Somewhat incredibly, Penn National Gaming (NASDAQ:PENN) shares have rallied some 29% so far in 2020. Despite a pandemic that has ravaged its business, Penn stock has added about $850 million in equity value through the first five and a half months of the year.
Unsurprisingly, PENN stock is the exception as far as the sector goes. Most casino operators have seen their shares fall sharply year-to-date. The novel coronavirus shut down the industry for much of the second quarter. Capacity limits and nervous customers will pressure results in the second half of the year and potentially beyond.
Yet PENN has rallied. The reason why is simple: a potentially transformative acquisition that closed in February. Investors loved the deal at the time, and clearly they still do.
I worry, however, that they love it a little too much. Hopes for sports betting have driven up multiple stocks – but by definition not every operator is going to win in that market. Even those that do may not see quite the explosive growth that some believe. And in the meantime, investors are ignoring very real risks in the business that drives all of Penn’s profit right now.
Admittedly, PENN stock at March lows below $5 was ridiculously cheap. Back at around $33, however, the rally at best seems to have run its course.
The Barstool Deal
Clearly, what’s driving the optimism in PENN stock is the company’s acquisition of a stake in Barstool Sports. Barstool will underpin Penn’s branding in sports betting, while its enormous audience should provide an easily accessible base of potential customers.
The market loved the acquisition. Penn shares spiked on the news, and kept gaining to a new all-time high. And there are reasons for optimism.
After all, sports betting is going to be a big business in the U.S. And it’s possible from a long-term perspective that the Covid-19 pandemic proves to be a positive for the market. State-level legalization is required, and more states may be more willing to contemplate legalized sports betting as a way to fix budget holes caused by the pandemic response.
The Barstool deal sets up Penn to be a potential leader in that key market. It also allows for cross-selling of online gambling products, where the company has had early success in Pennsylvania.
So the deal suggests some value in PENN stock. The question is if an acquisition that cost $163 million, and valued Barstool as a whole at less than $500 million, supports what looks like over $1 billion in outperformance so far in 2020.
Challenges in the Legacy Business
After all, shares of other regional casino operators have gone in the wrong direction so far this year. Boyd Gaming (NYSE:BYD) is down 26%. Eldorado Resorts (NASDAQ:ERI) has fallen 31%. The news for Macau-heavy casinos is just as bad, as Las Vegas Sands (NYSE:LVS) has declined 28% and Wynn Resorts (NASDAQ:WYNN) 35%.
Across the sector, the market is pricing in significant pressure on land-based casino operators. The impact of closures in March alone cost the industry as a whole billions of dollars. Interest rates, and expense, presumably rise going forward as bond markets price in higher risk.
There’s the possibility of a macroeconomic impact on visitation and spend. Older customers – the core of any casino’s slot business, which provides higher margins than table games – may stay nervous about visiting brick-and-mortar properties for years to come.
Penn National is not immune to these challenges. And it’s worth remembering that in a negative environment for the sector, PENN stock should underperform, not outperform. Including the leases owned primarily by Gaming & Leisure Properties (NASDAQ:GLPI), a real estate investment trust Penn spun out in 2012, the company has nearly $11 billion in debt. Relative to earnings, it’s the most leveraged player in the space at the moment.
The optimism toward the Barstool deal ignores all of those challenges. It’s still the legacy brick-and-mortar business that is the most important business – and that will be the case going forward as well. That business should have a lower valuation, not a higher one. Yet, again, PENN has added $850 million in market value so far this year.
Sports Betting and PENN Stock
PENN stock has added at least $1 billion in value simply due to investors revaluing its sports betting opportunity post-Barstool. And to some investors, I can see why that makes sense.
After all, DraftKings (NASDAQ:DKNG) has a market capitalization pushing $13 billion. Flutter Entertainment (OTCMKTS:PDYPY) stock has marched steadily higher on hopes for its FanDuel unit. And there’s one other regional casino operator whose shares have risen in 2020 (if modestly so): Churchill Downs (NASDAQ:CHDN), which can leverage its existing TwinSpires online horse racing platform to acquire customers and provide the technology for sports betting nationwide.
But that paragraph alone shows part of the problem here: every stock is rising. The same is true for suppliers, most notably Gan (NASDAQ:GAN), which has rallied more than 700% in a matter of months.
These companies can’t all win. U.S. sports betting will largely be a zero-sum game. Gains at one operator will be losses for another. Supplier profits come out of casino revenues.
Meanwhile, it’s far from guaranteed that sports betting will be that big a market. Major states including New York and California remain on the sidelines, and politically dysfunctional enough to see debates last for years on end. Online sports betting has only been legalized in a handful of states; in-person betting is not nearly as profitable.
More broadly, sports betting is a much smaller market than casino gambling. It’s not a 24/7 pastime. Outside of football, betting demand remains relatively thin. Yet investors in PENN are focusing on the smaller opportunity – and ignoring the bigger problem. If and when that changes, the rally in Penn National stock will be over.
Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets. He has no positions in any securities mentioned.
