Short Puts A Superior Way To ‘Play’ Boyd Gaming Stock (BYD)

Thirteen months ago, I put out a bearish piece on Boyd Gaming Corporation (BYD), and in that time, the shares have climbed about 36%, against a 20% gain for the S&P 500. I thought I’d look at the company again to see if the uptick in price was justified, or if the problems I identified earlier have only gotten worse. I’ll decide whether or not to join the crowd by looking at the most recent financial history here, and by looking at the stock as a thing distinct from the underlying business. Also, me being me, I’m going to write about put options.

You’re a busy crowd, dear readers, so I’ll come right to the point. I think the past year has been very good for the company. Returns have been spectacular on the top and bottom lines. It’s also the case that 2021 was good relative to a more typical 2019. Additionally, according to some of my favourite valuation measures, the shares are reasonably priced. The problem is that, according to others, they’re trading near decade highs. In the case of a “tie” such as this, I go with what I think the market will do over the next year. I’m not bullish on the S&P 500 at current levels, so I’ll continue to avoid the shares. That said, I know that some of you are apostates who (gasp!) sometimes think for yourselves, and may disagree with me. For those people, I recommend what I consider to be a superior risk-adjusted return below via short put options.

Financial Snapshot – Admittedly Spectacular

The first nine months of 2021 were much better than the same period in 2020, as you’d expect. Revenue was fully 61% higher, and net income had climbed from a loss of ~$218 million to a $354 million profit. Admittedly, net income in 2020 looked particularly bad because of a $171.1 million impairment of assets, but the point is the same: 2021 saw a dramatic turnaround. You may recall that 2020 was a “unique” year, though, dear readers, so it may be more fruitful to compare 2021 to 2019. Revenue in the first nine months of 2021 was actually slightly lower than the same period in 2019, while net income rose dramatically in 2021 relative to 2019. This performance appears even more impressive in light of the fact that 2019 was actually a fairly good year. Operating income was ~37% higher in 2019 than it was in 2018 for instance.

In my previous missive, I suggested that the probability was high that the dividend would be cut. It was cut… and the share price climbed. That rise in price was unexpected. In this missive, I’m going to try to tease out the chances that the dividend will be reinstated anytime soon. When asked about this on their most recent earnings conference call, the CEO demurred.

An analyst asked:

Hey. Maybe just following up on the return of capital question, how are you thinking about resuming the dividend here? What would you like to see first?

And the CEO, uh, “answered” the question thusly:

Well, obviously, our Board, as we just announced authorized the share repurchase. We believe that that is the most efficient and flexible way to return capital to our shareholders and that was a decision that was made of some others decision was made in the future then we will certainly report on it. But that’s all we have to report for now.

A cynical person might suggest that companies care more about buybacks because they goose EPS, and management compensation is generally geared toward growing EPS. Such a person might also suggest that this answer to the question “what has to happen before you return the dividend” reached almost politician levels of gobbledygook non-answer. Thankfully I’m not such a cynic, and I’m of the view that The Board made that decision based only on what it considered to be best for shareholders. The answer does leave us a bit bereft of insight, though, doesn’t it?

Fear not, though, dear readers, as I’m here for you. I called the cut in the dividend, and I’ll try to parse out the likelihood of a return of the dividend given what we know.

Dividend Returning – If the Will Exists

I’m as much of a fan of accrual accounting as any reasonably sane person can be, but when it comes to looking at dividend sustainability, or probabilities of the return of a dividend, cash is king. In particular, I want to look at the size and timing of future contractual obligations and compare those to current and likely future cash assets. Let’s start with the obligations. I’ve reproduced them here for your enjoyment and edification, dear readers. We see that 2022 will require an outlay of ~$400 million, and that figure will jump to ~$1.16 billion in 2023.

Against these obligations, the company currently has just under $571 million in cash, and has generated an average of ~$424 million in cash from operations over the past three years. While they’ve invested an average of $512 million in investing activities over the past three years, we should remember that they spent $934 million in acquisition activity in 2018. This obviously skews the cash for investing figure dramatically. It should also be noted that the company spent under $30 million on its dividend in the year before it was cut.

All of this suggests to me that the company has sufficient resources to start up the dividend over the next year. I think this will be supportive of the stock price, and would therefore be willing to buy the stock at the right price.

The Stock

To sum up so far, I think there’s nothing to stop the company resuming the dividend, and I assume that if it happens, the stock price will react accordingly. There’s risk that the company won’t reinstate it for reasons not relating to financial capacity, and there’s risk that the stock behaves unpredictably even if the dividend is resumed. For these reasons, I’m only willing to buy this stock at a reasonable discount. These are in addition to the reasons I normally cite for buying stocks cheaply. In general, I think buying stocks cheaply both reduces risk and enhances returns. Rather than express this in a theoretical sense, I’ll use these shares as an example. The investor who bought Boyd Gaming in early November is down ~16.5% since then. The investor who bought virtually identical shares exactly one month later is basically flat. The only thing that changed over this month is the stock price. The price at which you acquire an investment really matters, and I hope yet another example of this reality convinces you to never overpay for a stock.

