Investing The Hard Way: The Smart Money’s Take on Gambling Stocks
Over the last two weeks, I’ve covered the winners and losers from second quarter earnings reports in the gambling sector. Earnings releases are, of course, a major mover for stocks across all industries; witness the 40 percent post-earnings drop at Zynga (ZNGA) or the jump at Bally Technologies (BYI) after they reported a record fiscal year.
Stocks can also see major moves based on reports from Wall Street analysts. That said, analyst opinions should be taken with a grain of salt; few on Wall Street saw the 2008-09 financial crash coming, and so-called sell-side analysts from major firms actually encouraged the dot-com bubble of 1999-2000. Still, Wall Street analysts have mountains of data, and intense focus, with many gambling sector analysts focusing on a universe of a dozen stocks or less. And, often, what they are saying – to buy, sell, or hold a stock – is less important, and less interesting, than why they’re saying it.
With earnings season largely over for gambling operators, and a flurry of news – the slowdown in Macau, the PokerStars purchase of Full Tilt, and a number of new bond issues – in the industry, analysts have been busy re-evaluating their recommendations and projections for the gambling sector. Again, these projections should hardly be taken as gospel; but, taken as a whole, they offer an interesting look at where the “smart money” – the people in the financial industry most plugged-in to and most focused on the sector – think gambling stocks, and the gambling industry worldwide, are headed.
In Macau, for instance, the seeming contradiction I covered earlier this month continues. Analysts continue to ratchet down projections for year-over-year gaming revenue on the island; Bank of America Merrill Lynch became the latest last week, lowering its estimate for 2012 growth to 11 percent, down from 14.5 percent. While analysts are expecting strength in the August numbers, Merrill is hardly alone in its pessimism; both Union Gaming and Fitch Ratings made similar calls just last month, while Nomura Securities projects VIP revenue to fall year-over-year in August for the second consecutive month.
And yet, many of those same analysts continue to be sharply bullish on Macau-facing gambling stocks. RBC Capital Markets analyst John Kempf predicted gains of as much as 40 percent for Wynn Resorts (WYNN), noting that “longer term, we like the Macau story” despite the potential for “near-term volatility.” Kempf’s upside estimate largely matched those for the leaders in Macau – including Wynn, Las Vegas Sands (LVS), and MGM Resorts International (MGM) – earlier issued by Cantor Fitzgerald and Nomura – the same Nomura who has repeatedly lowered estimates for growth on the island.
In short, what Wall Street is saying largely echoes my arguments about Macau since stocks like LVS and WYNN peaked in early May; the short-term fears of slowing revenue and a “hard landing” in China have been priced in by the 20-30% decline in those stocks over the summer. Indeed, share prices of Macau operators have risen since bottoming last month, as savvy investors are returning to the stocks at new, lower prices. It looks like the summer weakness in Macau-facing stocks was largely overdone; and according to Wall Street, a new bull run may be just beginning.
Of course, not all gambling companies have a license in Macau; likely, no company regrets that fact more than Caesars Entertainment (CZR), which continues to struggle without a growth catalyst. Indeed, my long-term bearishness towards CZR has been vindicated by the stock’s recent steep drop. After reaching $17.90 on the day of its IPO – an offering one CNBC wag called “the dumbest thing I’ve ever seen” – Caesars stock has spiraled downward, hitting an all-time low at $7 per share on Friday. Analysts are coming around toward my view, as well. Last week Barclays assigned an “Underweight” rating to the stock, noting the company’s high debt level and sluggish revenue growth (due in part to the company’s decision not to enter the Macau market years ago). Analyst Felicia Hendrix noted that bankruptcy risk remained “on the forefront” of investor attitudes toward the stock.
