This article on deep value stock Dover Downs was written by Thomas Niel. Thomas is a private investor, a financial blogger and an accountant in Washington DC. Creative Commons photo by GregMontani, edited by Broken Leg Investing.
When investing in deep value stocks, it can be discouraging to see investments that “on paper” appeared to be screaming bargains turn into disappointing value traps. But once in a while, a deep value stock will not only trade up to its intrinsic value, but will do so within a short time frame (12 months). Unlike other games, investing can be beaten with just a few “winners” in a diversified portfolio. While it is difficult to anticipate such situations, screening for the best opportunities and diversifying prudently can help you find these “diamonds in the rough.”
Such was the case with Dover Downs. The company, a casino operator in the US state of Delaware, was the quintessential deep value stock. Trading at a material discount to net tangible asset value (NTA), and with a low multiple to operating cash flow, investors had shunned the stock.
The lack of love from “Mister Market” was no mystery: increased competition from neighboring states threatened Delaware’s once lucrative casino industry — until the early 2000s, Delaware and New Jersey were the only states on the Eastern Seaboard to offer casino gambling. With larger casinos opening in markets that previously provided Dover Downs its customer base (Washington, DC, and Baltimore, MD, metro areas), the market assumed the company would continue to decline.
But the emergence of catalysts in 2017 and 2018 had a strong effect on closing the gap between trading price and intrinsic value. Along the way, value investors received additional opportunities to add to their positions, as investor interest temporarily dissipated.
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Background To This Beautiful Deep Value Stock
Dover Downs Gaming and Entertainment operates the Dover Downs Racetrack & Casino in Dover, DE. Dover Downs was initially a harness racing track, but in the mid 1990s was permitted to add slot machines and eventually full casino gaming on the premises. A 165,000-square-foot casino was eventually built, as well as a 500-room hotel and conference center.
The addition of full casino gaming turned the property into a cash cow — at the time, Delaware was the closest legal casino jurisdiction, and players from the Washington, DC, and Baltimore metro areas flocked to play the slots at Dover Downs. In 2016, the property generated $182 million in revenue, $157 million of which came from gaming.
Dover Downs Tumble Into Deep Value Stock Territory
Dover Downs became a deep value stock due to declining performance following the legalization of casinos in Maryland in 2012. Several casinos opened within the Baltimore and Washington, DC metro areas, including Live! (2012), Horseshoe Baltimore (2014), and MGM National Harbor (2016). With such a plethora of nearby casinos, loyal out-of-town patrons of Dover Downs began staying home to play. As a result, Dover Downs began to see declines in revenue and earnings.
In addition to increased competition, the state of Delaware became hungrier for more of the gaming revenue. The state’s take of slots revenue increased in 2008 and 2009. While the state allowed Dover Downs to expand to table games in 2010, a license fee and high taxes on the revenue were the trade-off. As a result, while the state of Delaware and the horseman’s fund took home $77 million, the company was left with a net profit margin of less than one percent in 2016.
Deep Value Stock Dover Downs Tumbles From Roughly $3.30 to $1.03 per Share (Source: YCharts)
The trend of decreased gaming revenue and increased gaming taxes was not a winning combination. Investors wrote off the company, causing the stock to fall far below the company’s NTA.
Dover Downs: A Must Buy Deep Value Stock For Investment Letter Subscribers
While the long-term prognosis did not look good, Dover Downs had many positives for a deep value stock:
On a cash flow basis, the property was profitable, generating $10.4M in operating cash flow in 2016. Very little of this had to be spent on capital expenditures ($2.8M), giving Dover Downs plenty of cash to pay down debt incurred while building out the facility.
This debt was a concern, as it was set to mature not too long after our investment (Fall 2017). The credit facility was renewed another year, and the stabilization of Dover Downs’ revenues made it more likely the property would generate sufficient cash flow to service and pay down the debt.
Safety of principal and stability of value are important criteria before we decide on a deep value stock. Safety of principal was provided by the heavy discount to net tangible assets. Dover Downs shares were trading for around $1/share, and with NTA at ~$3.49/share, the discount was more than 70%. Stability of value was also present, as despite its tepid performance, the company had maintained this tangible asset value for several years.
The NTA of Dover Downs did not tell the whole picture — in addition to the casino and hotel facility (which had a replacement cost many times that of Dover Downs’ NTA), the company owned 69 acres of land adjacent to the casino, some of which bordered a local shopping mall. This provided the added opportunity to redevelop this land as retail outparcels.
On a cash flow multiple basis, Dover Downs was definitely deep value, with price to free cash flow at 4.53x at the time of our investment. It was safe to say the company offered more than sufficient margin of safety.
A Helping Hand From Lawmakers? This Catalysts Really Sweetened The Deal
When investing in deep value stocks, it is important to vet the likelihood catalysts will help bring the company’s shares closer to intrinsic value within a reasonable time frame. Many stocks that trade at significant discounts fail to meet this criteria and are considered “value traps” (shares may be cheap, but they will stay cheap for so long that a reasonable investment rate of return cannot be realized… and investors could even lose money).
At the time, Dover Downs had such a catalyst — Delaware realized that it could not continue generating more revenue from its casinos than the casinos made in operating income. So, the state created a Lottery & Gaming Study Commission to investigate and recommend changes that could benefit Delaware’s gaming industry.
This commission recommended changes (decreases in gaming revenue taxes, credits for marketing expenditures, elimination of table game license fees) that would boost the bottom line of the state’s moribund casinos. A senate bill was introduced in 2016 but was not acted upon during the legislative session.