As my regular reader-victims know, I measure the cheapness or not in a few ways ranging from the simple to the more complex. On the simple side, I look at the relationship between price and some measure of economic value, like sales, earnings, free cash flow, and the like. Please note that in my “take chips off the table” article, I was alarmed by the fact that price to free cash flow had hit a multi-year high above 40 times. On that basis, the shares have returned to a more typical 8.8 times free cash flow, per the following:

At the same time, the market is currently paying more for $1 of sales and book value than it has in nearly a decade. On these bases, the shares are hardly cheap.

In addition to looking at simple ratios, I want to try to understand what the market is currently “thinking” about a given company’s future growth. In order to do this, I turn to the work of Professor Stephen Penman and his book “Accounting for Value.” In this work, Penman walks investors through how they can use the magic of high school algebra to a standard finance formula to isolate the “g” (growth) variable. Applying this approach to John Wiley at the moment suggests the market is forecasting a long-term (i.e. perpetual) growth rate of ~2.5%, which I consider to be reasonably pessimistic.

For my part, I think the valuation is ambiguous here. Some measures point toward cheaply priced, some toward richly priced. In such circumstances, I tend to follow my perspective on the overall market. If I think the market is overpriced, I will avoid, and if the market is underpriced, I’ll buy. Given that I think the market is currently richly priced, and any drop in valuations will likely take Boyd down for the ride, I’ll avoid the stock at the moment.

Options as an Alternative

As I’ve written more and more on this forum, it’s come to my attention that some of you may (gasp) disagree with me on occasion! The following section is for the benefit of you lost souls. If you insist on taking a long position here, I think there’s a superior way to do it. When I write “superior” in this context, I mean specifically that there’s a better risk adjusted return available to you. Of course, I’m writing about short put options on Boyd Gaming.

In terms of specifics, if I were actually going to take a long position here (to be clear, I’m not), I’d sell the September puts with a strike of $40. These are currently bid at $1.65. That price represents a price to sales and price to book ratio closer to the decade average. It also offers a yield on risk capital of ~4.125%. In my view, this is not terrible for tying up capital for just under 8 months. I also like the fact that the seller of these puts won’t be exercised on the option unless the shares drop by ~29%. So the seller of the put either generates a 4%+ yield for 8 months and/or locks in an unambiguously cheap price for this stock. This is why I call such trades “win-win.”

I truly hope that you’re now simultaneously “amped”, “pumped”, and “stoked” about these “win-win” investments, because the more optimistic you are, the more joy I take in spoiling the mood by writing about risk. The reality is that every investment comes with risk, and short puts are no exception. We do our best to navigate the world by exchanging one pair of risk-reward trade-offs for another. For example, holding cash presents the risk of erosion of purchasing power via inflation and the reward of preserving capital at times of extreme volatility. The risks of share ownership should be obvious to readers on this forum.

I think the risks of put options are very similar to those associated with a long stock position. If the shares drop in price, the stockholder loses money, and the short put writer may be obliged to buy the stock. Thus, both long stock and short put investors typically want to see higher stock prices.

Puts are distinct from stocks in that some put writers don’t want to actually buy the stock – they simply want to collect premia. Such investors care more about maximizing their income and will be less discriminating about which stock they sell puts on. These people don’t want to own the underlying security. I like my sleep far too much to play short puts in this way. I’m only willing to sell puts on companies I’m willing to buy at prices I’m willing to pay. For that reason, being exercised isn’t the hardship for me that it might be for many other put writers. My advice is that if you are considering this strategy yourself, you would be wise to only ever write puts on companies you’d be happy to own.

In my view, put writers take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in a critical way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This circumstance is objectively better than simply taking the prevailing market price. This is why I consider the risks of selling puts on a given day to be far lower than the risks associated with simply buying the stock on that day.

I’ll conclude this rather long discussion of risks by looking again at the specifics of the trade I’m recommending to people who disagree with me and insist on taking long exposure here. If Boyd Gaming shares remain above $40 over the next eight months, the put seller will pocket the premium. If the shares fall in price, the put seller will be obliged to buy at a net price ~31% lower than the current level (the “net price” includes premia from the put option). Both outcomes should be very acceptable to a person willing to go long in this business. In fact, I consider this trade to be the definition of “risk reducing.” Writing about the power of short puts to reduce risk is a strange way to end a discussion of risk. This is neither the first, nor will it be the last, time that my writing goes somewhere strange. I’d get used to it if you want to follow me.

Conclusion

The past year has been a spectacular year for Boyd Gaming. Revenue and net income are up nicely, and I think the company is in the position to reinstate the dividend if it so chooses. The evidence seems to be that it prefers buybacks at current valuations, though. I’m not convinced the shares are cheap at the moment, and I think these shares will drop if the market swoons. For that reason, I’m going to avoid the name. In case you’re one of those apostates who goes their own path sometimes, and insists on buying this stock, I’d recommend selling the put options described above. I think 4% is a decent return for 8 months’ work, and I think it comes at much less risk attached than simply buying the shares at current levels.