Special purpose acquisition company (SPAC) Landcadia Holdings II (NASDAQ:LCA) is merging with Golden Nugget Online Gaming. So far, the deal has been good for LCA stock. Even with a recent pullback, LCA trades more than 40% above its initial price of $10.
There’s an intriguing case here. The opportunity should be massive: according to the merger presentation, Golden Nugget estimates U.S. online gambling could be a $20 billion-plus market at maturity. Margins are higher in online gambling, where GNOG will focus, than in sports betting.
Golden Nugget is the early leader in New Jersey, basically the only U.S. market of significance at the moment (though more are on the way). And Landcadia II, based on future revenue expectations, looks cheap relative to peers.
But it’s that last point that actually undercuts, rather than supports, the bull case for Landcadia II stock. Online gambling bulls shouldn’t be looking for the cheapest play. They should be looking for the best play. The problem with LCA stock is that I’m not remotely convinced that Golden Nugget Online Gaming will be the best play.
An investor will own only an online gambling play like LCA if she believes the market will hit it big. Investors who believe that online gambling could turn out to be something like cannabis, which has significantly disappointed relative to early expectations of market size, will avoid or even short the sector.
Based on that thesis, the key is to find the biggest potential winner. Owning a “cheap” stock won’t be a successful strategy if that company turns out to be a relatively minor player.
Indeed, we’ve seen this phenomenon play out in other growth markets. Electric vehicle manufacturer Tesla (NASDAQ:TSLA) is a great example, and there are many others in sectors like software. Owning the leader in a market with a huge opportunity has been a winning trade in recent years for logical reasons.
The problem with LCA stock is that Golden Nugget’s early success in New Jersey is unlikely to be duplicated elsewhere. The company is targeting the market in Michigan, for instance — but in that state the Golden Nugget brand has little pre-existing recognition. That’s not the case in New Jersey and Pennsylvania, given the longstanding presence of the Golden Nugget in Atlantic City. It will be the case in most other states that do legalize.
Outside of the East Coast, GNOG is just another online gambling play. That’s a problem.
Because competitors will have built-in user bases, DraftKings (NASDAQ:DKNG) offers casino products in three states, and can leverage its millions-strong database of daily fantasy sports players. The same is true of FanDuel, a unit of Flutter Entertainment (OTCMKTS:PDYPY), which has had its own success in New Jersey.
Then there are the regional casino operators like Penn National (NASDAQ:PENN), Caesars Entertainment (NASDAQ:CZR), and others. Those companies will roll into new markets with existing loyalty members and, thanks to capital raises this year, fresh cash to invest in user acquisition.
Bear in mind that it’s the new markets that drive optimism toward LCA stock and other online gambling plays. Yet Golden Nugget is best positioned in the handful of states that currently allow a full suite of online gambling products but aren’t enough to create much profit on their own. In new markets, Golden Nugget will open at a disadvantage.
The Balance Sheet Question
There’s another problem, too, that Matt McCall highlighted on this site last month. SPACs raise cash from early investors, then usually inject that cash into the merger target (in this case Golden Nugget) to drive growth. But $150 million of Landcadia’s cash actually is going to pay off debt incurred before the merger; another $150 million in borrowings will be assumed by GNOG.
After the merger, GNOG will have an estimated $80 million in its bank account. That’s simply not enough.
DraftKings, for instance, just raised nearly $1.7 billion. FanDuel is flush thanks to Flutter’s operating profits in Europe. The regional casinos shored up their balance sheets this spring.
Those companies can flood the market with incentives to acquire users that will be profitable over the long haul. (Indeed, we’ve seen precisely that trend play out in Illinois as its online sports betting market opened this year.) Golden Nugget won’t have quite the same luxury.
The company does expect to invest in Michigan and Pennsylvania in coming years, per projections from its investor presentation. But given the early state of the GNOG balance sheet, it won’t have the dry powder to ramp that spend if need be. Rivals will.
LCA Stock Is Cheap, But…
These qualitative concerns offset what admittedly seems like an attractive fundamental case. Based on management projections, and pro forma for the merger, LCA stock trades at a significant discount to DKNG and back-end provider Gan Ltd (NASDAQ:GAN) when looking at next year’s revenue. An investor can argue that the valuation gap could and should close, which would drive Golden Nugget shares to outperform after the merger.
But that case has to be based on the argument that Golden Nugget’s opportunity is equivalent to those of others in the space. And when understanding the story, that argument starts to fall flat. DraftKings has a real shot to be dominant in both online gambling and online sports betting. Penn National can leverage its stake in Barstool Sports. Caesars has tens of millions of loyalty members.
What does Golden Nugget have? It has a lead in New Jersey, yes. But, again, New Jersey alone isn’t driving the optimism toward the sector. It’s the national opportunity, which will potentially be accelerated as state governments look to raise revenue after the novel coronavirus pandemic.
iGaming bulls should be focused on that opportunity. And it’s hard to argue that, in a crowded field, Golden Nugget will emerge as the big winner. That fact explains why LCA stock is cheap — and why it’s likely to stay that way.
On the date of publication, Vince Martin did not have (either directly or indirectly) any positions in the securities mentioned in this article.
After spending time at a retail brokerage, Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets.