“Victory has a thousand fathers; defeat is an orphan.”
– President John F. Kennedy

Somebody fucked up. Actually, it’s clear already that lots of people fucked up. Lead underwriter Morgan Stanley screwed the pooch by pricing the stock at $38, only to see it drop to $31 within two days and still sit some 13% below its offering price as of Thursday’s close. The investment bank also stands accused of letting favored clients know that its analyst was reducing growth estimates for Facebook (FB) stock ahead of the IPO, behavior that is not only unethical but likely a violation of SEC regulations.

Mark Zuckerberg fucked up too. Like Morgan Stanley, he is being sued for failing to disclose material information to smaller investors. His reputation has taken a hit with larger investors, too. According to Wedbush Securities analyst Michael Pachter, Wall Street was so hurt that Zuckerberg wore his trademark ‘hoodie’ to analyst meetings – instead of the standard suit and tie normally required of people fleecing “muppets” out of billions of dollars – that it has refused to step in as Facebook stock has fallen. To top it off, he got married the day after his company went public at a nearly $100 billion valuation. Doesn’t he know how much tail eight or nine billion can buy?

Don’t forget the NASDAQ exchange. Chosen by Facebook for its listing over the traditionally more powerful New York Stock Exchange, NASDAQ saw its systems simply overwhelmed by the volume during Facebook’s first day of trading. Traders spent hours unsure whether orders in FB stock had been filled, an astounding development in a market now dominated by high-frequency trading, in which stocks are bought and sold in milliseconds. (Indeed, HFT was one of the culprits blamed for the NASDAQ glitches.)

Who else fucked up? Oh yeah, me. “There is too much hype around Facebook, too much potential in the company, and too great a story to sell for the stock to slip up early in its existence. Given that the IPO is already oversubscribed – meaning many more shares have been requested than are available — demand for the shares will most likely support the stock’s price for the near future,” I wrote on May 14th. In my defense, I might have been right, had not the above culprits screwed everything up. One hedge fund manager told Business Insider that the NASDAQ issues, and questions concerning order fulfillment, likely saved retail investors from themselves. “This should have been a blockbuster,” he told the website, lamenting the lost momentum from consumers – the same momentum I argued would hold up the stock. “Think about a guy who was going to put five grand on this,” he added. “You go to Vegas and $5,000 on the roulette wheel and it breaks, it’s like, hold on, I’m not going to do that.”

I also argued that Wall Street would step in to support the stock, and it clearly did so on Friday, with large orders coming in every time the stock neared the $38 offering price. By Monday, the Street did not have the ammunition or the will to continue to prop up FB. Whether it was the overwhelming bearish sentiment – no doubt driven, in part, by the NASDAQ mess – or their desire to get revenge on Zuckerberg for snubbing his nose at their dress code, the Street could not – or did not – keep Facebook above $38 per share. The media narrative turned on the company and the stock, and with retail investors pushed to the sidelines, the “Facebook is overvalued” theme took over, driving FB’s share price down.

While Facebook’s true value remains a source of argument, one thing everybody seems to agree on is that its IPO was a massive clusterfuck. The “botched IPO” was marred by “embarrassing technical glitches,” wrote CNBC’s Scott Wapner. “Fumbled,” wrote the Washington Post. Vanity Fair‘s Juli Weiner called it “a disaster.”

But let’s try a simple thought exercise. For the sake of argument, suppose that Facebook was priced on Friday not at $38, but at $28 per share. Suppose that NASDAQ didn’t botch trading execution that day, and the stock ran to, say $42 a share (its actual Friday high) before settling back down around $34 per share. Over the next four days, the stock drifted to $31, before closing Thursday at $33.03 (its actual Thursday close.) What would the story look like then?

Of course, it would be a lot different. Morgan Stanley would likely be congratulated – instead of scorned – for pricing the IPO relatively well, creating a pop in the first day of trading, while also providing near-maximum return to Facebook, its employees, and its early investors. Zuckerberg would be considered a new tech titan, instead of an immature hoodie-wearing douchebag. The NASDAQ would retain its image as the hip, tech-dominated exchange whose computers were out-competing the stodgy old NYSE with its antiquated human specialists running around the trading floor for the benefit of European tourists. Most importantly, I wouldn’t look like an asshole for recommending a stock that fell 20% in three days.

But, really, what would have changed? About $4.2 billion – the $10 per share price difference, multiplied by the 421 million shares released in the IPO – would have been gone somewhere different. Facebook itself would have received $1.8 billion less. Given that CEO Zuckerberg spent $1 billion on Instagram, a photo app that literally has never generated a single dollar of revenue, this is probably a good thing for the next entrepreneur who can devise a worthless but popular software program. Zuckerberg himself got an extra $300 million at the $38 offering price; his proceeds from the offering were, according to public filings, going to pay taxes, so now the debt-laden US and California governments get a bit more cash. The Wall Street banks would have earned about $15 million less at $28 a share, but seeing as how Morgan Stanley alone made an estimated $100 million in trading the Facebook debacle, that’s peanuts. Hedge funds likely lost out on potential trading profits from a lower-priced offering, as they would have used their inside position to gain IPO shares and then dump then on retail investors during the first day of trading. Smaller investors allocated shares through E*Trade, Fidelity, and the like would have done better at a lower offering price – they have already lost some $630 million in paper profits, according to the Boston Globe. But bear in mind, as the hedge fund trader above argued, that the NASDAQ trading glitches on Friday likely kept some retail investors out of the market – much like their hedge fund brethren – and probably saved some dough there. It’s also important to remember that many so-called “small investors” are lawyers and dentists and other jerkoffs you went to high school with.

So, long story short, all the criticism of Facebook, all the commentary and teeth-gnashing an analysis of the “fumbled,” “bungled,” “botched,” disaster of an offering really boils down to about $4 billion of paper profits that went from one group of rich assholes to another. Half of that money goes to Facebook as a company and Zuckerberg personally, who combined earned an additional $2 billion in the offering that everyone seems to agree was such a mess.

The hype leading up to Facebook’s offering has, amazingly enough, been surpassed by the idiocy following the offering. The best example of Wall Street’s skewed sense of markets comes from Wedbush’s Pachter, the analyst who apparently assigned a multi-billion valuation to Mark Zuckerberg’s hoodie. “The flop is 100% a function of a supply/demand imbalance…” he wrote in an email. “There is no question that had this deal been 1/3 the size, the market would have absorbed it and the deal price would have held.”

Pachter is correct. A smaller deal would have held. But for how long? Eventually the additional shares would have to be dumped on the market, causing selling pressure. (The share price of key Facebook partner Zynga was hurt badly by a secondary offering earlier this year, after they followed a strategy similar to that recommended by Pachter.) Pachter’s logic is typical Wall Street – if only they had put out fewer shares, we could have better manipulated the stock price. But that can’t last forever. Facebook is worth what it’s worth. Right now, it’s worth $70 billion.

At the end of the day, Facebook outsmarted investors. Had the IPO gone in a way considered “successful,” new investors would have more money. But it “failed,” giving the company and its founders, financiers, and employees an extra few billion. God willing, we can all fail that way.

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By the end of April, the gap between the two stocks had indeed narrowed. LVS would gain another ten percent to a three-year high before beginning to stall out. In late April, LVS slumped after its earnings release despite becoming the first casino operator to generate $1 billion in pre-tax earnings in a single quarter. “LVS became a momentum stock,”  I noted at the time. “And the Street loves to take down momentum stocks.” Meanwhile, WYNN, despite seeing earnings fall 19% year-over-year, continued to rise into the end of April.

And then the bottom fell out. World equity markets, which saw a strong first quarter, began to show weakness at the beginning of May, as worries about the faltering Greek banking system and its potential effect on Europe took their toll. And when the world economy sneezes, gambling stocks get pneumonia. LVS closed Friday at $46.38, down over 15% since the start of the month and off 25% from a pre-earnings high over $62 per share in early April. WYNN, meanwhile, is down 23% since the start of the month (even when including a 50 cent per share dividend paid last week). Amazingly, before Friday’s 0.4% gain to $101.94, the stock had fallen for thirteen consecutive trading sessions dating back to May 1st.

The effect on the recent drop on both stocks has been substantial. WYNN is trading near a 17-month low; LVS, meanwhile, has given up nearly all of its early-year gains, and returned to the range of about $36 to $48 in which it traded for nearly all of 2011. Their Macau subsidiaries, Wynn Macau (1128.HK/WYNMF.PK) and Sands China (1928.HK/SCHYY.PK) – which provide substantial portions of the parent companies’ value – have struggled as well, with disappointing April revenue figures at the Chinese gambling mecca another near-term headwind. LVS in particularly was likely hurt by the numbers, with its opening of Sands Cotai Central expected to provide a stronger boost to the island’s gaming revenue. Deutsche Bank analyst Carlo Santarelli told the Las Vegas Review Journal that “contributions from Sands Cotai Central don’t appear to be having a meaningful impact on gross gaming revenue to date.” With a new Wynn location now approved, and future construction from SJM, Galaxy, and Melco Crown expected, there are clearly worries that the Macau market may face saturation sooner than expected. Add in the fears of a so-called “hard landing” for China’s recently explosive growth, and the effect of a Eurozone collapse on the worldwide economy, and the optimism surrounding Macau appears to be diminishing. And even with the recent drop in stock price, neither WYNN nor LVS look particularly cheap at first glance, with the stocks trading at 20 and 24 times trailing earnings, respectively.

But as I argued during the good times in the first quarter, investors must look forward, and the recent weakness in two of the world’s leading casino operators should create a buying opportunity. Yes, Macau revenue figures came in below analyst estimates; but it still rose 22 percent to over US$3 billion for the month, nearly three times the April gaming win in Atlantic City and the state of Nevada combined. Yes, the Chinese economy may face some short-term troubles; yes, competition on the island will be fierce. But, honestly, who gives a shit? At 24 times earnings for LVS (23 for Sands China), does 4% growth in China for 2012, instead of 8%, really change the bull case? Is a Eurozone collapse going to change the cultural appeal of gambling, or the enormous economic benefit from the monopoly granted to Macau by the mainland?

There is so much more money to be made in Macau that even discussing a 22% actual, versus 24% expected, growth rate is just asinine. (Bear in mind, too, that given the high-rolling nature of gambling on the island, that “slower” growth could easily be a result of lower-than-expected hold.) As Melco Crown’s James Packer argued last week, the Chinese middle class is “going to change the world” – and change the island. The island’s model has so far been solely based on the VIP segment, but mass market growth now eclipses the rate of the higher-revenue, but lower-margin high rollers. Non-gaming revenue – still less than 1% of the total revenue for the island’s gambling operators – has the opportunity to grow exponentially. The pending construction of theme parks nearby is just a tiny step toward the expansion of Macau from a purely gambling-focused island to a more multi-dimensional resort destination. Operators like Wynn and Las Vegas Sands – who have successfully diversified their resort operations in Vegas, growing hotel, dining, and entertainment revenues at a strong clip – will be able to do the same on Macau, improving the bottom line as continued grogambling revenue growth adds to the top line. The mass market gambler and the non-gambling tourist have so far been literally ignored on Macau. That will change – to the operators’ benefit.

The overall story of Macau is not changed by economic worries or a 2 percentage point miss on a monthly revenue figure. What has changed is the relative strength of Las Vegas Sands versus Wynn, particularly over the last few months. While Sands CEO Sheldon Adelson has boasted of plans for a multi-billion dollar “Euro-Vegas” in Spain and seen 66% growth at the Marina Bay Sands in Singapore, Wynn has meekly bowed out of the running for a new casino in Massachusetts, and looks set to enter a bidding war in Australia. While Adelson has ponied up millions in political contributions to affect the national security debate, Wynn has engaged in pissing matches with former partner Okada and “Girls Gone Wild” producer Joe Francis. And while LVS posted a literally record-breaking first quarter, Wynn followed up a record-breaking 2011 of its own (the company set a record for gambling win on the Las Vegas Strip) with an 8% drop in revenue in Las Vegas and continuing worries about its market share in Macau.

When looking at Macau, analysts love to make projections and create models to estimate the present value of the companies operating in the market. This is why the April gross revenue “miss” matters to the Street: the new, lower, growth number goes into the spreadsheet, which means that Sands China’s projected 2017 market share of 16% now results in 2017 earnings of $3.46 per share instead of $3.69 per share, or whatever the number is that the computer spits out. So Sands China is now worth $27.23 instead of $31.25, and majority owner LVS is worth $53.23 instead of $57.60. This is absurd on its face; making accurate projections about a market like Macau, which is subject to so many varied and substantial economic, demographic, cultural, and political (the Chinese are still Communist, even if they don’t always act like it) effects, is simply impossible. The Street continues to attempt this projections, because if they’re wrong, they can just blame the model. But as the old saying goes, “Garbage in, garbage out.”

Granted, investors can use these projections as a benchmark, but common sense goes a long way in investing, and leaves one simple question. Which business do you want to own: one whose CEO is clearly intent on leaving a legacy as the most innovative, most aggressive, and most influential gambling executive ever, or one whose CEO seems a step behind, who is focusing on personal grudges and million-dollar vases?

Earlier in the year, I dismissed the Okada affair as a minor headache, and also noted that the forced redemption at below-market rates was worth somewhere in the range of $8 per share to existing shareholders, based on Wynn’s share price at the time. But the saga continues, with Okada’s recent document request threatening to shine potentially unflattering light on Wynn’s previous dealings in Macau. Meanwhile, Wynn was outmaneuvered politically in Massachusetts, and its potential bid for Australia’s Echo Entertainment is simply an attempt to get what Las Vegas Sands already has: multiple markets that can cater to Asia’s VIP clientele.

But what most concerns me about Wynn’s direction is the company’s widely reported – though unconfirmed – flirtation with Zynga (ZNGA). I  argued last month that Zynga has little chance to becoming the online gambling powerhouse some have forecast; but, that aside, the fact that CEO Steve Wynn is even considering the Facebook game developer as a partner raises serious questions. The most obvious is: what the hell is he thinking? Wynn properties are renowned for their opulence and attention to detail, and Steve Wynn has made his fortune through creating and marketing a brand that is associated with class, taste, and elegance. Wynn’s cachet is so great that his designer was granted a lengthy profile in the New Yorker earlier this year. That he would contemplate for a second associating his unique brand with the image of shut-ins playing Farmville on their phone is bizarre, at best. Granted, Wynn is late to the online poker party, with many potential partners already tied up with competitors. But the Wynn brand has created a $10 billion company; it is not to be tarnished in a high-risk attempt to enter a market that, for all the hype, still shows little hope of even noticeable returns in the next few years.

When looking at LVS and WYNN, the numbers are roughly similar. LVS trades, as noted, at a higher trailing earnings multiple; but that multiple is justified by its presence in Singapore and market share edge in Macau. And when you look at the direction on the businesses right now, Las Vegas Sands – and Adelson – have the clear advantage. Adelson’s grand plans will require substantial capital – and substantial risk. Planning an eleven-figure investment into Spain, of all places – with unemployment over 20% amid a potentially continent-wide currency crisis – is hardly a safe bet. It is a high-risk – but potentially high-reward – move. But Adelson’s goal for his company is clear: to be the dominant gambling powerhouse in the world, if not on the Internet. At the current, lower, share price, betting on LVS doing just that appears to be a risk worth taking. Right now, Steve Wynn’s goals are unclear, and his company’s stock less attractive. Yes, it’s substantially cheaper than it was just months ago; but what, exactly, are investors buying into?

On Las Vegas Sands’ most recent earnings conference call, Adelson noted that, based on its growth, size, earnings power, and dividend, LVS had only one peer among the 12,000 stocks traded on US exchanges: Apple (AAPL), the world’s most valuable company. That is the kind of company with which Sheldon Adelson wants to be associated. Wynn’s flirtation with Zynga and the general lack of direction his company has shown of late should make investors wonder exactly what kind of company Steve Wynn wants to keep – and what kind of company Wynn Resorts wants to be.

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Munger went on to explain his logic. Out of the thousands and thousands of equity securities available on the market at any given time, what are the odds that a new issue is the most undervalued stock in the market? After all, an IPO – particularly of a well-known company – is subject to relentless hype from the media and analysts, and is sold by brokers who get a larger commission to sell it relative to existing stocks. As Munger noted to some laughter, the stock can’t be very good if Wall Street is paying its salespeople extra to sell it.

Munger didn’t mention a specific company by name, but given that Facebook had filed for its own IPO just two days earlier, one would be forgiven for assuming the social media giant was on his mind. The Facebook offering is likely to be the largest Internet-related IPO on record, according to CNBC, and is already the most-hyped offering since Google (GOOG) went public in 2004. The social media giant is selling 334.7 million shares, with an estimated range between $28 and $35 per share. The total haul could be as high as $11.7 billion, with roughly half of the money going into Facebook’s coffers and the remainder going to inside investors, including CEO and founder Mark Zuckerberg. (The above data is subject to change ahead of the offering date, which is currently scheduled for this coming Friday, May 18.)

At current estimates, the IPO would value Facebook somewhere between $75 and $96 billion. The sheer magnitude of that valuation has already prompted cries that the company is vastly overpriced. At the high end of its range, Facebook would — today — be worth more than business giants such as McDonald’s (MCD), Cisco Systems (CSCO), and Visa (V), and just 6% less than Amazon.com (AMZN), which dominated Internet retailing back when Facebook was still a gleam in Zuckerberg’s eye. It would trade at some 99 times trailing earnings and 24 times revenue, despite the fact that first quarter 2012 earnings actually fell slightly compared to same period in 2011, according to the company’s S-1 registration statement. That slowdown in earnings is of concern to investors, given that the company’s high multiples require exceptional growth for the stock to have long-term value.

In addition, recent Internet IPOs have not fared well. Facebook game developer Zynga (ZNGA) and predatory lender Internet marketing company Groupon (GRPN) — which I named as two of the dumbest stocks in the market last week — have fallen sharply since their public offerings in late 2011. ZNGA is down 24% from its $10 issue price, while GRPN has fallen over 50%. Both stocks have shown lower-than-expected revenue growth and difficulty in converting sales into earnings — the same fears that would surround Facebook at its current pricing.

Those fears were stoked this week by an update to the S-1 regarding Facebook’s mobile business. The growing use of mobile devices to access the Internet is a real challenge for Facebook, whose mobile site is so limited that one analyst wondered this week whether it was “bad on purpose.” Why on purpose? Because Facebook hasn’t figured out how to, well, make any money off its mobile users. As the amended S-1 noted this week (per CNET.com), the “increased usage of Facebook on mobile devices has contributed to the recent trend of our daily active users (DAUs) increasing more rapidly than the increase in the number of ads delivered.” In other words, mobile users see less ads, which means the average user sees less ads, which means Facebook generates less revenue per user. And given that user growth is one of the company’s greatest strengths — indeed, the company highlighted that growth on the first page of its prospectus, used to inform potential investors about the stock — lower revenue per user severely diminishes the value of user growth. Daily active users (DAUs) grew 41% year-over-year in the first quarter, leading to 44% revenue growth over the same period — meaning revenue per user was still flat. Under its current model, revenue per user should decline as mobile usage increases, lowering the rate of overall revenue growth. At 24 times sales, Facebook cannot afford for that to happen any time soon.

If Facebook shareholders have any idea on how to tackle this problems, or any other advice for the company, rest assured that Mark Zuckerberg doesn’t give a shit. Zuckerberg will still control a majority of the company’s shares following the IPO, even if he dies. Small wonder that Zuckerberg showed up for the company’s “roadshow“ — where executives promote the stock to analysts and large institutional investors — in his trademark “hoodie,” eschewing the formal dress usually required for companies who are asking for billions of dollars. An investor in Facebook will truly be buying into “a Mark Zuckerberg production,” as the founder notoriously named the original Facebook site at Harvard; indeed, before the company’s $1 billion purchase of Instagram last month, even the company’s board of directors was “told, not consulted” by the CEO. Instagram, by the way, has never created a single dollar in revenue.

In short, it would appear that only a fool would buy Facebook stock. But there is a catch, known popularly as “the greater fool theory.” Any idiot can profit off of Facebook shares, dot-com stocks, or US real estate for as long as there is a bigger idiot with a bigger wallet willing to buy those assets at a later time. Eventually, the biggest idiot winds up with $10,000 worth of Pets.com stock, or an $800,000 house on an unfinished Arizona golf course. But a lot of smaller idiots make a lot of decent money on the way up. There is too much hype around Facebook, too much potential in the company, and too great a story to sell for the stock to slip up early in its existence. Given that the IPO is already oversubscribed — meaning many more shares have been requested than are available — demand for the shares will most likely support the stock’s price for the near future.

If that demand doesn’t materialize, Wall Street will create it. Given the recent weakness in many IPO issues — Groupon and Zynga among them — the country’s big investment banks simply cannot afford another flop. The Facebook underwriting is led by Wall Street’s three remaining giants — JP Morgan Chase, Morgan Stanley, and Goldman Sachs.  The IPO business, though much smaller than in the high-flying dot-com days of the late 1990’s, remains a lucrative source of revenue for Wall Street, who often receives as much as seven percent of the total offering in fees. Facebook has negotiated its fees down — supposedly to just 1.1 percent — but that would still represent some $1 billion in fees for the syndicate underwriting the offering.

The larger issue with the Facebook IPO, beyond the fees, is that the Street simply must get it done, and done right. Secondary private equity markets — where Facebook traded as high as $41 per share — are growing, and now can provide some of the benefits — such as liquidity, price transparency, and access to capital — that were formerly the sole function of the public markets. Tech firms are already somewhat disdainful of Wall Street to begin with , preferring their no-frills focus on intelligence and efficiency to Wall Street’s big-money, big-mouthed, well-dressed system of doing business. Any missteps in what will be the most important tech IPO of the past seven years will have long-term consequences for the Street. As such, the pressure from — and on — the market for Facebook shares will be intense. To borrow a term near and dear to investment bankers’ hearts, the Facebook IPO appears “too big to fail.”

I’m not necessarily arguing that Facebook stock will be artificially and/or illegally propped up by the markets. But its success will be a focus of the firms that, for better and worse, run the financial markets. In the short-term, FB stock will most likely exceed its offering price. With a small amount of the stock available to retail investors, through E*Trade and perhaps others, investors with the opportunity to get a piece — however small — of the Facebook IPO should take advantage. Beyond that, the common advice is to let the market settle down in the first few weeks of trading; advice that I would probably recommend, particularly for inexperienced traders.

In the long run, there is a lot of uncertainty about Facebook’s valuation, much of which I described earlier in the article. As Allan Sloan wrote in the Washington Post, “This price is insane. And anyone buying this stock as a long-term investment…will lose money…This has nothing to do with [the] company: It’s nicely profitable; I love the product. It has to do with math and with limiting factors — fancy language for the old truism that no tree grows to the sky.”

Sloan, however, was writing not about the Facebook IPO; but the Google IPO, in 2004. Google went public at $85 per share, closed its first day above $100, and never again traded below that price. It closed Friday at $605.23, up 612 percent in less than eight years.

In fact, Google faced many of the same criticisms at its IPO that Facebook does today. It was too over-hyped; its business model was based solely on advertising; its management was young, defiant, and unschooled in the ways of public governance. But their stories are similar as well. Facebook, like Google, has the ability to dominate the Internet world. As social media becomes more and more expansive, and more users use the site more often, it may become the entry point to the broader Internet, much as Google is now. Facebook has only scratched the surface of what it can offer its customers. If it can succeed, its $35 share price may seem as much a bargain as Google’s $85 price does now. More importantly, the strength of that story — that investors see Facebook as potentially one of the world’s most dominant companies — will buoy the stock for a long time. Bear in mind that Amazon — over a decade after its IPO — still sells at 90 times its forward earnings (for the year ending January 2013). AMZN has been criticized repeatedly for being an overvalued, overhyped stock (including by this author); yet the stock trades four times higher than it did less than four years ago. Facebook can easily trade in the same manner. The fundamental numbers may seem obscenely over-hyped; but Facebook will not, in the short term, go the way of Zynga and Groupon. The story is too good, the potential rewards too great, and the machine behind the stock too powerful. I’m a numbers guy; the numbers tell me that Facebook stock is a sell. But the market is what matters; and the market is going to keep Facebook stock up for a long time.

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Investors need patience, reasonable expectations, and investments in companies that have those qualities as well. On Wall Street, as the saying goes, “pigs get fed, and hogs get slaughtered.” Toward that end, here are, in my opinion, the five dumbest stocks in the current market. This is not necessarily advice to short these stocks – many are heavily owned by the “hogs,” and they can do some real damage while they are loose. These stocks will often see heavy and volatile trading, so the average investor may not want to take the risk of betting against them in the short term. But, in the long term, these stocks are nothing but trouble.

1. Zynga (ZNGA)

Zynga has already seen a steep drop, falling by nearly half since some poor dope bought the stock for $15.91 per share, an all-time high, back in early March. Of course, the Facebook game developer only went public in December, with the stock initially priced at $10 per share. ZNGA quickly fell to $8, soared over $15, then began its long decline to Friday’s close of $8.33. That drop included a secondary offering in late March, when Zynga’s Wall Street advisers convinced even more poor dopes to buy over $500 million worth of the stock at some $12 per share. Notably, those shares were sold not by the company to raise capital, but by its existing shareholders to cash in on the company’s then-elevated stock price.

That the company’s insiders have so little faith in its future is a bad sign for the stock, but certainly understandable; even at the seemingly bargain price of $8.33, Zynga is still wildly overvalued at some $6 billion. I argued two weeks ago that the company has no chance to become the online gambling powerhouse many predict; let’s assume, for argument’s sake, I am wrong (it has happened in the past). 888 Holdings (888.L) and Bwin.party Digital Entertainment (BPTY.L), two of the largest pure-play online gambling companies, have a combined market value of about $2.5 billion USD. If we assume Zynga will have success in the still-nascent US market, and perhaps create a gambling business with similar value, the rest of Zynga is still valued at some $3.5 billion.

Back out the company’s $1 billion in cash – which won’t last very long, as the company pisses it away on nine-figure acquisitions of mobile games that can’t keep an audience – and, even if the company succeeds in becoming an iGaming player, the legacy Facebook games are still valued around $2.5 billion. If the idea of spending your share of $2.5 billion to buy Farmville and Mafia Wars doesn’t strike you as instantly idiotic, bear in mind that Zynga is still unprofitable. Of course, as the company is found of pointing out, it is profitable as long as you exclude stock-based compensation for its employees. In 2011, stock grants totaled $510 million – representing more stock for insiders to sell to investors at inflated prices, likely with Wall Street’s help. Between the clear emphasis on favoring employees and insiders over shareholders, and a business model based on selling virtual goods for real money, Zynga simply makes no sense.

2. Groupon (GRPN)

Another Internet darling and late 2011 IPO, Groupon went public in November at an initial offering price of $20 per share. The stock traded as high as $31.14 the first day before closing at $26.11. Two weeks later, the company returned to that level, at $26.19 on November 18^th, and then it was over. The stock fell 40% in a week – for reasons that remain unclear – and after a rebound, GRPN shares were hammered again last month by the company’s disclosure that it had identified a “material weakness” in its accounting, and revised its fourth quarter 2011 results to lower reported sales and increase its net loss. Wall Street was shocked – shocked! – to discover that a company that had twice revised its IPO filing due to “creative” accounting might have had some issues with the financial truth. Groupon’s most brazen attempt to improve sales came before its offering, when the company actually tried to account for the full cost of a Groupon as net revenue, instead of the roughly 50% of face value the company actually receives. This attempt was roughly like a casino claiming the total amount wagered at its tables as revenue, and writing off customer wins as simply the cost of doing business.

Groupon also stretches the truth with its representation of its business model. The company is not the marketing company it claims to be, but is actually, as several analysts have noted, a predatory lender. The company offers up-front cash – through the initial purchase of Groupons – in exchange for long-term re-payment through the delivery of a business’ goods and/or services. In other words, the company is a loan shark that has a history of lying to the authorities; small wonder it is headquartered in Chicago.

Like Zynga, Groupon now trades well below its initial price, but its fall has been steeper. It closed Friday at $9.97 (after trading at an all-time low of $9.93), down by more than half from the offering price and off 68% from its first-day and all-time high. It may see a short-term rebound as traders move in, or investors talk themselves into taking a gamble on a rebound. Don’t get sucked in by the seemingly lower sticker price. Groupon’s business model is not sustainable. The company is bleeding cash, has completely outgrown its ability to monitor its accounting and its thousands of salespeople, and in many cases is helping to bankrupt its own customers. Groupon itself may not be far off.

3. Isle of Capri (ISLE)

I recommended a short sale of ISLE back in mid-March on this site; the stock promptly rose 12.4% in the next two days, revealing the extent of my influence in the investing world. But patience has been rewarded; after rising further, ISLE stalled in April, and closed Friday at $5.71, off about 8% from its price when I recommended investors short the stock.

Truth be told, Isle of Capri may not deserve to be on this list; it certainly has done nothing to merit a comparison to the corruption and lunacy of Groupon and Zynga. But I needed a gambling stock to keep up appearances, and I still believe ISLE to be the worst stock in the sector. It has a massive debt load – as I noted in March, over 35% of its revenues go to taxes and interest on its debt – and its brand is simply not strong enough to create growth in the increasingly competitive US market. Isle may be a fine company – and I have enjoyed the two properties I have visited – but its financials are simply too stretched for equity investors. Its bonds – which mature in 2014 and offer a nearly 7% yield at current prices – may be an interesting play for investors who appreciate the company and believe it will continue to survive. But there is simply not enough cash generated for equity holders to make substantial profits in the near term, and the long-term issues of cannibalization and regional competition show no signs of easing.

4. Research in Motion (RIMM)

I’ve covered Research in Motion – the maker of Blackberry smartphones – repeatedly for the investment site Seeking Alpha. Back in July 2011, I called the stock “a value trap” – a term for a stock that looks like a good deal, but isn’t.

Ten months later, RIMM is still a value trap. The numbers look phenomenal; cash of over $3 per share, and trailing earnings of $2.22 per share, all for Friday’s close of $12.01. But that closing price is the company’s lowest in some nine years; the stock has lost over 90% of its value since 2008. It has lost more than half of its value since my first negative piece on the stock in July. At each level – and with each negative article I wrote – there were bullish investors convinced the worst was over. It wasn’t – and still isn’t. Blackberry has been overrun by Google’s Android platform and the hugely successful iPhone from Apple. Its former dominance in the business world has been eroded by technological changes, and its consumer appeal has been decimated by its inability to deliver quality products that consumers actually want. With its market share in the single-digits, the smartphone pioneer is now exiting most of its consumer markets.

There are still investors hopeful that RIM will come back; they point to the company’s patent portfolio or the repeatedly floated rumor of an acquisition by Microsoft. They did the same thing at 45, and 35, and 20. With the stock now at 12, the story still hasn’t changed. Ignore the seemingly positive fundamentals – which will continue to worsen – and ask yourself one simple question: if you won’t buy a Blackberry phone, why would you buy stock in the company that makes it? And if you would buy a Blackberry phone, what the hell is wrong with you?

5. Lennar Corporation (LEN)

Lennar builds homes in the United States. Convinced yet? You should be. But, there’s more. The stock trades at 20 times its 2013 earnings estimates (and 35 times this year’s consensus). It’s doubled since October. It’s burned $380 million in cash in the last five quarters. It’s trading at twice its book value, even though the carried value of its assets will collapse if the US housing “recovery” sees any stumbles.

The company itself is hopeful that “the housing market and the overall economy are stabilizing,” echoing similar prayers throughout the industry. According to Reuters, homebuilder sentiment in March was the highest it has been since June 2007 – right before the most recent housing bubble burst. Not only the homebuilders but investors are buying into the recovery too soon and on too little evidence.

If an investor did believe strongly in the housing recovery, he would be wise not to buy Lennar stock, but to buy an actual freaking house. The price of the home may decline, but there is still some value in owning a home. The same, right now, is not necessarily true of Lennar.

Business News

Las Vegas Sands (LVS)

LVS beat analyst estimates in the first quarter, becoming the first gambling company to post $1 billion in earnings in a single quarter. Revenues rose 31% year-over-year to $2.76 billion, an industry-wide record according to the company’s earnings release. The company’s strength in Macau was not the only driver; EBITDA (earnings before interest, taxes, depreciation, and amortization) at the company’s Marina Bay Sands property in Singapore grew 66%, and revenue and earnings grew at the US operations in Las Vegas and Pennsylvania. Overall, adjusted earnings of 70 cents per share swamped the Wall Street consensus estimate of 60 cents per share.

And, yet, the stock fell sharply after the earnings were released after the US market closed on Wednesday, dropping some 4.75% over the next two days despite two positive trading sessions in the broader US market. As Barron’s noted, some investors seemed to be spooked by the company’s “defensive” tone on its post-earnings conference call. “The tone of LVS’ Q1 earnings call at best can be described as contentious,” wrote Nomura Securities’ gambling analyst Harry Curtis in a note to investors, pointing out that the company was reluctant to share additional information on the new Sands Cotai property that opened earlier this month, as well as the company’s announced development in Spain.

Curtis wasn’t exaggerating; Adelson was more than a bit ornery on the call, using his opening statements to blast rumors of a seventh concession on the island, a potential loss of table games as the new project opened, and the widely reported $35 billion price tag on the company’s proposed European expansion. “For those people…that know more than we know, and maybe you [sic] would ostensibly know more than the government knows, it’s right to apply for a job [with] us as a government relations person,” he told listeners sarcastically. Later, in response to a question on “positive hold impact” on EBITDA in Vegas and Singapore, Adelson bristled again. He instead gave the 200-day moving average, dismissing the quarterly hold rate, and offering to provide a “multimillion dollar prize” to anyone who could guess the company’s win rate from a quarterly basis down to the minute. “Just being sarcastic about that,” Adelson added at the end – as if it wasn’t already obvious. He again took a rather imperious tone when he told BofA Merrill Lynch analyst Shaun Kelley to “call this number again” next quarter when asked about potential cannibalization of existing Sands properties by the new Sands Cotai Central.

That cannibalization might be a real issue, because Sands’ Macau operations that were not as impressive as they seemed at first glance. The 25% revenue growth was actually below the growth in the total Macau gambling market, meaning that LVS likely lost a small amount of market share in the quarter. Worse, profit margin took a tumble, as EBITDA grew 21% and net income just 5.8%. The latter figure was clearly below expectations, and helped drive the share price of Sands China (1928.HK), the company’s Hong-Kong listed subsidiary, down 2.4% after its earnings release.

With LVS on a such a bull run – particularly in 2012, as the stock is still up 31.3% year-to-date – it appears expectations may have just gotten ahead of the company’s impressive growth. LVS has now corrected by some 10% from a three-year high reached earlier this month. As I argued back in March, LVS became a momentum stock – and the Street loves to take down momentum stocks. As Nomura’s Curtis noted, this may result in additional near-term downside for the stock. Long-term, Adelson’s vision, constant drive toward expansion, and impressive earnings growth make the stock worth a look if it continues to fall. As Adelson himself noted in his opening statement, only one other stock of the more than 12,000 listed on US exchanges have the combination of size, growth, and a quarterly dividend offered by LVS: market darling – and the world’s most valuable company – Apple.

Bally Technologies (BYI) and International Game Technology (IGT)

IGT continues to struggle, despite beating analyst estimates with fiscal second quarter earnings and raising its full-year earnings guidance to a range of $0.98 to $1.04 per share. The market responded by pushing the stock down 4.7% for the week to a close on Friday of $15.79. Despite strength in the overall market, and the gambling sector, IGT stock is down for the month, year-to-date, and last twelve months.

What exactly caused IGT‘s decline is unclear; what is clear is that its competitors are nipping at its heels, perhaps one reason the stock has stagnated for most of the last two years. Small-cap provider Multimedia Games (MGAM) has nearly tripled from October lows, thanks in large part to a blowout December quarter. Meanwhile, shares of the US’ second-largest manufacturer, Bally Technologies (BYI), have doubled, reaching a four-year high this week after fiscal third quarter earnings set a quarterly revenue record for the company and earnings rose by more than 50 percent.

The market’s sentiment toward the respective companies’ growth prospects can be seen in their earnings; BYI now trades at 20 times the midpoint of its guidance, and MGAM 26. Even struggling WMS Industries (WMS) – who saw three separate declines of over 10% in 2011 based on earnings misses – is valued at around 20 times earnings. Yet IGT trades at just 16 times the low end of its fiscal 2012 earnings guidance. Its lower growth rate and skepticism about its $500 million acquisition of Double Down Interactive in January are likely contributing to IGT’s lower multiple.

In this week’s Barron’s, analysts noted that continued growth in Asia and the expansion of casinos in North America could lead to gains for slot machine manufacturers – the same case I made on this site back in January. According to the report, analysts at Morgan Stanley and Sterne Agee chose IGT as the prime beneficiary, noting its North American market share of 50% and its huge cash flow advantage over competitors WMS and Bally. But it also noted that IGT “expects” to get 45-50% of new orders in 2012 – forecasting a likely (albeit small) decline in market share. And Nomura’s Curtis (the same analyst who noted Sheldon Adelson’s “contentious” tone) noted in the IGT conference call that its competitors are “underselling” IGT’s products. Given the low margins and competition for casino operators, particularly in the US, lower prices could be of definite interest, and take their toll on IGT’s profit margin. CEO Patti Hart noted that average selling prices for the company’s machines did improve year-over-year; but can IGT sustain its current pricing if competitors continue to challenge it? Furthermore, IGT may not be the prime beneficiary of growth in Macau and the rest of Asia; IGT’s international market share is substantially lower – “in the mid-teens,” according to Hart.

So, if IGT can increase its market share overseas, if it can continue to hold the line on pricing without seeing its North American dominance erode, and if it can integrate Double Down and gain more than the one-cent per share earnings boost it expects in the near future, it is a long-term buy. Simply put, IGT has to execute. Right now, its competitors are doing a better job – and the valuations, and recent earnings releases, prove that point.

Penn National (PENN) and Boyd Gaming (BYD) 

Two of the largest US-facing casino operators also reported strong earnings. Penn National, which operates 26 facilities in 19 states, also hit a nearly four-year high before settling in at Friday’s close of $45.20. Its first quarter earnings (reported last week) beat analyst estimates, and the company raised its full-year earnings guidance to $2.48 per share, from a previously estimated $2.26. Boyd also beat earnings estimates, but its stock fell 4.3% for the week, closing Friday at $7.89, up modestly year-to-date.

Despite the good news, both company’s reports – and conference calls – showed the continuing headwinds facing US-based operators. Penn’s conference call Q&A was dominated by talk of “cannibalization” in Kansas City, Illinois, and Maryland, while Boyd CFO Josh Hirsberg was asked about the effect of the new Revel on the company’s 50%-owned Borgata property in Atlantic City. These issues are nothing new for the companies, which in fact compete head-to-head in Illinois, Louisiana, and Mississippi.

Furthermore, neither company saw substantial revenue growth outside of acquired properties. Boyd’s legacy Las Vegas properties were “up slightly” year-over-year, while its smaller Downtown operations grew the top line 2.4%, according to the company’s earnings release. Penn actually saw revenue decrease in two of its geographic segments, with most of its top- and bottom-line growth coming from its acquisition of the M Resort in Henderson, Nevada. Boyd showed strong performance in the Midwest and South, growing market share and margins, but was still weighed down by its huge debt load. Operating income was $76 million – but interest expense nearly $64 million.

In short, with PENN trading at 18 times its 2012 guidance, and BYD nearly 20 times its 2013 estimate, it becomes difficult to see where earnings growth will come from. Acquisitions often carry a high cost – with Boyd’s huge debt load, any large purchase will be difficult, if not impossible – and so-called “same store” sales should continue to stagnate. Competition, taxes, and debts will remain headwinds even as the US economy slowly recovers.

In reviewing last quarter’s earnings results, I wrote the following: “Focus on Macau and casino suppliers; ignore companies who are tied to the over-regulated, under-performing American market.” Despite modest improvement for PENN and BYD, that advice still seems sound. Both stocks are still richly valued, both still face a wealth of challenges, and neither can provide the growth that international operators – or their suppliers – will offer. While this week’s earnings may have surprised analysts, the issues facing the companies in the future shouldn’t surprise anyone who truly understands the gambling industry.

Business News

Over the last two-plus weeks, Zynga’s fall has accelerated; it closed Friday at $9.22. The reasons for the fall are difficult to parse; a secondary offering in late March, where shareholders sold an additional $515 million worth of shares into the market increased the stock’s “float” and may have helped push the stock down. But with a young (the company only went public in December) and speculative (Zynga is not yet profitable) stock, the drivers of even large movements like the current one-month, 33% drop can be difficult to tease out.

For bulls touting ZNGA at its new, lower, price, the company’s potential in online gambling has become a common selling point. Zynga’s CEO Mark Pincus has called online gambling a “natural fit” for the company, noting that Zynga Poker is already the world’s largest online poker provider. As my Seeking Alpha colleague “Modernist” argued, “Zynga incorporates tokens (like poker chips) within its games.” So, the theory goes, all Zynga has to do is wait for legalization, turn the “real-money gambling” switch on, and watch the profits roll in.

Unfortunately for Zynga shareholders, it ain’t going to happen. There are entirely too many hurdles for Zynga to clear for it to reach any sort of market share in a US online gambling market that, ohbytheway, is still non-existent. For all the coverage of the late December re-interpretation of the Wire Act, there has been little real-world movement. New Jersey’s bill has cleared a hurdle in the state Senate, but will likely face legal challenges from the state’s racetracks. Nevada has begun the process of  licensing online poker providers, with an eye toward having online poker up and running later this year. And that’s it. The two states, combined, have a population of roughly 11 million, less than 4% of the total US population. In Nevada alone, fourteen different companies have applied for licenses to serve a market of less than 3 million people in a state that has traditional casinos (and traditional poker rooms) in nearly every major city, including the (perhaps former) gambling capital of the world. (And, no, neither Zynga nor Wynn are one of the fourteen applicants.)

If and when the US gambling market comes to fruition, there are still a host of challenges for Zynga. In the market – and in the business media in general – there seems to be an idea that any idiot can run a casino. As I noted back in February, casino stocks often see roughly similar valuations, no matter their target markets, customer base, or brand appeal. Since “the house always wins,” it’s just a matter of getting people in the door and counting money.

This idea is patently untrue; just ask Donald Trump, whose casinos went bankrupt  three separate times. Branding and the customer experience are key in the competition for the gambling dollar, a competition that will be exceptionally fierce in the potential US iGaming market. Nobody understands this better than Steve Wynn, whose properties are renowned for their opulence and attention to detail. As such, his flirtation with Zynga is particularly surprising. The Zynga brand is not, as yet, suited to the online gambling market. Its games like Farmville and Words with Friends don’t conjure up the idea of thrilling, high-stakes, mental combat; they remind consumers of bored grandmothers and mid-level white-collar workers killing time at the office. Is a Zynga-branded poker game going to challenge an operation run by, say, the joint venture between Caesars Entertainment (CZR) and 888 Holdings? That joint venture will have the World Series of Poker imprint (through Caesars) and the technical and marketing expertise of 888, one of the few operators to see growing poker revenue in the mature European market. That JV will have a brand that appeals to poker players, and new potential customers; it will have the opportunity to offer WSOP seats in promotions, and cross-brand its online activities with live circuit events and its nationwide loyalty program. What will Zynga offer, free tokens for Mafia Wars? (One doubts that small-time poker players will create enough rake for free rooms at Wynn’s $250 average daily rate.)

Furthermore, Zynga’s social aspect is, in the poker arena, a negative, not a plus. I played online poker for several years pre-Black Friday; online poker players do not want to play with their friends. They want to take money from anonymous strangers, or at least have the opportunity to write “you f***ing donkey ur mother is a whore” in the chat box when they lose. Friends who want to play poker together meet at somebody’s house with a case of beer and buy in for fifty or a hundred dollars a piece. Most online poker players – particularly the profitable ones – want to play for higher stakes, at multiple tables, on trustworthy, high-end software.

And there we get to yet another problem for Zynga: its software is, technically speaking, a piece of shit. The company has been repeatedly criticized for simply ripping off designs from smaller makers. Forbes gaming columnist Paul Tassi called Zynga “a creatively, and I would argue morally, bankrupt company.” Complaints about the bugs in the company’s games are common; a long-time player told Tassi “they fix very few” of the game issues brought to their attention. Losing 50 tokens in Mafia Wars is one thing; but a bug in an online poker platform can cause severe damage to an operator’s reputation – and its profits. The expertise needed to operate a gambling platform, particularly under the predicted state-by-state US regime, will be extensive. Age verification and geolocation software must be foolproof, as fines for serving out-of-state and/or underage customers will likely be severe. The software must be technically flawless; even an outage of a few hours – or God forbid, an opening for hackers to see hole cards and/or affect gameplay – will send players stampeding to competing sites. Nothing that Zynga has done should give investors any confidence that it will succeed on all these fronts.

It is true that that the arguments above against Zynga becoming a profitable iGaming company have focused on the poker market. Some have argued that Zynga could simply convert its existing games (such as bingo) to a real-money format, and reap its rewards there. Might the company also look to the UK and Europe – 35% of its revenue comes from overseas – where legalization regimes are already in place?

Well, no. First, the concept of US-based, US-regulated, legalized online platforms for games like bingo, blackjack and roulette is still a pipe dream. No legislator, any time soon, will dare sponsor such a bill, and eighteen months later face the inevitable nationally-hyped story about the 13-year-old who got his parents’ credit card and blew $10,000 at a high-stakes online blackjack table. It doesn’t matter whose fault such an event really is – even teenagers should know not to split kings – but the political risk of full iGaming legalization is so high that it seems nearly impossible in the current political climate. Even should such a regime come to be, the same issues facing Zynga in the poker market will face the company in other games. The company right now simply does not have the branding or the technical prowess to compete in what will surely be a highly competitive industry.

In Europe, that market is already well-covered, well-established, and slow-growing. Furthermore, the oft-cited potential of Zynga to move its users from free games to real-money ones has not materialized on the Continent. As Christian Tirabassi of Italy’s Ficom Leisure told the recent iGaming North America Conference: the Facebook user “does not convert” to real-money games. The social game player is well aware of the existing real-money alternatives, and chooses not to take that risk. “I don’t believe in the easy transition from social games to real [money] games,” Tirabassi told the audience.

Without the potential for real-money house games, Zynga is left with online poker, with a initial eye to the prospective US market. From there, all Zynga needs to become an online gambling powerhouse is to see poker legalization move at a faster pace than it has, or anyone thinks it will; completely overhaul its brand image and market to a demographic that has essentially no interest in its legacy games; complete a massive upgrade of its technical capabilities; and then outsmart competitors who have decades more experience in the gambling industry and partners who have already succeeded in the cutthroat European iGaming market.

Even then, without a full legalization of varied online games, what is the US poker market really worth? I’ve noted in the past that online poker had slowed dramatically in the US even before Black Friday; European operators are clawing one another’s eyes out over the shrinking pool of “net depositors” (ie, losers). As Joe Brennan, director of the Interactive Media Entertainment and Gaming Association (IMEGA) noted in an interview, “[A]t the end of the day, poker is not a big business…In the long term, the only way you can be successful in the poker business is if you can dominate the market in terms of share.” To even consider entering the online gambling market, Zynga must travel a long road of massive changes, and substantial investments. To predict that this company  with no gambling experience and substandard technical operations will become the market leader is simply a bridge too far.

Business News

Despite writing on several occasions about Macau-facing stocks, I have largely neglected the three Asian operators: SJM Holdings (880.HK, and SJMHF on the US pink sheets); Melco Crown Entertainment (MPEL, and 6883.HK); and Galaxy Entertainment (27.HK, and GXYEY on the pink sheets). This is unsurprising as well; I live in the US, and we don’t give a shit about other countries coverage of foreign stocks is more difficult to find. However, focusing on only the three US-based operators would have caused investors to miss out on significant returns over the last two years. Galaxy stock is up nearly 500%, while Melco Crown and SJM have tripled. Wynn Macau has returned just under 100%, and Sands China about 2.5 times its April 2010 price; stellar returns, to be sure, but still lagging their Asian counterparts. (MGM China has, surprisingly, lost a small amount of ground since its Hong Kong offering in mid-2011.)

The Asian operators have not only seen their stocks outperform those of the Yankee invaders; but their business continues to outpace Wynn, Sands, and MGM. SJM Holdings – founded by Macau magnate Stanley Ho – leads the pack with a 27% share of the Macau gambling market, with Galaxy next at 20 percent. Melco Crown struggles to just 14 percent of the market; but the three firms combined still control 61 percent of market share.

With this week’s opening of the Sands Cotai Central, market share figures may stay roughly fixed for the next couple of years. Sands is likely to grow its market share from 17 percent with the new property; Melco Crown may also benefit from additional visits to its City of Dreams thanks to its new neighbor on the Cotai Strip. But it appears unlikely that any new properties will be built before 2014 at the earliest, and competition from new licensees on the island seems even less likely.

As such, going forward, it is all about valuation and execution for the three Asian operators on Macau. For SJM, the question is whether the company can keep its market share lead. Market share has eroded steadily over the past year, down from 32.6% in early 2011, according to Bloomberg. With the extravagant Sands Cotai now on-line, the question in the market seems to be: has SJM lost its leading edge?

Right now, the market appears to think that it has. The succession issues involving former chairman Stanley Ho last year first shook investor confidence in the stock. The legal drama surrounding the family did not help ease fears that Ho, a man so well-connected worldwide that the FBI sought to turn him into an informant, would leave behind a far less capable successor. Indeed, at its current price of HK$16.32, SJM trades at just 17 times 2011 earnings, lower than all its competitors save for laggard MGM.

The low valuation seems unusual for a market leader; but clearly investors don’t believe SJM can stay on top for long. Its decline in market share over the last twelve months – some five and a half percent – is substantial enough that SJM revenues, theoretically, should show little or no growth in 2012. Analysts are expecting revenue growth of between 3 and 18 percent, according to Reuters; yet with the overall gambling market expected to grow at about 20 percent, and ancillary sales still miniscule (hotel and catering sales totaled less than 1% of total revenue for SJM in 2011), even double-digit revenue growth seems optimistic. As our own Jamie Hinks noted this week, SJM actually saw March revenues decline 2.2 percent year-over-year, compared to 24% growth in the overall market. “That could be a sign of things to come for SJM,” Hinks wrote.

If it is, SJM stock could face serious problems. Given that Macau is a growth story, a low-growth stock is going to fall out of favor. From that standpoint, SJM’s low earnings multiple makes sense. And, without a near-term catalyst to reverse the market share decline, that low earnings multiple seems likely to stay. At first glance, SJM seems undervalued – but it most likely isn’t.

On the other side is Melco Crown Entertainment, a joint venture of Australia’s Crown Limited and Lawrence Ho, son of SJM’s Stanley Ho. As noted, Melco’s market share is just fourteen percent; but its City of Dreams property occupies a prime spot on the Cotai Strip. With this week’s opening of Sands Cotai – and a corresponding jump in LVS stock to a four-year high – Cotai is the new area of investor focus on the island, and Melco Crown may benefit. Already, analysts at Goldman Sachs have upgraded the stock, forecasting a “spill over effect” as the new Sands project attracts tourists to the Strip. Goldman raised its targets on the Hong Kong-listed shares to HK$44.40, a 21% premium to its current price of HK$36.70. MPEL is already up 48% year-to-date, and as stocks like Las Vegas Sands (LVS) have shown of late, Wall Street loves high-momentum stocks in the gambling sector. In the short term, continuing optimism about Cotai looks likely to boost MPEL’s stock price; in the long term, if the company can take advantage of the opportunity to strengthen its market share, the 20-30% annual revenue gains will pay off for investors. Trading at 21 times earnings, MPEL is still a bit pricy. But the stock should enjoy a tailwind for a good while longer.

The final Asian operator on Macau is Galaxy Entertainment. As noted, Galaxy has been the best performer of any of the Macau licensees, up nearly 500% over the last two years and over 60% year-to-date. Not coincidentally, the stock is also one of the priciest, trading at 26 times 2011 earnings, on par with red-hot Sands China.

Galaxy’s recent success is a bit of a surprise; its full-year 2011 earnings came in below estimates, and its failure to authorize a year-end dividend disappointed investors. (As a point of comparison, SJM authorized two dividends totaling HK$0.65 at year’s end, offering a 4% yield to its shareholders.) And yet, the stock continued to climb, rising another 23% since those earnings were announced.

Galaxy looks like a strong bet; in addition to legacy operations on the Macau Peninsula, it not only has a well-received property on the Cotai Strip (the Galaxy Macau) but, as it noted in its annual report, also “Macau’s largest contiguous landbank with an integrated resort permit.” The Galaxy Macau – which, in just seven and a half months of operations, helped Galaxy more than double its revenues and triple its earnings per share – is projected to quadruple in size.

Galaxy also appears to be one of the leaders in the growing “mass market” segment. The traditional VIP player – brought in by so-called “junkets” to play in outsourced gaming parlors – has driven nearly all of Macau’s recent growth. Now, higher-margin, lower-revenue mass market players are the casino’s newest target audience. As Nomura Securities (16) noted in March, mass market revenue growth is outpacing VIP growth; the firm selected Galaxy, Melco Crown, and Sands as potential beneficiaries of that trend. In that month, Galaxy grew its mass market revenue 300%, thanks to the opening of the Cotai property, showing its exposure to the fast-growing and profitable mass market customer.

In short, it looks like all good news for Galaxy; which, combined with high earnings multiple and the 500% rise since 2009, seems somewhat scary for contrarian-minded investors. A stock can’t go up forever, can it?

But it doesn’t appear that the bull run is over yet. With the dual operations of Galaxy Macau and the legacy StarWorld property, Galaxy may make a run at SJM’s lead in market share. With investor momentum firmly behind the stock – even through somewhat disappointing earnings reports – and the possibility of becoming the market leader, there is still plenty of upside for Galaxy stock. Yes, the valuation is high, competition fierce, and economic worries still present. But those issues have been around for years, and Galaxy has easily outperformed all of its rivals. With further growth in the market and the possibility of increased market share, Galaxy’s top- and bottom-line growth should still be able to support its above-average valuation.

Business News

Within the sector, however, there were a number of themes that moved valuations – some covered here in my column and some to keep an eye on in the future. As we move into April, and toward the beginning of another round of corporate earnings, a review of the first quarter’s key developments in gambling stocks, and what they mean for investors going forward.

Macau, baby.

Shares in publicly traded operators on the Chinese island of Macau boomed, as growth in the enclave continued to impress; gambling revenues rose 27% year-over-year in the first quarter. Shares in all six of the island’s casinos rose sharply in the quarter:

Chart courtesy Yahoo! Finance

First quarter chart of Galaxy Entertainment (27.HK); MGM China (2282.HK); Sands China (1928.HK); Wynn Macau (1128.HK); SJM Holdings (880.HK); Melco Crown Entertainment (MPEL) in aqua. 

Even laggard Wynn Macau – facing concerns about the company’s weak market share in Macau – saw a rise greater than that of the global industry at large, while its competitors saw returns between 26 and 43 percent for the quarter. This is nothing new, of course; with the exception of MGM China (which has been roughly flat since going public in the summer of 2011), each of the Macau-facing operators have seen gains of at least 90 percent over the last two years, with leader Galaxy up over 400% since April 2010. With the island continuing to defy skepticism about a “hard landing” on the Chinese mainland and a corresponding slowdown in gambling, the stocks may have further yet to run.

Strength in Macau also boosted the share prices of US operators with substantial stakes in Macau subsidiaries: Wynn Resorts (WYNN), MGM Resorts International (MGM), and Las Vegas Sands (LVS). LVS led the way with a 30% return; MGM rose 24%, while WYNN, beset by the feud between founder Steve Wynn and shareholder Kazuo Okada and fears that its position in Macau is eroding, rose just 10% for the quarter. (Guess which one of the three I recommended back in January.)

Despite the strength in the US-listed stocks, all three lagged the returns of their Macau-based, Hong Kong-listed subsidiaries. As I noted in my piece on pairs trades last month, the opportunity still exists for investors to bet on the strength of Macau by buying stock in the Asian subsidiaries and shorting the US-listed parents. For the quarter, those trades would have returned 6%, 3%, and 2%, for MGM (my favorite of the three), Wynn, and Las Vegas Sands, respectively. Those returns would have lagged the market, of course; but the lower-risk nature of the pairs trade makes it still worth a look going forward.

Beyond the casino operators, investors can look to “junket” companies to play Macau’s growth. I recommended VIP room operator Asia Entertainment and Resources (AERL) back in January; the stock has risen slightly since I covered it but, at Friday’s close of $6.10, still looks undervalued.

Macau isn’t the only market in Asia.

Despite the gaudy numbers and impressive growth, Macau is not the only booming market in Asia. In 2011, LVS made almost as much profit from its Marina Bay Sands property in Singapore as it did in the better-known Macau market. Smaller, emerging markets such as Korea and even Cambodia offer opportunities as well. In March, I covered stocks in both countries. Paradise Co Ltd. (034230.KS) and Grand Korea Leisure (114090.KS), which dominate the “foreigners-only” market in South Korea, both rose modestly in the quarter. Both stocks still appear to have some upside, though both bear the standard risks of emerging-market and gambling sector stocks.

The other company profiled in that piece was Cambodia’s NagaCorp (3918.HK), which had a far more interesting quarter. On March 9^th, the stock rose to HK$4.01, having risen 90% since the start of the year. It started to fade from there, and a week later I noted that the stock was still above the target prices set by the analysts covering the company. The stock continued to struggle, until announcing this week that it would sell an additional 214 million shares between $3.04 and $3.18 per share. The stock fell sharply, and closed Friday at HK$2.99, down over 25% in less than a month. “Should the stock pull back, it would be an interesting – and no doubt exciting – play on the Asian gambling market,” I wrote back in March. The 25% decline offers a far more reasonable entry point, and the stock’s roller coaster first quarter proves that owning NagaCorp will definitely be interesting – at the least.

The US online poker “gold rush” is on, but investors have been shut out.

The late December, opinion from the US Department of Justice sparked a short-term rush into gambling stocks. But, as I noted in my first piece for CalvinAyre.com, much of the euphoria subsided rather quickly, at least in the stock market. Stocks such as Boyd Gaming (BYD) and tiny PokerTek (PTEK) gave back their gains within weeks; European online gambling providers 888 Holdings (888.L) and Bwin.party Digital Entertainment (BPTY.L) – both of whom have joint ventures with licensed US operators – saw initial spikes, then flattened out in January.

BPTY actually finished down about 7% for the quarter, despite a reasonably positive 2011 earnings report in late March. Of note, however; poker revenue actually declined year-over-year, showing the headwinds in the mature European online poker market and perhaps adding a much-needed dose of skepticism toward the potential of the still-apocryphal US market.

888, on the other hand, had an excellent quarter, rising nearly 50% after strong year-end earnings showed revenue growth of 26% and a doubling of pre-tax earnings. According to the company’s annual report, 888 moved from 13^th to fourth in poker traffic during the year, meaning that Pwin’s loss appears to be 888′s gain. Still, other than two big moves – first when the company pre-announced strong 2011 revenue figures in late January, and then again in late March when profit figures were revealed – 888 stock largely stayed flat, despite the rising broad market in Europe. Combined with BPTY’s lack of movement, it appears investors are still taking a “wait-and-see” approach to the US online gambling market. Outside of earnings, the stocks basically did not move. It appears, as I argued back in February, the regulatory and political atmosphere surrounding online gambling is so volatile and so confusing that investors are almost paralyzed.

Industry insiders, however, are not. The quarter saw a flurry of activity as industry players raced to stake their claim in the online poker “gold rush”. Slot maker Bally Technologies (BYI) introduced new server technology for online gambling, while industry leader International Game Technology (IGT) bought Facebook game developer Double Down Interactive for $500 million. IGT may now compete with Zynga (ZNGA), whose COO has discussed the social media company’s interest in the online gambling space. Churchill Downs (CHDN) purchased Bluff Media in advance of “the liberalization of state or federal laws with respect to Internet poker in the United States.”

The problem for investors, however, is that the deals have all involved small, privately held companies. The avenues for investment in the online gambling space are primarily stocks like ZNGA, BPTY and 888, all of which have substantial risk beyond US Internet poker. Meanwhile, the expenditures by existing operators and suppliers can affect share prices; IGT had a lackluster, slightly negative first quarter due to weak December quarter earnings and perception that the company overpaid for Double Down. While Internet poker is a hot topic in the gambling industry, for gambling investors, it has so far been much ado about nothing.

There are some serious challenges for regional US casino operators. 

Despite the run-up in the broad market, and in the gambling sector, regional US casino stocks lagged. Other than Isle of Capri (ISLE), which rose nearly 50% (one of the reasons I suggested shorting that stock three weeks ago), US operators stagnated. Penn National Gaming (PENN) rose in line with the broad market at 12.8%, but competitors Pinnacle Entertainment (PNK), Boyd Gaming (BYD), and Ameristar Casinos (ASCA) rose just 6.3%, 2.0% and 5.0%, respectively.

I have been notably bearish on this group of companies, recommending them as a short play in a pairs trade with Macau-facing operators such as WYNN or LVS, and noting the political and competitive challenges facing the highly-regulated business. But the weak first quarter performance may signal tough times ahead for these stocks. Gambling stocks are highly correlated with economic expectations, but they are also volatile. Casino stocks should rise faster than the overall market in the good times – because they often fall further when fear returns to the market, and the highly leveraged, economically sensitive casino business falls out of favor. The fact that higher-risk sectors such as semiconductors and housing saw above-average returns in the first quarter, while casino stocks were left behind, is a bad omen for US casino operators. The lack of enthusiasm for these stocks in a market environment where similarly high-risk sectors such as semiconductors, airlines, and home builders were booming does not give investors confidence. More importantly, it makes whether the market will provide support to the stock prices of PENN and ISLE should sentiment turn more bearish.

Given the high-debt, low-growth nature of these stocks right now, even bulls must admit they are high-risk plays. High-risk plays should offer high rewards – but for ASCA, PNK, and BYD, the expected first-quarter rewards didn’t materialize. That should make investors nervous going forward.

Business News

But options do not necessarily have to be used for high-risk plays; in fact, they can be used to lessen investor risk. This is of particular value in the gambling sector, where many stocks are highly volatile. Options can be used to provide downside protection against a steep fall; to protect already-captured paper profits; or to fix an entry point for an investment at a price below the current trading price.

Given continuing concern about whether the current bull market in stocks can continue – every market in the world is up year-to-date, except for Spain – focusing on protective strategies should be of key interest to investors right now. Gambling stocks, which are often highly correlated to the broad market, have boomed as well. The BJK exchange-traded fund (BJK), which comprises 60 gambling stocks worldwide, is up 14.5% year-to-date and 40% from its lows in early October just six months ago. Investors looking to protect existing profits, or who are worried that the notoriously fickle gambling sector may have some downside in the short term, can look to the option market to mitigate their risk.

The simplest form of risk mitigation in the options market is through the purchase of a put option. A put option gives the owner the right to sell a stock at a given price at any time before the option expires. Puts can be used where a stock has a steady run-up, and an investor still feels the stock has more room to run, but wants to lock in existing profits. Las Vegas Sands (LVS) has been one of the market’s best-performing stocks, up over 35% in 2012. If an investor bought in around $40 per share in mid-December, he would be sitting on a 44% paper gain. What to do? He may still be bullish on LVS long-term, and feel that the stock may have room to run. But the continuing broad market concerns upset him, and he worries about the stock turning downward if economic worries spook the market.

The simplest way to handle this situation is to buy a protective put. A January 2013 40 put is currently asked at $2.21 per share ($221 per contract – each contract represents 100 shares.) With a purchase of this put, the investor can sell LVS for $40 per share at any time between now and January 18, 2013. His original investment is now guaranteed for over nine months, for just one-eighth of the paper profits made.

The problem with this strategy is the price. If the same investor wanted to guarantee current profits, and purchased a January 2013 57.5 put, it would cost $8.15 per share – nearly half of the profits already generated. A new investor in LVS who bought the same protective put would need to see a 14% return by January simply to break even. Given the volatility in gambling stocks, protective puts will always cost more, since the odds of a big downward move are higher.

The price issue can be mitigated through the use of a collar. A collar simply adds the sale of a call option – a right to buy – to the trade. The proceeds from the call option go toward paying for the put option; the trade-off is that the investor then gives up potential upside. The graph looks like this:

graph courtesy of ©thismatter.com

In our LVS example, our investor has a cost basis of $40. With the stock at Friday’s close of $57.57, he initiates a protective collar. He buys the January 57.5 put at $8.15, and sells a January 65 call at $4.60. The net cost is $3.55, 20% of the current paper profits generated. But the trade is locked in; no matter what happens, at any time until January 2013 the investor will be able to sell his LVS stock for a net total of $53.95 per share, a 34.9% gain from the $40 entry price. If the stock rises past $65 per share, the investor misses out any upside, but still sees a handsome 62.5% return on his overall investment. The key here, though, is downside protection. The use of options guarantees already-made profits, at a reasonable cost.

Options can also be of use to new entrants into a stock, through either covered calls or cash-secured puts. I have used these strategies extensively, and successfully, in my own portfolios. It’s important to note that the two are equivalent strategies; both entail the sale of potential upside in return for a lower entry point into the stock. Again, these strategies are valuable in relation to gambling stocks because of the sector’s volatility; options are priced based on the potential range of the movement of the underlying stock. Gambling stocks are more likely to move further, faster, and more often, so the options are priced accordingly; long-term investors in the sector can take advantage of volatility through the sale of options.

Covered calls are generally better-known, but cash-secured puts are easier to understand, so we will focus on that strategy. A covered call simply entails the purchase of the stock and a corresponding sale of a call option for an equal number of shares. We purchase LVS at $57.57, and sell the January 2013 67.5 option for $3.85 per share. The option proceeds give us 6.7% downside protection; if LVS falls to $53.72, the investor still breaks even, having already collected the option premium (which is paid up front). Should the stock rise beyond $67.50, the call option will be exercised. If the stock breaks $71.35   – a substantial 24% gain – the investor misses out on any additional upside.

But cash-secured puts better show the value of the strategy, in that they can literally allow an investor to set the entry price at which he wants to invest in a stock. The “cash-secured” is a key part of the trade; selling puts alone – a so-called “naked put” – adds substantial risk. It requires the use of margin in the account, and losses from a naked put can be multiples of the upfront premium received. The sale of a naked January 2013 50 put on LVS – with a premium of $4.75 per share – would face a 100% loss if LVS fell to $40.50, a 30% drop. Beyond that level, the losses escalate, with the total possible losses dwarfing the maximum potential return.

