The house always wins: Why the casino business model is (almost) always profitable

Casinos are often regarded as one of the most profitable businesses in the world. We explore what goes on behind the scenes and share a few reasons why we think NagaCorp is a good investment opportunity.

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  • Published on 20 Nov 2019

The house always wins: Why the casino business model is (almost) always profitable  | Open a FREE FSM account and manage all your investments conveniently in ONE place
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The secret to a casino’s long-run profitability lies in the house edge, which ensures that on aggregate, the income produced by all wagers is greater than the total pay-out on all winning bets.
The combination of the house edge and rising visitor arrivals is incredibly powerful as in the case of NagaCorp, which recorded a 30% CAGR for its gross gaming revenue since its IPO.
As the only licensed casino operator in a city where the number of tourist arrivals is expected to double by 2025, NagaCorp is in a prime position to benefit from the rising demand. 
Our target price for NagaCorp is HKD 16.5, representing an upside potential of about 13% (as of 20 Nov 2019).


I vividly remember the very first time I stepped into a casino. It was back in June 2015 when I visited Melbourne for a holiday. A friend of mine, who was studying there at that time, suggested that we pay a visit to Crown Casino, recalling how he’d won big at the roulette tables several days ago. The visit proved to be a fruitful one – by the time we stepped out, we each had about AUD 2,000 in our pockets, 10 times more than what we had started with.

Enticed by the prospect of another huge win, we headed back the very next day, only to lose almost all our previous day’s winnings after spending just less than an hour in the casino. It was at this moment when I truly understood the meaning behind the saying “the house always wins”.

Casinos are statistically proven to be profitable businesses 

While the day-to-day operations of a casino might be complex, the overall business model is actually very simple to understand. A casino is a place that offers games of chance, in which players have the opportunity to win an amount in excess of their initial wager. However, these games are never fair as the odds of winning are skewed slightly towards the house.  

In each game, the casino has a built-in statistical advantage which ensures that over the long-run, the income generated by all wagers is greater than the total pay-out on all winning bets, a scenario known as positive net wins. This statistical advantage, otherwise known as the house edge, is the secret to how casinos maintain their profitability over time. 

Take the game of roulette for example. The pay-out ratio of a straight up bet (single bet on one number) is 35 to 1. The game would be fair for both sides if the wheel had exactly 36 pockets, in which case the house edge would be zero as shown in the calculations below. 

House edge = (Pay-out x Win probability) + (Loss x Lose Probability)
                      = ($35 x 1/36) + (-$1 x 35/36)
                      = $0

In reality, however, the European version of the roulette wheel has 37 pockets in total, numbered from 0 to 36 (Figure 1). This means that the probability of success for such a bet is only 1/37, whilst the pay-out remains at 35 to 1. It is this seemingly insignificant mismatch between the pay-out and the probability of winning that forms the house edge. 

House edge = ($35 x 1/37) + (-$1 x 36/37)
        = -2.70%

Figure 1: Different layouts of a roulette wheel    


Source: Casinochecking.com

An alternative way of interpreting the house edge is that, on average, the casino is expected to win 2.7% of the player’s money over a set period of time. Needless to say, the house edge for American roulette, which has 38 pockets in total, is much higher than its European counterpart at 5.26%, and this is why you should always pick the European version over the American one. Based on statistics, we can conclude that the casino’s earnings depends on calculated probabilities, unlike the players who rely heavily on luck. 

Roulette is only one example. Modern day casinos have more than a hundred different games, each with its own house edge that can be as high as 35% for certain games (Table 1). While this does not mean that players will lose every single time they bet against the house, the house edge does ensure that on aggregate, as long as there are sufficient players, the casino will always win more than it loses, which is why running a casino is such a profitable business. 

Table 1: House edge of various casino games  

Game House edge
European roulette (single zero) 2.70%
American roulette (double zero) 5.26%
Baccarat (no tie bets) 1.20%
Blackjack (average player) 2.00%
Craps 1.58%
Sic Bo 8.00%
Slots 5% to 15%
Keno 5% to 35%
Source: Wizard of Odds, iFAST Compilations

Factors that will propel the future growth of NagaCorp

The combination of the house edge and higher visitor footfall is an incredibly a powerful one, as it enables casinos to expand their gross gaming revenue (GGR) over the long-run. The effect is clearly visible in the case of NagaCorp (HKEX:3918), which saw its GGR grow at a compounded annual growth rate (CAGR) of close to 30% since its IPO (Figure 2). More recently, the company reported that its 2018 GGR rose by a massive 66%, driven mainly by the opening of Naga 2 in late-2017.


