ones I've been to, they do a very good job. It's good food. If they can achieve a quarter of the footprint and success of Chipotle, I think they're well on their way. You mentioned Ron Shaikh and Panera. I will always remember the day that Panera went private and Ron Shaikh, the CEO at the time, was sitting on the set at CNBC and he could not have been happier that his company was going private. He talked about how one-third of his time as CEO was spent on things related to Panera being a public company. He was interested in getting that time back and focusing more on the restaurant. I'm interested to see what the Kava Group wants to do with the money, because that's

always a great question whenever a company is getting ready to go public, what are they going to do with the money they get? And if and when Panera files, I'm interested to see that as well too, but not just the money, but what that business looks like now. Because You and I remember when Panera was a public company that was struggling because they had a confusing footprint in their locations. Ron Shaik had the famous memo where he basically compared Panera restaurants to a mosh pit and just said, we got to make these more efficient. They appear to have done that, and much of that has happened while the business has been private. As an investor, I'm not necessarily ready to throw my money at both of these.

I am very interested to read more. Yeah, I am. I was a shareholder a time ago in Panera. That was the gateway to me teaching my kids a little bit more about what I did for a living and ultimately helping them start their own portfolios as well. I do have a little bit of an emotional connection to Panera, Chris, I'm not going to lie. In looking at the two today, I like the idea of Panera being more than just Panera now. That to me makes it a far more attractive potential opportunity. I'm with you, I want to learn more, I want to read more. I'm not saying you got to jump in there and this is a no-brainer. I do think when you look at Kava, and your point there, it is very local

right? It is a D.C.-based concept. And so, Cava was very much in, sort of, this Middle Atlantic region for the most part. Buying Zoe's gave them access, I think, something like 300 restaurants at the time. So, it really helped springboard their footprint. And so, I would imagine the money is going to really go towards helping open more stores and maybe put the balance sheet in a little bit of a better position. But I think that when you look at something like 350 stores today, and then you look at where Chipotle is today, I think just over 3,100 stores now, they're still targeting. I think they're calling for somewhere in the neighborhood of 7,000. I feel like we can discount that a little bit.

Even if you discount that 20%, you get it back down to something in the mid-5,000s. a big opportunity for additional growth even from today. Chipotle is, I don't think, exemplary of every restaurant opportunity out there. I think it's one that has really succeeded over time for a lot of different reasons, but I think it at least gives you an idea of what Cava could be one day if that concept continues to gain traction. They don't have to worry about the mosh pit experience that Ron Shaikh was always talking about. As a consumer going into Padera, I think you and I both would agree, we felt that experience. It was disorderly at best. It's far different now. Cava, you hit the nail on the head. It is like Chipotle,

just Mediterranean. They have nailed that throughput experience down. Furthermore, restaurant business today is in a far different place with mobile ordering, with delivery, with picking up at the store. These are businesses that I think have really handled the way the restaurant industry has changed in such a short period of time. Speaking of Chipotle, they report after the closing bell on Tuesday, what is one thing you're going to be watching for in their results? Well, I think the restaurant-level operating margin is a good metric to pay attention to, Because from that one thing, you get a lot of additional information.

And so, looking at last quarter, for example, when they talked about restaurant-level operating margin of 25.3%, and that was up from 23.5% a year ago. And they talk about the increase being primarily due to the benefit of sales leverage, being able to push more traffic through the store, right? And that's one of the neat things about restaurants. if they can ramp that traffic up, it really shows the operating leverage that some of these businesses can generate, because you have a lot of those fixed costs that just go into keeping a restaurant open. But you see also a little bit of a better glimpse into how delivery impacts

their model. Lower delivery fees can actually help margins. But by the same token, we'll also get some information from that operating margin number in regard to food costs and increases or decreases in hourly wages for employees. So you get a lot of information just from that one metric. Jason Moser, thanks for being here. Thank you. There's an estimated $900 million that will be wagered legally on Super Bowl 57. With more states legalizing sports betting, you'd think more of the businesses involved would be rolling in profits. That's not the case. Philadelphia Eagles fan Matt Frankel and Cincinnati Bengals fan Ricky Mulvey gear up for the big game by taking a closer look at the reasons why so many