Selling a cash-secured put in LVS at $50 per share requires coverage of $5,000 (each options contract represents 100 shares). The investor receives the premium of $475 up front, leaving $4,525 of capital at risk. The potential return is 10.5%, or about 13% on an annual basis – not a bad return at all. In this trade, the investor is faced with two outcomes: first, the put is unexercised, as the stock never reaches the strike price. If LVS stays above 50 until January 2013 – or if it dips without the option being exercised, and clears 50 before January, which does happen – the investor keeps the 10.5% return. If the stock falls, the put seller is obligated to buy the stock at $45.25 per share – a 21.4% discount to LVS’ current price.

For a long-term investor bullish on LVS, neither outcome seems particularly troubling. Yes, sometimes LVS will dip strongly, and the investor will buy the stock at $45.25 when it is trading at $35 or $40. But the same paper loss would occur with a straight purchase of the stock. The biggest risk is the sale of the upside. If LVS doubles by January, the return is unchanged at 10.5%, and the investor has missed out on substantial profits.

But if an investor feels that the current market is due for a correction – as I do – but still feels strongly about its long-term health – as I do – cash-secured puts are a solid way to play that thesis. LVS, currently trading at $57.57, can return 10% over 9 months with a downside entry price of just $45.25. WYNN – still one of my favorite stocks in the sector – closed Friday at $124.88. But the sale of the cash-secured January 2013 110 put, bid at $10.75 per share, allows an entry point of $99.25, 20% below its current price and a price the stock hasn’t reached since 2010. The return on that trade is nearly 11%. In highly volatile MGM, investors can set an entry price of just $7.13 per share – 47.6% below Friday’s close of $13.62 – by selling a cash-secured January 2013 7.5 put. The return on that trade is just 5.2%, but the downside risk is owning a multinational industry leader with exposure to the Macau market at nearly half of its current price.

As I noted last week, options strategies require substantial research before investors put them to use in real-money accounts. (When researching on the Internet, be sure to add a healthy dose of skepticism to your portfolio as well; here is a somewhat technical piece I wrote last year on a seemingly “low-risk” strategy often promoted online.) But these hedging techniques are well-suited to the fast-moving gambling sector and can be used by investors for more control of their portfolio and more protection against the downside. And yes, often, less upside. But nothing in investing – or life – is free.

Business News

A stock option is simply an option to purchase – or sell – 100 shares of a stock at a predetermined price, called the “strike price.” In American-style options, the option can be exercised at any time between purchase and the expiration date, with the expiration date occurring on the third Saturday of each month. “European-style” options are only exercisable on the exact date of expiration, which is the third Friday of each month. (In practice, they are usually distinctions without much difference, as American options are rarely exercised before expiration; investors looking to exercise an option will often simply re-sell the option and take their profits through the options market, rather than waiting for delivery of the stock.)

The appeal of options – like gambling itself – is the possibility of big returns. If a “call” (right to buy) option is purchased for $1 on a stock trading at $10, and the stock goes to $15, a shareholder makes 50% on his trade. An owner of the call option makes 400% – $4 of profit from $1 of initial capital committed. The downside risk is obvious, particularly in “out of the money” options – options whose strike price is below the trading price (for right-to-sale, or “put” options), or above the trading price (for call options): if the stock stays flat or drops, the options trader loses everything. As such, trading in options is usually not a suitable strategy for long-term investing, retirement saving, or inexperienced investors (no matter what the various Internet banner ads for options seminars might promise).

That said, I do believe that option trading has some value. For one, it’s fun. I fondly recall a well-timed option play on the price of gold in advance of a Ben Bernanke speech back in 2010, part of whose profits paid for a fancy dinner and lower-level seats to an Oklahoma City Thunder game, and made my then-fiancee very happy. (A few more similarly profitably trades and we might have gotten married.) More seriously, allocating a small portion of the portfolio to option trading keeps investors attuned to the markets and spices up what can, quite honestly, be at times, a dull, monotonous process. Long-term, fundamentally sound investing can get boring. Making occasional stock option plays can add some excitement. Just because we’re planning for the future doesn’t mean we can’t go to the casino every now and then.

The first place an options trader might look to go is Macau. Macau-facing casino stocks continue to sizzle as the Macau gambling market shows exceptional growth. News that February gaming revenue on the island rose 22.3%, ahead of analyst expectations, drove US-listed Macau operators higher. Despite skepticism, the bull run in Macau continues; options traders can look to profit from momentum in the stocks through the purchase of call options on the island’s casino owners.

Hong Kong-listed companies such as MGM China, Wynn Macau, and SJM Holdings trade warrants (essentially call options) on the Hong Kong Stock Exchange (you can see a listing of SJM warrants here.) But foreign investors may have a difficult time accessing these products, as higher commissions, currency risk, and complicated tax considerations make an already risky trade more difficult. The easiest way to play Macau is through options on US-listed stocks. Las Vegas Sands (LVS), MGM Resorts International (MGM), and Wynn Resorts (WYNN) all offer exchange-traded options available to individual investors.

What makes options interesting is the wealth of ways in which to use them. Short-term traders expecting that March results in Macau will again surprise analysts, and create further growth in the stocks of LVS, MGM, and WYNN, can look to April options. These options have the lowest cost, because they require the quickest moves. A 15 call option on MGM – entitling a purchase of the stock at $15 per share anytime between now and April 20th – is asked at just 22 cents. With the stock closing Friday at $14.20, MGM needs to rise 7.2% between now and expiration. The ask price of 22 cents is per share; thus, a single contract in MGM would cost $22, plus commission. Exercise of the contract – the right to purchase 100 shares at $15 each – would cost $1500, but the need to commit additional capital can be avoided by simply re-selling the option. A higher-risk – and higher-reward – play in MGM would be to buy the April 16 call, asked at just 6 cents. Should MGM stock break $16.06 by April 20th – an admittedly substantial 13% rise – this option would become profitable, and quickly. At $17 per share, each contract, purchased for just $6, is worth $100. A fine return, indeed.

Why would I recommend MGM for a short-term options trade when I have been so negative on the stock in the past? Because MGM is loaded with debt and facing an uncertain future – two of the reasons I recommended avoiding the stock – its stock is extremely volatile. Its beta is 3.67, meaning, on average, it moves 3.67 times as wildly as the overall market. This volatility is good for options owners. If an investor is long an April 16 call option, it doesn’t matter if the stock stays at 14 or goes to 3 – either scenario means the option expires worthless. But the volatility in MGM makes the possibility of a 13% monthly move higher – indeed, MGM made similar moves in early February, January, late December, and October. Given the high rate of return if the bet proves profitable, the volatility inherent in MGM stock makes it an interesting trading vehicle; an options speculator need only to be right on occasion to make the gamble worthwhile.

It’s also important to note that a trader need not hold the option to expiration – nor does the stock necessarily have to reach the theoretical break-even point for a profit to be made. If, for example, MGM moves from $14.20 to $15.20 next week, the April 16 option – which is now far closer to being profitable – will jump in price, and a trader could close the trade out in a week for a likely substantial gain. Speculating on options is a race of stock movement versus time. The passage of time – known as “time decay” – is the biggest enemy facing options traders. It’s why heavy investing in out-of-the-money options is a dangerous full-time pursuit. It’s also why a trade that could potentially return 1500% or more, such as the MGM April 16 call, looks so enticing.

Options need not only be short-term bets. LVS, WYNN, and MGM all offer Long Term Equity Anticipation Securities, known as LEAPS. LEAPS are simply long-dated options; all three stocks offer options that expire in January 2013 and even January 2014, some 22 months from now. Looking at LEAPS offers a way to leverage bets on the underlying securities. WYNN remains one of my favorite stocks in the gambling sector, and closed Friday at $126.57. Investors who are highly confident in the stock can purchase 100 shares outright for a total investment of $12,657. Or they could look to the LEAPS market. A January 2013 WYNN 120 call – “in the money,” as the strike price is below the current trading price – is asked at $21.35, or $2,135 per contract. A confident WYNN investor could purchase 6 January 2013 120 calls for a total of $12,810 – nearly equivalent to the cost of 100 shares. If Wynn rises to $150 per share over the next 10 months – a healthy 18.5% gain – an outright shareholder would earn a profit of $2,343. The options owner would earn $865 per contract (each contract costs $2,135, and is now worth $3,000, as the call owner can purchase 100 shares at $120 each and sell them for $150 each.) Thus, the total profit on the options trade is $5,190, a 40% return, versus the 18.5% for the pure shareholder. As the stock price rises, the divergence between options profit and shareholder profit continues; should WYNN reach $162.70, the shareholder enjoys a 28.5% return, but the options trader’s investment has doubled.

There is a catch, of course – the risk to the options trader is far higher. If WYNN drops below $120 and stays there until January, a shareholder could lose as little as 5.2%. The options owner – who owns a right to buy the shares at $120 – is wiped out at $119.99, losing all $12,810 in risk capital on even a modest decline in the underlying stock.

It is a fool’s errand to try and explain options strategy in a single article; there are books and newsletters, seminars and websites devoted solely to ideas and trading strategies using options to speculate. Indeed, any investor attempting options strategies should spend substantial time learning the options market, and potential strategies, before making options trades. But the two examples above show some of the appeal – and risk – involved in options, particularly in the usually volatile gambling sector. It’s worth repeating that speculating on “out of the money” options is a high-risk endeavor; but it’s also worth pointing out that, through other strategies, options can be used to limit investment risk. I’ll discuss some of those strategies next week.

But for investors, allocating a small – and I mean small – portion of the portfolio to occasional speculative bets is an interesting, fun, and occasionally highly profitable way to expand a portfolio’s reach. As the saying goes in gambling, one should never wager money one cannot afford to lose. The same goes with options speculation. But occasionally, the roulette ball lands on 22, the craps shooter stays hot, and MGM reaches 17 before the April 16 call expires. There’s nothing wrong with putting a manageable amount of money out for a little excitement.

Business News

The US stock market has moved steadily higher in 2012, defying critics who question why the market has doubled in three years. European debt worries, soaring gas prices, weak consumer confidence, and the prospect of a divisive US presidential election between two relatively unappealing candidates have done nothing to slow down the bull market.

Gambling stocks have benefited from the improved market; the BJK exchange traded fund, which comprises a number of gambling stocks from around the world, is up nearly 20% year-to-date and up some 35% from its lows in early October.

The recent strength in gambling stocks, however, makes them a prime candidate for short sales by investors who believe the market rally will end in the near future. Selling a stock short entails borrowing shares of that stock, selling them into the open market, and then predicting that the stock price will fall, allowing an investor to repurchase them at a lower price, keeping the difference as a profit. The purpose of the trade is to select stocks that are predicted to fall in value, and to take advantage of the decline in price. A short sale is simply a bet against a stock.

As an example: an investor sells short (or “shorts”) 100 shares of ABC stock at $10 per share. He borrows the 100 shares, selling them for a credit of $1,000. If ABC drops to $9, the investor can then purchase 100 shares for $900, return those shares to the original holder, and earn $100 on the trade.

Short selling is a risky maneuver for a number of reasons. First, the loss on a short sale is theoretically infinite. Buying 100 shares of ABC at $10 per share means an investor can lose $1,000. Shorting 100 shares of ABC at $10 shares can result in a loss greater than the initial investment. If ABC goes to $30, the investor must then repurchase the shares for $3,000, creating a $2,000 loss on what appeared to be an initial investment of just $1,000. Secondly, shorting stocks requires payment of interest to the lender (as with any loan); in this low-interest rate environment, these costs are obviously lower, but can still provide a headwind against potential profits. The amount of interest depends on a number of factors: the investor’s account size, short position, and the security shorted. Securities in high demand from short sellers can have a “hard to borrow” fee, reflecting brokers’ difficulty in finding actual shares of the stock to borrow. (An excellent recent example was Groupon (GRPN), which many investors tried to sell short. That stock trades at just $18, below its $20 initial offering price, but many short sellers have likely seen little gain off their trades, owing to those “hard to borrow fees” and interest on the loan.) Thirdly, selling short entails betting against a market that, generally (though clearly not always), moves upward.

But the most important issue with short sales is timing. The renowned economist John Maynard Keynes famously said, “Markets can remain irrational a lot longer than you and I can remain solvent.” It is not enough to be right that a stock will decline; it is also important to be (relatively) right as to when a stock will decline. An acquaintance of mine correctly predicted the collapse of the housing bubble in the US, and shorted one million dollars’ worth of housing-related stocks. Unfortunately, he did so in late 2005, and finally capitulated on the trade in 2006, down some $700,000. Housing stocks would collapse soon after, with a number of his selections going bankrupt (the Holy Grail of short selling); the trade was right, but the timing was wrong.

The timing issue is especially relevant in the gambling sector, where, as I’ve noted previously, stock valuations are so correlated with broader economic sentiment. As I wrote two weeks ago, investors can tease out broader economic effects by using pairs trades – offsetting the short position with an equal long position in a similar stock – but this, like every investing strategy, has tradeoffs. Most notably, returns are likely capped, as the correlation between two stocks – say, as in one of my examples, Wynn Gaming (WYNN) and Las Vegas Sands (LVS) – limits the likelihood of big gains. Because paired stocks are predicted to move in the same direction, pairs trades are generally designed for lower returns.

