Now that the gaming industry has experienced its first round of loan defaults, it is time to revisit fundamental investment decision criteria.
- Foxwoods Resort Casino, located in Connecticut, is in the process of re-structuring $1.45 billion in debt. It is the largest casino in the US and has four hotels with over 2,700 hotel rooms and 31 restaurants. It serves a huge daytrip market that includes Boston, Providence and Hartford, an area that it shares with only one other large casino.
- The Inn of the Mountain Gods Resort & Casino located in southern New Mexico 140 miles from the nearest population concentration of El Paso, needs to restructure $200 million of debt incurred when it replaced its original casino and hotel with a luxurious new resort complex. It has been profitable in only three of 11 quarters since opening in 2005.
- In northern Michigan, the new Odawa Casino Resort is struggling to meet the debt service on $200 million incurred when the tribe replaced its old casino and added a hotel in an attempt to become a destination resort in a seasonal tourist market that is otherwise sparsely populated.
- In Las Vegas, Strip casinos have rushed to add restaurants, hotels, condominiums and retail in recent years, without expanding gaming floors. The effect of this change in business model is shown by the fact that gaming revenue at Strip casinos now accounts for less than one-half of total revenue. The $2 billion Fontainebleau complex is in bankruptcy while still under construction. The $8.6 billion, 18 million-square foot CityCenter gaming complex which recently opened on 67 acres on the Strip is reported to be the single most expensive privately funded project in the western hemisphere.
Gaming revenue at all U.S. casinos experienced an average annual compound growth rate of over 6 percent between 2001 and 2007; Native American casino revenue increased at 13 percent. During this remarkable growth period, huge amounts of capital have been invested in non-gaming amenities in an attempt to increase market share. More restaurants and hotels have been added to numerous casinos across the country along with convention centers, show rooms, golf courses and other capital intensive and often payroll-intensive amenities. This has generally proven to be a good strategy and has resulted in vibrant casino entertainment complexes that are wonderful assets to their communities, generating jobs, entertainment and tourist dollars. These amenities have been successful in broadening the customer base beyond prolific gamblers to include a broader range of patrons seeking entertainment.
Amenities can be effective in boosting gaming revenue by inducing players from the existing market to spend more at the casino, expanding a market by attracting different patrons from the existing market, or by drawing people from a greater distance. A few amenities can be profit centers, such as a well-conceived restaurant or hotel or a gas station/convenience store. Many are break-even at best and some function consistently as loss leaders. The amount of capital invested in these amenities can be huge, while the economic return from them can be minimal.
These casino investments should be evaluated on the basis of the incremental amount of new business they generate for the casino, both in new gaming revenue and contribution to overhead from the operation of the amenity. This economic benefit must then be compared to the additional debt that is incurred to construct them.
The characteristics of each market must be carefully studied when calculating likely economic benefits from a new amenity. For instance: will a new hotel really draw players from outside the current market or will existing players fill the hotel and spend their same gaming budgets over two days instead of in one-day visits? Or perhaps the hotel will be filled with tourists who are not big gamblers. Will a showroom or convention center bring new patrons who gamble before and after an event, or will it attract non-gamblers who fill up the parking lot and drive casino regulars to a competitor? A golf course is a prestigious casino amenity, however there are few markets where a course can be economically justified on the basis of the incremental gaming revenue it attracts.
In many instances, it seems like the investment criteria of incremental revenue and return on investment may have been over shadowed in the decision-making by “we want it and can afford it” or “we need one because our competitors have one.” These latter criteria are acceptable if paid for out of cash flow or with very low leverage, but high debt leverage can jeopardize the golden goose (the casino) when negative market forces occur, such as a recession or extreme competition. Relatively large investments chasing small incremental revenues create unnecessary risk.
Many casinos found they were not immune to recent problems in the U.S. economy, which caused the casino industry to experience its first revenue decline in two decades. A business decline of 5% in 2008 and a slightly higher rate in 2009 has created financial stress for a number of highly leveraged casinos and substantially reduced distributions in others with large capital investments.
A casino gaming operation has a relatively high fixed cost and low variable cost, making its bottom line cash flow very vulnerable to a business decline. Such expenses as surveillance, security, cage operations and slot machine leases cannot be significantly reduced when casino revenues decline. Nor is there a “raw material” cost at a casino to provide an expense savings when business falls off. Thus, a large proportion of any decline in top line revenue flows through to the casino’s bottom line. (Casinos in states with high gaming taxes experience a higher variable cost and therefore cash flow may be less sensitive to a decline in business.)
In looking at an investment in a new amenity, decision-makers should never lose site of the fact that no investment they can make in bricks and mortar will ever equal the return on investment from the casino. Thus, each subsequent expenditure on additional casino amenities will diminish the return on the overall investment. Investments made with reasonable debt levels that produce a well-conceived casino complex, one that is financially viable and protects market share, is a prudent business strategy. Investment in expansions and amenities that have only marginal incremental returns or are loss leaders can greatly increase the financial risk for a casino.
A good sensitivity analysis that demonstrates the financial impact of a business decline on the casino’s ability to meet its debt service obligations is an effective tool in preventing over-investment that can topple an enterprise when market conditions deteriorate. The model used in an analysis must accurately consider the behavior of both fixed and variable costs in the event of a revenue decline. By showing how cash flow will be affected if various levels of business decline occur, and comparing these cash flows to new debt service requirements, decision-makers are better able to assess the financial risk of a planned venture.
It appears that the casinos mentioned in the opening paragraph may have gone too far in trying to capture the marginal gaming dollars in their marketplace and/or generating new dollars. Public companies have an obligation to maximize profits for their shareholders, but stability and risk are important value considerations, too. Native American tribes, where casino profits may fund government and social services and provide needed income to tribal members, should probably take a more conservative business approach.
About the Author:
Stephen Sherf is a former member of Cayuga Hospitality Consultants.