gambling companies can't seem to turn a profit and one business that's bucking the trend. Casinos have been around for thousands of years. Who started gambling? Who's the first big-time riverboat gambler. Who cares? We're talking about gambling today with the Super Bowl coming up. Frankly, Matt Frankel, why a lot of these betting companies aren't profitable. Some more states open up. Many of them are in growth mode, but something that really stood out to me about the company DraftKings is that its operating income in the trailing 12 months was negative $1.5 billion. They are not alone in that category of unprofitable casinos. Let's start with this question. How do you lose money running a casino? It seems counterintuitive, doesn't it?

After all, a casino, it's a business that doesn't really sell a product. It's a business that people go into planning on just literally giving their money to. I've walked into a casino and said, here, I'll lose this $100, and then I'm done. It seems counterintuitive, but it's expensive to run a casino. I mean, just physical casinos have the disadvantage that they need a physical property. And it almost always costs more to build a casino than it's worth. Just as an example, MGM Resorts recently built the MGM Springfield. They spent $960 million to do it and ended up selling it to a real estate investment trust for $400 million. So that debt just sits on their balance sheet, they're paying interest on it, and they didn't even recoup the investment.

Physical casinos have taxes, rent, insurance. All casinos, online or physical, have marketing expenses. Customer acquisition costs are very high because there's so much competition. The more legalization it gets, which is the thesis behind gaming right now, the worse the individual casinos are going to do. Look at Atlantic City. Atlantic City was a dominant gambling town two decades ago. Then they opened up gambling in Philadelphia, in New York, in Connecticut, and online, and it just completely died. There are a lot of costs involved with not only running a casino, but keeping up with the other casinos and getting the customers to want to give you their money. One of the issues with the online

ones, it's got to be the marketing expenses, because they give you a little taste, hoping you'll hang on for a long time. Then it's fairly easy for gamblers to do the $5 bet and then the automatic $200. Then if you spread that around the different sportsbooks, you can have a pile of money to bet and hopefully not get addicted to it. I want to focus in on DraftKings though, because as you mentioned, that's not a gambling company with a large physical presence. They do have sportsbooks open. I'm wondering if they're focusing on the right things. The stock has gone up because it's announced a layoff, good for them. However, the DraftKings CEO said this back in November in an interview, Jason

Robbins, quote, down the road, we will be valued on a multiple of EBITDA and all that matters is maximizing that number. As long as we do that, we'll have the highest valued company we can have." When you hear a quote like that from leadership, do you think that company is focusing on the right things. Well, yes. Positive EBITDA would be great. But DraftKings is a textbook example of how much it costs to get gamblers to give you their money. Just to put some numbers behind it, in the latest quarter, DraftKings did just over half a billion dollars, $502 million in total revenue. Out of that, $322 million were sales and marketing. So, that layoff that you mentioned is going to help

them in their administrative costs and things like that. But when you're spending over 60% of your revenue on just sales and marketing, and that's not including just general business expenses, it doesn't leave a lot of room for profitability. So, that's the big thing. I think they should focus on customer loyalty, customer retention, because the more loyal your customers are, the less you have to spend on sales and marketing. So, yes, they're focused on the right things. I don't know if they're going to get there in the ways that they're trying to do. Yeah, it's not like other industries where there's high switching costs, it seems. As more states open up, I don't see how the land grab for gamblers' dollars ends,

even if you're five years past, let's just say, full legalization in the United States. Yeah, it's literally the opposite of high switching costs, right? There are other sites that will pay you $200 in free bets to come over to them. You can just cycle through those. It's literally the opposite of a sticky business. Switching incentives, not cost. There is no cost. There's switching incentives. Looking a little bit more at the macro environment, you're going to see this on Sunday as gambling companies try to bring more of the experience into their advertising. FanDuel is doing the Gronk Kick, which is a live commercial where Rob Gronkowski is going to kick. And if he makes the field goal, then gamblers win, I think it's