That risk has been echoed by ratings agencies, who at their core are essentially analysts for debt, instead of stocks. Standard and Poor’s earlier this month downgraded its outlook for Caesars debt – which was already granted “junk” status – to “negative,” similarly citing revenue weakness in both Las Vegas and Atlantic City. This week, the agency made a similar revision to its outlook for debt in Caesars LINQ, Caesars’ wholly-owned subsidiary that is developing the $550 million Project Linq development in the center of the Las Vegas Strip. S&P’s take on the Linq project was interesting. While it allowed that its “location and product offering seem promising,” the agency also pointed out that the open-air project was “somewhat unique and untested in the Las Vegas market.” S&P summed up Caesars’ struggles by adding, “Given [Caesars'] very weak credit measures and its limited capacity for debt repayment, a revision to stable or positive rating momentum would require meaningful outperformance relative to our forecast.” In other words, the current outlook for Caesars is to limp along, with bondholders hopeful – though hardly confident, as evidenced by unsecured Caesars debt yielding over 20 percent – the company can somehow find a way to pay the interest on its loans. That’s hardly a ringing endorsement of Caesars stock, given that shareholders would be wiped out if the struggling giant were to declare bankruptcy.
Caesars’ combination of high debt and exposure to the sluggish US market is one that I have warned against many times. With competition increasing across the US, and both Las Vegas and Atlantic City struggling, US operators simply cannot create the growth necessary to turn debt into a earnings driver from a dead weight around their necks. Even MGM – despite its exposure to Macau – is feeling the heat. On Tuesday, New Constructs president David Trainer told MarketWatch.com that MGM is “a bad bet.” Trainer argued that MGM, with its low return on equity and high level of debt, “is probably not a sustainable business for all that long.” Trainer argued that the stock – already down some 30% from March highs at around $10 per share – could drop to as low as $5 per share. “There is no value to this business when you look at…what is left over for equities,” he told the site. A day later, Lazard Freres analyst Jake Fuller, despite giving MGM a “Buy” rating and a price target of $13, echoed those concerns. “Risks include a softer GDP scenario, which could slow the pace of Strip recovery, and high debt levels, which leave MGM more vulnerable than peers to a downturn,” he wrote in a note to clients published at Barron’s. With even bulls pointing to the balance sheet difficulties at MGM, investors seeking exposure to Macau are far better off choosing WYNN or LVS – Fuller’s top pick in the gambling sector, incidentally – both of whom command higher market share in Macau than MGM, have better balance sheets, and lack the massive exposure to Las Vegas that could cripple MGM if the US recovery does stall. Indeed, Bank of America Merrill Lynch downgraded MGM earlier this month based precisely on the fear that the presumed recovery in Las Vegas would not come in 2012.
Fuller was less bullish on pure-play regional operators, noting that “July regional win data was generally weak.” Fuller called Penn National (PENN) the “marquee regional name in our coverage list,” but still pointed out that he “see[s] little to get us interested in the story.” That indifferent tone marks much of Wall Street’s stance toward regional operators in the US. Brean Murray initiated Boyd Gaming (BYD) with a “Neutral” on Tuesday, noting that weakness in Atlantic City (where Boyd owns 50% of the Borgata) and the Las Vegas locals market offset “decent results” elsewhere. Boyd has also recently received “Neutral” ratings from Nomura and Sterne Agee and a “sector perform” from RBC Capital – the equivalent of yet another “neutral.” Similar sentiment holds toward other US-focused operators such as Isle of Capri (ISLE) and Ameristar Casinos (ASCA), where “hold” and “neutral” analyst ratings abound. If the US economy rebounds, these levered companies could see a strong rebound in earnings; if it struggles, the stocks could fall sharply, perhaps to zero. As I argued while discussing “cannibalization” in the US gambling market, the winners and losers are going to come down to branding and execution. Like the rest of us, it appears Wall Street isn’t entirely sure which horse to back just yet.
