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Investing The Hard Way: Third Quarter Review

Q3-Review-investing-the-hard-way

That was a little better. After falling 12% in the second quarter, gambling stocks – as measured by the Market Vectors Gaming ETF (BJK) – rose about 6.7% in the third quarter, and are now up a tidy 10 percent year-to-date. Most of the gains came over the last two months, with the index being led by a boom in Macau-facing stocks.  Las Vegas Sands (LVS) and Wynn Resorts (WYNN) are both up more than 20% over the last two months, while Melco Crown Entertainment (MPEL) has risen over 35% since August 1st.

Investing the hard way - Third Quarter ReviewThat’s the good news. The problem for gambling stocks is that despite the rise in the third quarter, the news in the industry really wasn’t all that good. While Macau share prices were up in the second half of the quarter, they still are nowhere near their April highs, as gambling revenue on the island continues to see a slowdown. While August was the second-best month ever on the island, year-over-year growth was just 5.5 percent, after anemic 1.5 percent growth in July. In our special feature on Wells Fargo’s “Gaming Model Book,” I noted that the brokerage expects 12 percent year-over-year growth on the island in 2013. But that model is based on a table cap of 5,700 tables – not the 5,500 tables set by Macau gaming regulators. After weeks of analyst comments that the table cap was becoming “mythical,” a sentiment gaming inspectors put an end to in late August. The limit on tables on the island may, along with a slowing Chinese economy, keep Macau’s gambling revenue growth in the single digits through next year.

In iGaming, the quarter’s big news was of course PokerStars’ purchase of Full Tilt Poker and its accompanying settlement with the US Department of Justice. The big loser from that deal, as I noted in August, was bwin.Party Digital Entertainment (BPTY.L), which fell some 14% to an all-time low in response to the news. Surprisingly, the PokerStars deal did little to affect other iGaming stocks; not even news of Stars’ apparent interest in European casino and sports betting could shake share prices in the sector. Nearly all of the European operators saw gains in the third quarter, led by 888 Holdings (888.L), who soared over 40%, thanks to a record-setting first half of the year. But with the Eurozone crisis still present, if quiet (perhaps a little too quiet), and PokerStars looking to use its advantages as a privately run firm, European iGaming operators seem likely to face challenges in the fourth quarter.

In the US, the news is the same as its been. Overall growth is slow, meaning some companies succeed, while others don’t. Regional operator Pinnacle Entertainment (PNK) had the strongest quarter of any US-listed gambling stock, rising 27.2 percent, but competitors Boyd Gaming (BYD) and Penn National Gaming (PENN), both saw modestly negative returns over the same period. Slot machine manufacturers Bally Technologies (BYI) and Multimedia Games (MGAM) turned in bullish earnings reports; WMS Industries (WMS) and International Game Technology (IGT) turned in disastrous results, leading to analyst downgrades. Not surprisingly, BYI and MGAM rose, while IGT and WMS fell 16.5 and 17.9 percent for the quarter, respectively. Meanwhile, US Internet stocks continued to collapse, as visions of billions in regulated iGaming profits came no closer to reality. Facebook (FB) fell another 30 percent in the quarter, closing at $21.66, 43% off its IPO price of $38 per share. The launch of the company’s first-real money app did little to move the stock price. Zynga (ZNGA) – which has its own real-money aspirations – did even worse, hitting all-time lows during the quarter, and falling by nearly half over the three months, to just $2.84.

Indeed, across the gambling sector, it’s hard to see too many reasons for optimism. Meanwhile, there are significant challenges, ranging from potential regulatory action to competition to overall low growth across segments and markets. With gambling stocks so closely tied to economic sentiment, jitters in the broad market – caused by the approaching US “fiscal cliff”, a reboot of the European sovereign debt crisis, or a “hard landing” in China – could, on their own, take down share prices in the gambling sector. It’s worth pointing out that gambling stocks in 2012 saw four months of gains, followed by a three-month crash, followed by the recent two-month surge. It’s unclear just how long the current bull run will last.