$10 million of a prize pool. DraftKings and Coors have this bet where gamblers can essentially pick out the details of a commercial, everything from how many people are in the bar, how many of the men have facial hair. And the reason they're trying to do that is they're trying to set themselves apart as entertainment companies. But I wonder, you know the insurance business pretty well. Are these companies more like car insurance, where you have a commodified product and the only thing that separates what you do is the marketing? Yeah. There are some ways that DraftKings, in particular, differentiates themselves. They continually add, like you said, innovative bet features. They recently added early payout.

That's a cool feature that I saw. If your team's 40 points ahead and you have a bet on it, they'll go ahead and pay you out before the game's over, so you can go ahead and use that money for another game. Things like that are differentiators. But yeah, at the end of the day, it's really not that hard for other companies to add these features in. It's a programming thing. It is definitely a commoditized thing. The big bull case right now is, it's only legal in about a third of the states. As time goes on, if DraftKings were to, say, triple its revenue, would that result in profitability? That's where it needs to go if there's a real path to profitability here.

Is the path to profitability just iGaming, then? More of these companies are lobbying for essentially allowing online casinos on their apps, which I should mention has terrible second-order effects because if you're a problem gambler, then having a slot machine in your pocket gives you access to the game whenever, wherever you want, and you have no social impacts of going to a casino, and it's easier to hide the addiction because you don't have to leave your couch. Is that the only way that these companies can get profitable, though, is by introducing the slot machines onto their applications? I don't think so. The reason why is because the kind of gamblers that would make

that a profitable business. Meaning, people who go and spend a couple thousand dollars at a time and can afford to do it, not the problem gamblers, but people who can afford to do that, they want to be well taken care of, like how brick-and-mortar casinos do. It's really tough to compete for that kind of gambler as an online operation. It's still a pretty small part of DraftKings' business. The sports betting part of it is only in states right now that cover 37% of the U.S. population. There's a lot of room to grow that. The iGaming business is only in about 11% of the population, states-wise. But I don't see that as a big profit driver going forward. Yeah, it could give people

something to do, like you could play online blackjack during timeouts in your football game and things like that. But I see it as more of an adjacent business as opposed to a path to profitability all in itself. There's no stopping the dopamine drip. We've talked about why a lot of these companies are unprofitable. However, it is an addictive product and that can create a sticky revenue stream. Some have beaten the market. Are there any that you think investors should pay attention to in the gambling entertainment space? Sure. One in particular is one that's actually partnering with DraftKings, Churchill Downs. They're best known for their namesake racetrack. They host a Kentucky Derby.

They're partnering with DraftKings to develop the horse bedding capability. But they are a very profitable casino company. They have physical casinos, they do have some online operations, but they're mostly physical casinos and racetracks. They ran a 15% net profit margin in the most recent quarter. Just to put that in perspective, DraftKings ran something like a negative 80% net margin. They were very net profitable. All their business segments were profitable, including horse racing, gaming, online. They were profitable in all their different business segments. They're growing, they're buying back shares, things that value stocks do, not unprofitable

gaming companies. You don't have to have unprofitability to be a successful casino company. Churchill Downs, I believe, has beaten the market over time. It has solidly beaten the market over the past five years. It's like when you realize that the railroads have just, what is it, on some stretch of time, the railroad companies have solidly beaten the NASDAQ. Sure. Old money does okay. As we wrap up, we've got the Super Bowl coming this weekend, and the Philadelphia Eagles are taking on an illegitimate opponent out of the state of Missouri. Any storylines or picks you want to chat about before we wrap up? Well, you won't get any arguments from me there. I'm born and raised right outside of Philadelphia,

So, I'm a very die-hard Eagles fan. So, I'm going to be rooting for my birds this weekend. I'm also biased as someone from Cincinnati. I think that's enough said about my thoughts on the Kansas City Chiefs. Matt Frankel, always great catching up with you. All right. Thanks for having me. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.