Of course, those trades also provide lower risk. Again, short selling is a high-risk strategy. But it does have some benefits. A correctly timed short sale – particularly in a volatile sector such as gambling, where stocks can fall 10 or 20 percent in a matter of days – can offer substantial profits. On a portfolio-wide basis, a short position also offers benefits, by limiting the effect of the overall market on an investor’s returns. If an investor is 20% short, and 80% long, a large decline in the broad market will have less effect on his portfolio then if he were 100% long. (Indeed, the ability to go long and short is what puts the “hedge” in the term “hedge fund”; theoretically, good hedge fund managers should profit whether the overall market is up or down. Unfortunately, the SEC requires that direct investors in a hedge fund have a net worth of at least one million dollars. So, if you’re not a millionaire, you’re stuck investing your own hard-won capital based on the advice of a stand-up comedian.) And, to be honest, selling short can be fun. It’s a contrarian bet that keeps investors sharp and can honestly provide a bit of a thrill. It’s much like betting the “Don’t Come” line in craps: sometimes, it’s enjoyable to be the turd in the punch bowl. Toward that end, here are two interesting short plays in the gambling sector:

1. Isle of Capri (ISLE).

Given the seemingly unrealistic optimism about the US economy, I would recommend a short in any of the US-facing casino operators, but ISLE looks to have the weakest fundamentals and the best short-term case for a short sale. I covered ISLE briefly in my piece covering pairs trades, recommending pairing a short position in the stock with a long position in a company with exposure to the fast-growing Macau market, such as WYNN or LVS. But, at this point, ISLE’s profile seems to offer enough potential reward to make a pure short sale worth the risk.

As I noted in that piece, over the last twelve months, over 35% of Isle of Capri’s net revenue has gone to pay off gaming taxes and interest on its massive debt. That debt – over $27 per share after subtracting the company’s cash – is suffocating for a company that closed Friday at $6.27 per share. All of ISLE’s relatively impressive cash generation must pay off interest on that debt. Indeed, in fiscal year 2011 (ending in April), the company generated $65 million in free cash (defined as cash from operating activities minus capital expenditures: money spent on property purchases, upgrades and maintenance). That figure is substantial for a company whose market value is just $244 million. And yet, the company accrued $90 million in net interest expense for the year, leaving Isle of Capri still some $25 million in the hole.

Buying a stock entitles a stockholder the right to a portion of a company’s profits. As such, equity holders in ISLE must wonder: how long will it take for those profits to trickle down? Nearly all of the cash flow over the last three years has gone to interest payments to the company’s bondholders. Meanwhile, net debt is down only slightly since 2007, meaning that debt service will continue to gobble up the company’s free cash flow for the near future.

Nor does there seem to be any route to growth for ISLE. Revenue is down on a company-wide basis from pre-crisis levels, and down sharply at several locations over the last five years. Isle of Capri’s properties are in highly competitive regions, such as Kansas City, St. Louis, and the struggling Mississippi market, while its brand does not have the value of many of its competitors – Isle of Capri is often the third or fourth strongest casino in the region.

And yet, ISLE is up 34.3% in 2012, and up 50% from its lows in early December. Why? Why would a company that has earned just eight cents per share over the past year, that cannot return cash to shareholders, and that has so little potential for growth see such a sharp move upward? The answer is simple: ISLE has been swept up in the bullish tide for the broad market, and gambling stocks in particular. But the stock’s bull run seems unlikely to last. ISLE’s stock price has stalled over the past few weeks, showing the lack of confidence by potential buyers. With full-year earnings not due until June, and little else to move the stock, it seems a good bet to decline, particularly if the broad market run-up finally slows down. Risky stocks are the first to fall when fear returns to the market, and ISLE’s debt load and lack of growth are scary indeed.

2. 888 Holdings (888.L) and Bwin.party Digital Entertainment (BPTY.L)

On the other side of the business – and the ocean – from ISLE are 888 Holdings and Bwin.party Digital Entertainment, two online gambling providers. Both stocks have performed well since the December 23^rd Department of Justice opinion that appeared to have paved the way for legalized online poker in the United States:

888 in blue, BPTY in red; chart courtesy Yahoo! Finance

The key word in the preceding sentence, however, is “appeared.” 888, through a partnership with Caesars Entertainment (CZR), and Bwin.party, through its tie-up with MGM Resorts (MGM) and Boyd Gaming (BYD), were both poised to enter the US market. Investors cheered the early news, with strong 2011 earnings from 888 adding further fuel to its stock price in late January. But it “appears” that online poker in the US is farther off than the early optimistic predictions after the DOJ opinion. Potential legalization measures in both Iowa and New Jersey look unlikely to pass, leaving Nevada as the sole state with any real possibility of regulated, legalized online poker. Hopes for online poker advocates now rest on California and the federal government, neither of which should relied on for any investment, in any industry. Even Bwin.party co-CEO Jim Ryan believes 2012 legalization is unrealistic, backing the projection made by our own Calvin Ayre.

In the meantime, both 888 and BPTY have stalled out, leaving investors to wonder how much support will arise if their stock prices begin to tumble. Both stocks – owing in large part to the regulatory uncertainty they face not just in the US, but in Europe – are highly volatile, and perhaps more fit for trading than for long-term investing. In this case, the trade is simple – a short sale in either stock is a bet that bad news, or even no news, will arise before good news. Given the lack of opportunities in the US in the near-term, it seems unlikely that either stock will have a positive catalyst going forward. If the market realizes that its initial euphoria was unfounded; if continuing economic worries on the Continent hurt the already mature gambling market there; or if a weaker broad market leads to a flight from high-risk stocks, 888 and BPTY will be hit, and, if history repeats, hit hard.

Shorting 888 and BPTY are high-risk trades, even by the standards of a typical short portfolio. Legalization efforts in a new state, progress in Nevada, or even the rumor of a deal between Senate Majority Leader Harry Reid and Republican Jon Kyl can spike these stocks. But, barring unforeseen developments, investors in the online gambling platforms are, in the short term, betting on politics. Even worse, they are betting on politicians in Washington and Sacramento, two capitals of dysfunction, to get their shit together, to put it bluntly. In an election year, it would seem wise to take the other side of that bet.

Business News

But, despite its size and growth, Macau is not the only jurisdiction in Asia with legalized, land-based gambling; nor is it the only market catering to the notoriously avid – and often high-rolling – Chinese customer. Given that much of Macau’s growth may be already “priced in,” other smaller Asian markets may be the next location for an investing “gold rush.”

Korea is often cited as a possible future gaming hotbed; as our own Eric Bianchi noted last year, “there is no reason why” Korea cannot reach “the heady heights that Macau and Singapore have achieved.” Korea offers a modern economy, a stable, democratic government, and an excellent transportation system. According to Paradise Co Ltd.’s (034230:KS) 2010 annual report, tourist visits to Korea by Chinese citizens are expected to double by 2012, due to aggressive marketing and simplification of the visa process by the South Korean government. Chinese VIPs now drive revenue in the country, replacing the traditional Japanese customers sought by Korean operators. Seoul itself – again according to Paradise – is literally perfectly positioned for the Asian gambling boom: 61 major cities are located within a two-hour flight.

Two interesting plays on the Korean market are Paradise and Grand Korea Leisure (114090:KS). According to Inside Asian Gaming, the two companies account for 95% of the “foreigners-only” market. (Currently, only one casino, the majority state-owned Kangwon Land casino, is authorized to accept Korean customers; that may change, however, as Bianchi noted last year.) Both companies are similarly valued, with forward P/E ratios based on 2012 earnings in the range of 10 to 12, depending on how accurate the analysts are. Those analysts, however, are remarkably bullish on the stock; 24 out of 24 covering GKL, and 18 of 18 following Paradise, rate each stock a “Buy” or “Strong Buy,” according to Reuters.

Paradise is likely the more speculative – and more potentially lucrative – play of the two. In 2012, according to Samsung Securities, the company plans to expand into other Korean areas – including the island of Jeju, known as Korea’s “mini-Macau.” (Interested investors can review selected Paradise analyst coverage at their investor relations website.) In addition, by 2016, the company expects to have completed a massive new casino at the Incheon International Airport outside of Seoul, which will be the largest foreigners-only casino in the country, according to the Korea Times. GKL, on the other hand, is likely the more stable play, owing to its less aggressive expansion plans and its majority ownership by the South Korean government. That stake provides access to government officials, and sympathy for the company’s projects; but, of course, adds bureaucracy and public relations considerations to an already overly politicized industry.

The continuing expansion of the Chinese gambling market, and the potential addition of new Korean customers when (or before) Kangwon Land’s exclusive license in expires in 2015, provide substantial growth opportunities for the country’s two leading operators. But, as in any emerging market, there are risks. For one, Korean opinion is not nearly as favorable toward gambling as it is in many of its Asian neighbors. “Corruption, bankruptcy, and broken homes have been typical of the images of gambling in the minds of Koreans,” wrote the Korea Herald last year, in the preface to what was a favorable interview of new Kangwon Land CEO Choi Heung-jip. Choi didn’t disagree, noting that “all our staff are unjustly branded as the seeds of black money and corruption.” (Kangwon Land is also publicly traded, under stock symbol 035250 on the Korean Stock Exchange. But its majority government ownership, requirements to divert profits to local authorities and agencies, and the pending dislocation caused by the expiration of its exclusive domestic license make the stock too risky, even by emerging-market standards.)

There is also substantial political risk involved in the Korean market, notably for Paradise’s Incheon project. As Inside Asian Gaming noted last summer in a skeptical piece on the potential for Korean gambling, Seoul may be, by air, an hour from Beijing and Shanghai, and one and a half hours from Tokyo. It is also fewer than 40 miles from the Demilitarized Zone (DMV) that separates North and South Korea. “If the Hermit Kingdom [North Korea] decided to lob some ballistic missiles over the border, it would put a crimp in anybody’s casino holiday,” the magazine noted dryly. Should North Korea instead implode, South Korea’s economy would still take a hit. “Think ‘Fall of the Berlin Wall’ times one hundred, and with halfstarved refugees,” IAG suggested. The magazine was also critical of the gambling industry on Jeju, where Paradise intends to purchase at least one operation. “The economy on Jeju is dying,” an industry source was quoted as saying. With direct flights from Taiwan to Mainland China – flights that previously went through Jeju or Macau – and Japanese interest in the island waning, the magazine argued that “mini-Macau” was simply “not very successful.”

Still, Korea represents the next big potential gambling market in Asia, whose continent-wide appetite for games of chance continues to show astounding growth and defy its skeptics. Yes, North Korea’s regime remains an issue for the South Korean economy; that has been true for the past two decades. Yet since 1998, South Korea’s stock market has quintupled in price. Jeju’s struggles likely stem from the fact that “mini-Macau” is actually nothing like Macau; astonishingly, as IAG noted, the total inventory of the island’s eight casinos amounts to just 197 slot machines and 178 tables. With both Paradise and GKL in line for growth, whether from foreign or domestic customers (and hopefully both), the current valuations have room to expand. With so many investors focused on Macau, the Korean companies could provide an opportunity to buy into “the next big market” before the market spotlight shines on it.

*          *          *

An even smaller, riskier market can be found further south, in Cambodia. (Yes, Cambodia. I told you it was risky.) The stock to play in the country is NagaCorp (3918.HK). NagaCorp stock had a rough day on Friday, falling 4%, slowing a bull run that had seen the stock rise 35% in just two weeks. The catalyst was strong 2011 earnings [pdf], which beat analyst estimates. CLSA Asia-Pacific called 2011 “a stellar performance” and predicted “a strong year” in 2012. Citigroup Global Markets reiterated its own “Buy” rating, and was likewise bullish on 2012. Before the earnings beat, Daiwa Capital Markets called the stock the “cheapest casino stock in the region.” (As with Paradise, analyst reports on the stock can be downloaded at the company’s investor relations website.)

NagaCorp operates NagaWorld casino in Phnom Penh. As Daiwa noted, the company has a monopoly license in the country’s capital, which forbids any competing casinos within 200 km (124 miles) until 2035. The company also has perhaps the best tax structure of any casino operator in the world, with a monthly tax payment of $320,000 USD per month, rising 12.5% annually. For 2010, the company’s effective tax rate was just 8%, well below not only average worldwide casino rates but below the 20% rate for other Cambodian corporations.

And, indeed, analysts are correct in calling 2011 a banner year. Revenue increased 49%, while net profit more than doubled. With a final dividend of HK 12.09 cents per share, the total payout to shareholders for the year was HK 24.1 cents per share, a dividend yield of 6.28%. The payout ratio stayed reasonable at 70%, as the company retained earnings likely needed for a US$369 million  expansion, expected to be finished in 2016.

And that’s the good news. The problem, in the short term, is that the recent run-up in the stock price may have removed much of its value. Three of the four most recent analyst reports posted on the NagaCorp website all offered “Buy” ratings on the stock (one report left the stock unrated). But the reports, written between mid-January and late February, offered target prices of $3.44 (CSLA), $3.25 (Citi), and $3.60 (Union Gaming Macau), respectively. Friday’s close of $3.84 is well past all three targets – and both Citi’s and CSLA’s target prices were calculated after the well-received earnings release. Analysts are notorious for re-calculating target prices upward as a stock rises, but investors should hold them to their original bull case. NagaCorp’s new valuation may mean the stock has moved too far, too fast.