Following the successful launch of Naga 2, the company is already embarking on its next expansion project, Naga 3, which is another integrated casino, hotel and condotel. When completed, Naga 3 is projected to vastly broaden NagaWorld’s gaming capacity by adding another 800 gaming tables and 2,500 electronic gaming machines (Table 2). 

The company expects the additional capacity from Naga 3 to tie in well with Cambodia’s burgeoning tourism industry, where visitor arrivals are expected to skyrocket over the next few years as more people recognise Cambodia as a destination for both business and leisure within Southeast Asia. Propelled by higher visitor footfall and a larger gaming capacity, NagaCorp’s revenue is estimated to grow at a CAGR of close to 20% over the next three years, reaching a high of USD 2.3 billion in 2021.

Figure 2: NagaCorp’s gaming revenue expected to climb further on higher visitor arrivals and the addition of Naga 3



Table 2: Nagaworld’s gaming capacity will more than double when Naga 3 is completed

  Naga 1 NagaCity Walk Naga 2 Naga 3*
Launch Date December 2016 August 2016 November 2017 2025 (expected)
Project Type Integrated casino and hotel Underground duty free shopping mall Integrated casino and hotel Integrated casino and hotel/condotel
Floor Area (sqm) 113,000 13,000 108,000 544,000
Gaming Capacity 250 gaming tables, 1700 EGM - 300 gaming tables, 2500 EGM 800 gaming tables, 2500 EGM
Hotel Capacity  700 rooms - 900 rooms 4,720 rooms
*Currently in development
Source: Company Data, Moody’s Investors Service, Morgan Stanley Research

Furthermore, NagaCorp also benefits from the favourable regulatory environment in Cambodia. In contrast to its neighbours, such as Singapore and Malaysia, where casino operators are required to pay a gaming tax based on their GGR, Cambodia does not have a formal casino tax law. 

Instead, casino operators like NagaCorp pay a fixed obligation to the Ministry of Economy and Finance on a monthly basis. For the full year 2018, NagaCorp made a total of USD 8.8 million in fixed obligation payments, representing only a tiny fraction of the USD 1.47 billion revenue it earned that year. 

Moreover, NagaCorp has a firm foothold in Phnom Penh’s tourism sector, secured by a monopoly license that grants the company exclusive rights to operate casinos within a 200km radius of Phnom Penh up till 2035. This unassailable economic moat, combined with a profitable business model, higher visitor footfall and favourable regulatory environment are key factors which should enable NagaCorp to continue to deliver superior financial performance over its peers for the years to come (Table 3). 

Table 3: NagaCorp’s gross gaming revenue growth far outpaces its regional peers 

  2015 2016 2017 2018 2019E 2020E 2021E
Macau 28,852 27,896 33,093 37,372 36,814 39,220 41,921
    -3% 19% 13% -1% 7% 7%
Singapore 4,778 4,164 4,605 4,555 4,194 4,219 4,261
    -13% 11% -1% -8% 1% 1%
Philippines  2,463 2,823 3,027 3,560 4,226 4,730 5,282
    15% 7% 18% 19% 12% 12%
Malaysia 1,436 1,359 1,367 1,557 1,486 1,461 1,476
    -5% 1% 14% -5% -2% 1%
NagaCorp 481 501 926 1,434 1,785 2,003 2,244
    4% 85% 55% 24% 12% 12%
Source: Bloomberg, Company Data, JPMorgan estimates
Gross gaming revenue is presented in USD (millions)

Attractive upside potential and dividend yield

In addition to the factors mentioned above, NagaCorp (HKEX:3918) is also trading at attractive valuations of just 14.6X 2020 earnings, lower than our estimated fair multiple of 16.5X derived from the Gordon growth model. Our target price of HKD 16.5 represents an upside potential of close to 13% (as of 20 Oct 2019). To sweeten the deal, the company also has an attractive dividend yield of approximately 4.28%, which effectively means that investors are getting paid while they wait for share prices to appreciate.

While NagaCorp (HKEX:3918) may not be the first name that comes to mind when discussing about the gaming industry, it is undoubtedly a company that still has plenty of room to grow. The monopoly license, rising visitor footfall and upcoming expansion plans are all important factors that will help ensure the continued growth of the company in the long-term.

Figure 3: Over the long-run, share prices are driven by earnings



Table 4: Strong earnings growth for NagaCorp expected

  2018 2019E 2020E 2021E
Forward PE Ratio 12.81 15.86 14.6 13.53
Expected Earnings Growth 14.00% 35.91% 6.12% 11.54%
EPS (HKD) 0.71 0.96 1.02 1.14
Source: Bloomberg, iFAST Compilations



Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.


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