Assessing A Deep Value Stock? Meet Our Ultra Scorecard’s Core Criteria
To be considered for investment, we have a set of core criteria to weed out weaker opportunities. Dover Downs met all these:
- No Chinese operations
- Not an exploration firm
- Average Daily Volume above $1000 USD equivalent
- Low price to NTA (more than 70% discount)
- Low Debt/Equity (existing credit facility but was being paid down rapidly)
- Adequate past earnings/catalyst (reduction in state gaming taxes)
- Past Price Above NTA (prior to expansion of gambling in Maryland, shares traded above NTA)
- Existing operations (company-owned operating business that was generating cash flow)
- Buybacks/insider buys (no buybacks, but majority shareholder was accumulating more shares)
- No shareholder dilution
- Small market cap (well below $100M threshold)
- Market cap above $1M (market cap ~$34M)
Ranking Criteria: How To Tell If You Found An Exceptional Deep Value Opportunity
To pass for consideration, a company does not have to meet all of these, but meeting just a few is a strong positive. These are used to assess one opportunity against another.
- Price to NTA below 25%: Did not pass, but discount still material (~29.5% of NTA)
- Market cap below $50M (Pass)
- Angry activist: Did not pass; also, controlling shareholder limited activism potential
- Cyclical depressed industry: Company was facing headwinds, but gaming is not cyclical
- Buybacks AND insider buys: Insiders buying, but no buybacks
While Dover Downs did not pass many of these ranking criteria, both the discount to NTA and the under-the-radar (market cap well below $50M) nature of the stock made it a strong consideration. The presence of a controlling shareholder was also a plus, as management had “skin in the game” to bridge the gap between trading price and NTA.
When A Deep Value Stock Falls Further… Were You Wrong Or Is It a Chance To Average Down?
For most of 2017 and the beginning of 2018, Dover Downs shares stayed around the $1.00 mark. During the winter of 2017, the company’s stock price iced-over, as the price plunged to $0.92. That 11.5% dropped may have been disheartening, but allowed investors a chance to lower their cost base further.
In early 2018, shares saw a boost as the legislative actions in Delaware started to bear fruit. Shares spiked up to ~$1.40 during February 2018, but settled back around the $1.25-$1.30 level, allowing for continued accumulation. At this point, while the shares were not the bargain that had been in late 2017, it seems much more likely that the stock would soon trade back up to fair value. And, even with the recent uptick, the company continued to trade at a more than 50% discount to NTA.
Dover Downs Gives Deep Value Stock Investors Multiple Chances to Average Down (Source: YCharts)
Chocolate Sauce AND Sprinkles On Our Sunday?? Additional Catalysts Emerge
While the specter of decreased gaming taxes boosted Dover Downs shares, an additional regulatory catalyst emerged. During the time of our investment, the US Supreme Court heard a case regarding on the future of legalized sports betting in the United States. At the time, only Nevada was allowed to take traditional bets on sporting events. This was due to a 1992 law grandfathering existing legal sports betting. Delaware had in the past allowed limited sports betting (parlay cards), and Dover Downs offered these at its casino.
In May 2016, the Supreme Court decided the law restricting sports betting was unconstitutional, and all 50 states were free to legalize sports betting. While New Jersey took the case up to the Supreme Court, Delaware had been highly motivated to legalize full sports betting itself, and not too long after the decision, allowed casinos in the state (including Dover Downs) to begin taking sports wagers.
Dover Down’s Second Major Rally Due to a Wildcard Catalyst Realization (Source: YCharts)
While most of the gaming industry saw a boost from the decision, Dover Downs may have seen the biggest jump on the news — shares rallied from ~$1.50 up to more than $2/share, as investors saw the company as a means to gain exposure to a newly legalized line of business.
Shares took a dip in the weeks that followed, as investors started to realize that sports betting, while lucrative, is not the cash cow that slots and table games are to the gaming industry. This dissipation of interest provided an additional buying opportunity, as investors continued to value the stock at a discount to the company’s NTA. With the emergence of stronger catalysts, it became apparent that Dover Downs had begun to fully stabilize its operations and now could justify a valuation closer to its peers.
The Cherry On Top: Deep Value Stock Investors Are Often Blindsided By Great News
Dover Downs Investors Experience One of the Sweetest Parts of Buying Deep Value Stocks: Unexpected Good News. The Stock is Up Over 200% in 6 Months (Source: YCharts)
With the business stabilized, Dover Downs became a more attractive merger candidate. Twin River Management Group, a privately held casino company that owns properties in the US states of Rhode Island, Colorado, and Mississippi, agreed to a deal in which it would go public via a merger with Dover Downs. The terms of the deal implied Dover Downs shareholders would receive more than $3/share in consideration for their shares, sending the stock up another 50%.
While the deal has yet to close, within a one-year period, Dover Downs shares have gone from trading at a significant discount to NTA and a price of $1, to trading close to their intrinsic value, for a 200% increase in value.
Your Deep Value Investing Career: Use Dover Downs As A Guide
The story of Dover Downs is a prime example of the benefits of investing in deep value stocks. While most deep value stocks have a rationale behind their undervaluation, within the pool of opportunities lie a few diamonds in the rough.
The key is assessing the strengths of these opportunities. By first weeding out less attractive candidates (Chinese stocks, exploration companies, illiquid securities, high debt/equity), we get a pool of options that offers margin of safety of principal and stability of value. Digging deeper, we could see that Dover Downs had the makings of a strong opportunity due to a heavy discount to NTA, low price/operating cash flow multiple, and the existence of catalysts that would move the needle in terms of profitability.
While it is impossible to “predict the unpredictable,” the odds were with us on Dover Downs. Not every deep value investment will generate such a high return in a relatively short time frame, but in the aggregate, deep value investments such as these, chosen mechanically and widely diversified, can produce big returns over the long haul.
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