Short-term pessimism aside, investors should expect several of the key themes I’ve covered to continue going forward. Indeed, the third quarter served to emphasize the value of a few simple rules in the gambling sector. In no particular order: 

1. Avoid debt-heavy casino operators. 

Caesars Entertainment (CZR), whose manipulated stock price rose as high as $17.90 after its February offering, continued its long, slow slide, falling 40% in the third quarter and touching an all-time low of $6.80. Weak August earnings were part of the problem, but the stock fell another 20% after dropping when those results were announced. It is becoming clear that investors simply want no part of the company, who is struggling just to pay the interest on its $20 billion debt. It’s not just equity investors; as I noted in August, Caesars bonds are yielding over 20 percent, showing that the bond market views Caesars as a possible candidate for bankruptcy in the near future. 

Caesars wasn’t the only high-debt company to struggle. MGM – with a $13 billion debt load, albeit one supported by a stronger asset base than that held by Caesars – fell slightly for the quarter, despite the boom in Macau-facing stocks in August and September. MGM did see nice gains for those two months, but still lagged WYNN and LVS. Indeed, after outperforming its Macau competitors in the first quarter, MGM has underperformed significantly against not only WYNN and LVS, but Melco Crown and Galaxy Entertainment (GXYEY.PK). MGM’s debt, and low market share in Macau, likely are key reasons why the stock has not kept up with its peers. With no short-term catalyst to reverse either problem, investors should continue to prefer other Macau names to MGM. 

2. Execution, execution, execution. 

No matter which market, the gambling industry right now is a competitive, even cutthroat sector. With so little overall growth, gambling companies of all types are essentially playing a zero-sum game, where one company’s gain is another’s loss. 

As such, investors in the gambling sector need to focus on marketing, branding, management, and most importantly, execution. In the slot machine manufacturer segment, for instance, I noted all the way back in February that Bally and Multimedia Games were clearly taking market share away from IGT, while WMS was struggling to get back on its feet. Sure enough, IGT and WMS wiped out in Q3, while Bally and MGAM benefitted from strong earnings reports. On their conference calls, executives from Bally exulted in their success, while IGT CEO Patti Hart complained about the negative impact of the economy on her business. 

Of course, Bally had a record-breaking fiscal year, in the exact same business, in that exact same economy. And Hart’s decision to repurchase $1 billion of IGT stock looked foolish at the time, and downright moronic a month later, when IGT fell 20 percent after horrific third quarter earnings. Amazingly, Hart made the decision to make an “accelerated repurchase” of $400 million worth of shares with just two weeks left to go in the fiscal third quarter – the very same quarter whose results were so horrific that stock in an established, multi-billion company fell 20 percent in a single day. Hart had to have known the quarter’s results would be weak; it was nearly over. Her decision to go ahead boosted the stock by 14 percent; but, after the post-earnings collapse, that decision alone cost IGT shareholders some $80 million. Seeing that decision, watching IGT’s market share slowly decline, and hearing the divergent attitudes on earnings calls, investors should ask one simple question: with which company do I want to invest? The answer should be pretty clear. 

Along the same lines, investors should continue to avoid bwin.Party, even at its current depressed levels. Its poker business continues to erode with little effective response from the company. Its own co-CEO (a title which should be a red flag in and of itself) has said the company’s goal is “to be number two.” Its marketing doesn’t match the flamboyant, controversial, but always memorable campaigns of Paddy Power. Its products don’t compete with the innovative steps taken by privately held competitors, such as PokerStars’ introduction of Zoom Poker or Bodog’s recreational poker model. Is it any wonder the stock hit an all-time low this quarter? 

It’s important to note that these judgments are not being made with hindsight. The struggles at IGT and WMS have been going on for months. As we predicted here at CalvinAyre.com, bwin.Party’s merger was doomed from the beginning. For these three stocks – and other companies in the gambling sector who lack a coherent branding strategy, competent management, or a compelling reason for an investment – it seems unlikely that a turnaround is right around the corner. Indeed, it seems far more likely that continued struggles at the company will lead to continued struggles for their share prices. 

KISS: Keep It Simple, Stupid 

Nothing I’ve written here is particularly ground-breaking; nothing in this articles requires a Ph.D. in finance or years of experience in the stock market. It has been pretty simple in the gambling sector so far in 2012: buy good stocks. Look for growth; look for execution. Avoid debt. Avoid bad management; executives very rarely change. It sounds simple, and it sounds easy, but it’s worked so far in 2012. And it seems likely it will work going forward as well.