Red Rock Resorts Inc (NASDAQ: RRR) generated a below average return on equity of 5.7% over the past twelve months, while the Consumer Discretionary sector returned 8.8%. Even though Red Rock’s performance is subpar relative to its peers, it’s useful to understand what’s really driving the company’s low ROE and how it’s trending. Understanding these components may change your views on Red Rock and its future prospects.
Red Rock’s Return On Equity
Return on equity represents the percentage return a company generates on the money shareholders have invested. Return on equity or ROE is defined as follows:
ROE = Net Income To Common / Average Total Common Equity
A higher return on equity suggests management is utilizing the capital invested by shareholders efficiently. However, it is important to note that ROE can be “manufactured” by management with the use of leverage or debt.
Red Rock’s historical ROE trends are highlighted in the chart below.
source: finbox.io data explorer – ROE
Unfortunately for shareholders, Red Rock’s return on equity has decreased each year since 2015. ROE decreased from 23.2% to 5.8% in fiscal year 2016, decreased to 5.7% in 2017 and the LTM period is also its latest fiscal year. So what’s causing the steady decline?
What’s Driving Red Rock’s Declining Return On Equity
The DuPont analysis is simply a separate way to calculate a company’s ROE:
ROE = Net Profit Margin * Asset Turnover * Equity Multiplier
Created by the DuPont Corporation in the 1920s, the analysis is a useful tool that helps determine what’s responsible for changes in a company’s ROE. It highlights that a firm’s ROE is affected by three things: profit margin, asset turnover, and its equity multiplier or financial leverage.
Analyzing changes in these three items over time allows investors to figure out if operating efficiency, asset use efficiency or the use of leverage is what’s causing changes in ROE. Strong companies should have ROE that is increasing because its net profit margin and/or asset turnover is increasing. On the other hand, a company may not be as strong as investors would otherwise think if ROE is increasing from the use of leverage or debt.
So let’s take a closer look at what’s driving Red Rock’s returns.
Red Rock’s Net Profit Margin
The net profit margin of Red Rock has generally been declining over the last few years. Margins decreased from 10.5% to 2.4% in fiscal year 2016, decreased to 2.2% in 2017 and the LTM period is also its latest fiscal year.
Therefore, the company’s decreasing margins help explain, at least partially, why ROE is also decreasing. Now let’s take a look at Red Rock’s efficiency performance.
Red Rock’s Asset Turnover
It appears that asset turnover of Red Rock has generally been declining over the last few years. Turnover decreased from 0.46x to 0.45x in fiscal year 2016, increased to 0.45x in 2017 and the LTM period is also its latest fiscal year.
source: data explorer – asset turnover
Therefore, the company’s decreasing asset turnover ratio helps explain, at least partially, why ROE is also decreasing.
Finally, the DuPont constituents that make up Red Rock’s ROE are shown in the table below. Note that the table also compares Red Rock to a peer group that includes Boyd Gaming Corporation (NYSE: BYD), MGM Resorts International (NYSE: MGM), Las Vegas Sands Corp.(NYSE: LVS) and Hyatt Hotels Corporation (NYSE: H).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Red Rock’s continuous fall in return on equity is the result of a worsening net profit margin, a declining asset turnover ratio and increasing leverage. Therefore when looking at the core operations of the business, Red Rock shareholders have reason to be concerned due to the company’s general decline in profitability along with a general decline in operational efficiency and increasing leverage.
The DuPont approach is a helpful tool when analyzing how well management is utilizing shareholder capital. However, it doesn’t necessarily tell the whole story. For example, how do the company’s ROE trends compare to its peers or sector? How about in absolute returns? I recommend that investors continue to research Red Rock to gain a better understanding of its fundamentals before making an investment decision.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.