The benefit of a fixed cost business model
Let’s say ABC is a casino operator with revenue and costs of $110 million and $100 million respectively, and its revenue increases by 10% in the following year, which causes modest increase in labor costs, maintenance expenditures, and fixed license fees.
ABC’s overall costs increase by say 5%, and instead of making $10 million in profits, it’s now making $16 million in profits ($121 million in revenue and $105 million in costs.) In other words, a 10% increase in revenue results in a 60% increase in profits. Assuming that the earnings before interest, tax, depreciation, and amortization (or EBITDA) multiple remains unchanged, this results in an increase to the share price.
The above chart shows the firm—which is generating $110 million in revenue, with $100 million in costs—is initially valued at say 10x EBITDA, or $100 million, with $70 million in debt and $30 million in equity. Now since revenue and costs rose by 10% and 5% respectively, owing to the fixed cost nature of the casino business, ABC’s EBITDA will rise to $16 million.
The total value of the firm at the same 10x EBITDA multiple will rise to $160 million. But the debt remains unchanged at $70 million. So equity will rise from $30 million to $90 million, or by 200%, as a result of the 10% increase in revenue.
This shows that when a company with high fixed costs touches breakeven, each additional customer becomes massively profitable. At this point, profit grows exponentially since each additional customer who comes in is at a minimal cost to the operator.
The pessimistic view
Let say ABC’s revenue drops by 5% to $104.5 million, but its costs decrease by say 2.5% to $97.5 million since state governments don’t lower license fees. ABC now experiences EBITDA of $7 million annually. Based on the same 10x EBITDA multiple, the firm is now valued at $70 million.
Remember that its debt is $70 million, which signifies that a 5% decline in revenue has entirely wiped its shareholder value, as shown by the above chart. This is the risk in high-debt casino stocks like MGM Resorts (MGM), Boyd Gaming (BYD), and Caesars Entertainment (CZR). This also explains why gambling stocks are more volatile than other stocks.
However, to avoid the risk of investing in such stocks individually, investors can invest in exchange-traded funds (or ETFs) like VanEck Vectors Gaming (BJK) and Consumer Discretionary Select Sector SPDR Fund (XLY) that give exposure to the industry.