The continued expansion of gambling in the US may benefit one group of gambling companies: slot machine manufacturers. In that sector, a clear divergence has been taking place for most of 2012, as upstart Multimedia Games (MGAM) and long-time bridesmaid Bally Technologies have clearly outperformed struggling WMS Industries (WMS) and still-dominant International Game Technology (IGT). Analysts have clearly noticed. Only four companies cover MGAM; yet all four give the stock a “Buy” rating despite the fact that it has already quadrupled since October, after posting three outstanding quarters in a row. That kind of unity is actually somewhat scary for MGAM shareholders, particularly since three of the analysts following the stock have initiated their coverage in the last three months. Investors must wonder if the analysts lack the long-term understanding of Multimedia Games’ business – bear in mind, the stock tanked for about seven years before its recent bull run – and if the seemingly “smart money” is just late to the party. With MGAM trading at a historically high multiple, and a new, higher tax rate coming in 2013, the analysts’ unanimous support of the stock may be a contrary indicator in this case.
For Bally, sentiment appears a bit more mixed. After posting that record fiscal 2012, the stock saw a nice pop; but on the 16th Deutsche Bank downgraded the stock to “Neutral.” But even while the bank questioned BYI’s valuation and the “headwinds” of a weak economy and potential belt-tightening by its casino customers, Deutsche noted the “shrewd management decisions and strong content” from Bally. Analysts still assigned a price target of $49, about 10% above BYI’s current share price of $44.96 and just below a four-high of $49.32 reached in late April. With Brean Murray adding its own “Buy” rating this week, with a price target of $54, it’s clear that Wall Street is impressed with Bally’s execution of late, even if some – like Deutsche Bank – feel the share price now fully reflects that strength.
For WMS and IGT, the story is far different. Both stocks crashed after earnings releases in early August, with WMS dropping 18 percent and IGT 20 percent – stunning and unusual falls for established, billion-dollar companies. WMS’ difficulties were likely exacerbated by a double downgrade to “Underweight” by JP Morgan and Bank of America Merrill Lynch, with both analysts noting the likelihood of decreasing earnings going forward. With the stock still trading around 14 times earnings – a multiple that normally suggests a market expectation of some earnings growth – WMS may have further to drop. Certainly, if Deutsche Bank is targeting the growing, properly executing Bally Technologies at 16 times its fiscal 2013 earnings, struggling WMS is not going to trade at 14 times earnings; something has to give, most likely WMS’ share price.
IGT, too, faced a series of downgrades after its earnings disaster, with Credit Suisse and Morgan Stanley – among many others – moving the stock down to “Neutral,” though Goldman Sachs gave the stock the dreaded – and rare – “Sell” rating. Indeed, after losing 20 percent on the day earnings were released, IGT fell another 5 percent the next day, likely in response to the newly bearish analyst sentiment. Even JP Morgan, which lowered its price target to IGT to $16 – some 20 percent over IGT’s current price just above $12 per share – noted that the conference call was “less than encouraging,” echoing my sentiments from a week ago. What is notable in reviewing analyst comments on IGT is how often the word “competition” comes up. Indeed, Bally – despite having just 19 percent market share in North America last quarter – is clearly on the mind of investors in IGT, the dominant market share leader in the Americas and the largest slot machine manufacturer in the world. IGT is still the “big dog,” still has an impressive brand, and is trading about 12 times its expected adjusted earnings for fiscal 2012. But it is not executing well, its management seems oblivious, incompetent, or both, and there is no clear strategy for IGT to return to its previous perch as not only the leader in market share, but the leader in design and innovation. IGT is a struggling, drifting company right now, and the mass of “Neutral” ratings reflect a company that has a wonderful legacy and a still dominant position but simply cannot create any enthusiasm on Wall Street right now.
Of course, Wall Street isn’t always right. But, right or wrong, its analysts can move stocks, and the opinion of those analysts – who spend thousands of hours analyzing the gambling industry – should be of interest to anyone investing in gambling companies. Later this week, I’ll review an analyst overview of the entire gambling sector, and discuss what another member of the “smart money” is predicting for the gambling industry, and gambling stocks.