The more obvious problem is that investors in NagaCorp are facing the political and financial difficulties associated with operating in Cambodia. While the country has moved past its horrific civil war of the 1970′s, its commitment to democracy is still uneven; its current ruling party the Cambodian People’s Party came to power in a bloody 1997 coup. Will the company’s 24-year monopoly persist through another change of power? Surely, NagaCorp’s 8% effective tax rate – that agreement is due to expire in 2018 – will require renegotiation with a new regime. The horror stories of Vietnamese gamblers facing kidnapping and severed digits as a result of losses while gambling in Cambodia are further proof of the still-uneven regulatory and legal climate in that country.

There’s also the issue of competition. Outside of Phnom Penh, Cambodia offers a number of casinos, many taking advantage of Thailand’s ban on gambling. (NagaCorp has expressed interest in building in Thailand should that market open up.) According to Daiwa Capital Markets, some 40% of NagaCorp’s revenues come from Vietnam, a market coveted by Las Vegas Sands’ (LVS) Sheldon Adelson, who is proposing two massive installations in Hanoi and Ho Chi Minh City. Movement in either market could hurt NagaCorp’s growth, and its stock price.

In short, NagaCorp is a classic emerging market stock. High-risk, but high-reward, it promises explosive growth and the potential for substantial investor profits. Indeed, the stock has risen some 265% over the last twelve months. But that is also the problem; given that sharp rise, many of the risks associated with the stock may no longer be properly priced. At current levels, the stock looks fairly valued at best; but its high volatility makes it worth keeping an eye on. Should the stock pull back, it would be an interesting – and no doubt exciting – play on the Asian gambling market.

Business News

The 2012 iGaming North America conference closed on Tuesday. After a rather optimistic session on Monday, with speakers estimating the potential US online gambling market between $12 and $20 billion annually, Tuesday’s sessions focused on the operational and legal aspects of iGaming in the States. Not suprisingly, the focus on details brought a more somber, and skeptical, tone to the proceedings.

Of particular note was the afternoon session discussing the important – and underlooked – issue of payment processing for online gambling operators. As panelist Joel Leonoff, President and CEO of Optimal Payments, operator of eWallet provider Neteller, noted, payment processing has been “far down the list of priorities” in the rush to claim space in the potential online poker and lottery markets. Leonoff questioned whether overseas software companies such as 888, Bwin.party, and Ongame Network – whose acquisition by Shuffle Master was announced during yesterday’s session – had the proper relationships and knowledge to properly outsource such processing in the U.S.

Fellow panelist Robert Holmes, President and CEO of RaceUwin.com, an online wagering site for American horse racing, recounted his own “nightmare” in dealing with the country’s two major credit card companies, MasterCard and Visa. RaceUwin.com had originally been able to accept transactions from Visa cardholders, while MasterCard – for over a year – declined transactions to the completely legal, regulated, and licensed site. Finally, MasterCard relented; and as Holmes described, “we turned on one switch, and the lights went out on the other side.” Overnight, Visa began declining “100%” of payments, an issue that continues some 45 days later, according to Holmes. Six years after the passage of the Unlawful Internet Gambling Enforcement Act of 2006 (UIGEA), “you would think the industry would have all this sorted out,” commmented moderator Tony Fontaine of ProPick Racing.

It was clear from the panel that the industry is not even close to having it sorted out. Leonoff replied that the processing system, even for legal online wagering, is “vey broken; it doesn’t work.” Legislative bodies and regulatory agencies have “left it up to the banking system to be the judge and jury and what’s legal,” he added. Indeed, the travails of RaceUwin.com prove Leonoff’s point.

What would happen in the processing system should intrastate online poker and gambling – such as the system proposed in Nevada – come online? Wells Fargo Senior Company Counsel Ted Kitada noted that, eventually, “business considerations will probably override” the legal concerns. In other words, when the banks were able to get their piece of online gambling – and, if that piece was large enough to justify risk-taking in a slow-moving, highly bureaucratic industry – they would move. In the meantime, operators must face a dangerous level of uncertainty. John English, another panelist who is the Senior Vice President of American Wagering, noted that credit card rejection, or any other form of financial blockade, was “a doomsday scenario” for his company’s smartphone wagering business in Nevada. Holmes wondered later that if the current system offered such challenges to operators, how would the industry manage the multi-state compacts often assumed to emerge in the wake of state-by-state legalization? This session made clear that the rosy projections of the future for American online gambling don’t yet factor in the challenges and difficulties faced by current operators.

***

In Monday’s session, a few panelists questioned whether the Department of Justice opinion reinterpreting the 1961 Wire Act’s effect on online gambling had quite the dramatic effect many industry observers had assumed. Tuesday’s session, “The DOJ Has Spoken – Who Wins and Who Loses?” attempted to answer that question. Three panelists – and later, law professor and CalvinAyre.com contributor I. Nelson Rose – were asked to comment on the statement, “The DOJ opinion accelerates the process for legalized, regulated iGaming in the United States.” Lobbyist Joe Brennan argued against the proposition, noting that the new opinion simply “created a different kind of ambiguity” versus the gray area in the law prior to the December announcement. “No one will invest in tooling up in this industry without additional clarity,” he added. Shuffle Master general counsel Katie Lever argued otherwise, playfully noting her own company’s acquisition of Ongame the day before as evidence of the industry movement following the DOJ opinion. Brennan rebutted her argument by noting that none of the well-known transactions – including IGT’s purchase of Double Down Interactive – had yet received regulatory approval. Nor could Shuffle Master deploy the Ongame technology in the United States without additional legal and regulatory action. There “is an almost irrational exuberance for online gaming in the United States,” Brennan concluded, using a phrase that conjures up memories of the original Internet bubble in the 1990′s. (In a sign of the audience’s awareness of the long road ahead for the industry, Brennan was overwhelmingly voted the winner of the debate, for which he received a round of applause and hopefully a free drink or two at one of the conference’s afterparties.

Rose was called up from the audience toward the session’s end; the respected professor was more positive about the DOJ’s effect. The Wire Act had been used to threaten Nevada and the US Virgin Islands against previously instituting intrastate online gambling, he noted. Under the new interpretation, that would no longer be the case, freeing legalization efforts in not only Nevada, but potentially in states such Iowa, Connecticut and New Jersey. The tone of the debate was respectful, and the panelists intelligent; but the divergence of opinions and the focus on utterly technical aspects of gambling law showed the continuing lack of clarity in the industry (with the added bonus of making many audience members thankful they had skipped law school.)

The lessons from the conference could be summed up by the title of the day’s final session: “Legalized Online Sports Betting – In Our Lifetime?” There are myriad possibilities and markets for US online gambling: poker, online lottery sales, games of chance, sports betting. The technical knowhow, the marketing ability, and the desire from business to invest capital in the industry all presently exist. The question remains: when will they be unleashed? And just whose lifetime are we using as a measuring stick?

Overall, however, the conference should be considered a major success. The panels were interesting, intelligent, and well-versed in the field. According to the organizers’ media guide, attendance rose nearly 50% year-over-year, reflecting the increased interest in the sector. While there are many thorny problems to be resolved, the potential for the market is clearly vast. In the meantime, the flurry of legal, regulatory, political, and economic issues surrounding iGaming will make the industry’s growth frustrating, lucrative, and most definitely, fascinating.

Conference News

The main program of the 2012 iGaming North America conference kicked off Monday at Las Vegas’ Planet Hollywood. The conference is, according to its organizers, “designed to introduce the land-based gaming businesses of North America to the global iGaming industry.” Sessions Monday focused on the legal, political, and economic aspects of online gambling, primarily in the U.S., a market many in the gambling industry believe will create billions of dollars in revenue. (Estimates from Monday’s speakers ranged from $12 billion to $20 billion annually.)

Exhibitors were scarce at the conference; however, this is likely due to the fact that much of the discussion centered on the future of American iGaming business. With that market still held up by the lack of legal and political clarity at all levels of US government, the lack of exhibitors angling for near-term business made sense. One notable exception was Ongame Network, whose acquisition by Shuffle Master was ironically announced just an hour before a session on “M&A” (mergers and acquisitions) convened at the conference.

Still, speakers at Monday’s session ranged from US legal experts to European investment bankers to experts in the online gambling field, discussing nearly every aspect of the iGaming industry. Among the highlights:

• Michael Jabara of Valtus Capital opened the “M&A” session by predicting a “convergence” in the gambling industry as a whole. Jabara noted that the worldwide gambling business had “no global brand leader.” “There is no Coca-Cola, no Mercedes-Benz, no Jaguar,” he pointed out. Jabara predicted consolidation in the gambling business, arguing that continuing expansion by the industry’s major players into new territories and new platforms would likely mean that, by 2020, there would indeed be globally known, highly respected, gambling brands. Who would they be? Jabara didn’t say, though he did list Wynn Gaming, Las Vegas Sands, and Genting as the three current leaders in the industry.

• In a later session, Deutsche Bank’s Andrew Zarnett and iGaming Capital’s Melissa Blau followed up on Jabara’s commentary by noting the “confusion” in the gambling industry as its largest land-based players move into the online sector. Last year,  Caesars acquired online game developer Playtika, noted Blau, while earlier this year slot maker International Game Technology purchased Facebook operator Double Down Interactive. Caesars – traditionally a casino operator – was now moving into game development, while IGT – one of the world’s largest game developers – was now moving into operations. Blau suggested this paradigm shift could represent the new way forward, although some attendees questioned the purchase price IGT laid out for DoubleDown. Overall, Blau – an experienced veteran of online gambling in Europe – was notably more subdued about the US market than some of her fellow presenters.

• Christian Tirabassi of Italy’s Ficom Leisure was more detailed in his criticism of social media, based on his experience in the long-running European market. The Facebook user “does not convert,” Tirabassi said flatly. The Facebook user knows the game is just for fun, he argued, and that user knows there are alternatives. “I don’t believe in the easy transition from social games to real [money] games,” he concluded. Tirabassi’s attitude is likely of interest to investors in Zynga, whose CEO said at another conference on the same day that Zynga and online gambling were “a good natural fit.”

• Among the concerns of all speakers was the potential nature of the US regulatory regime. On “The Federal Legislation Panel,” Penny Coleman, former general counsel of the National Indian Gaming Commission (NIGC), was far less ebullient about December’s Department of Justice opinion reframing the 1961 Wire Act than many industry observers. That opinion, written by the Office of Legal Counsel (OLC), “is an attorney’s opinion,” Coleman noted. “And we all know what attorneys’ opinions are worth,” she added humorously. Coleman commented on her time with the federal government that “we ignored more OLC opinions than we followed” and that the new interpretation of the Wire Act was “true, until it’s not.” (iGaming Capital’s Blau agreed, saying of the DOJ opinion that “she didn’t see it as the great windfall” many others had.) Later, asked when and if she believed federal regulation of online gambling would be forthcoming, Coleman said she believed it was highly unlikely any legislation would be passed before the November US presidential election. When asked the same question, fellow panelist Linda Shorey of K&L Gates noted with a laugh that she was pretty sure legalization would occur “by 2010.” Asked to update her timeline, Shorey added that “her crystal ball was murky.”

Given the still-unclear legal and regulatory issues facing US iGaming, there was a wide range of opinions on the viability and size of – and the future winners in – American online gambling. A few speakers were notably skeptical of the multi-billion dollar revenue estimates for the market, given the fact that, as of right now, a slow, state-by-state rollout seems far more likely than a sweeping legalization at the federal level. Still, the conference featured interesting and intelligent speakers commenting on all aspects of Internet gambling across the globe. Tuesday’s session looks set to provide  more insights into a messy, interesting – and potentially lucrative – industry.

Conference News

To avoid the impact of extraneous factors, investors in gambling stocks can hone in on their stock-picking abilities by initiating a “pairs trade.” A pairs trade simply entails a “long” position in one stock, with a corresponding – and equal – “short” position in another. These trades are commonly used in arbitrage, where investors attempt to capture short-term inefficiencies between similar securities (for instance, shares of the same company that are traded on different exchanges.) However, pairs trades can also be used to play two stocks in the same sector.

Since the trades essentially cancel each other out – we are long and short an equal amount – pairs trades are  “market-neutral,” meaning the effects of the broad market are immaterial to the strategy’s success. A pairs trade is simply a bet that one stock – our long position – will outperform another, similar, stock – our short position.

As an simple example outside the gambling sector, let’s take Coca-Cola (KO) and PepsiCo (PEP). Both companies, being global distributors of beverages, sell similar products to similar markets, and face nearly identical challenges. The stocks are equally dependent on strength in the global economy, and equally sensitive to rises in input costs such as sugar and corn. If we buy $10,000 worth of KO, and short $10,000 worth of PEP, such broad market effects will be cancelled. If the price of sugar spikes, dampening enthusiasm for each stock and lowering their price by 5%, our trade remains unchanged. Our position in KO drops $500; our short position in PEP gains $500, and we are equal. If good economic data starts a worldwide bull market run, boosting each stock by 10%, we again are unaffected. KO rises $1000; our short sale of PEP loses $1000, and our net account stays flat.

The only events that can move this trade are company-specific changes. If KO outperforms PEP, we make money. If it falls behind PEP, we lose. If both companies report earnings, with KO beating expectations and PEP disappointing, KO stock might rise 5%, while PEP drops 4%. In our example, our KO position rises $500, our PEP short sale gains $400, and we, in total, make a $900 profit. Pairs trades allow investors to tease out broad market effects, and focus on a simple thesis: that stock A will outperform stock B.

With a pairs trade, however, the economic effects are removed. If we go long WYNN, for example, and short MGM, the stock market could rise 60% as Obama is re-elected, Iran gives up its nukes, and unemployment drops. Or the market could collapse by 80% as the euro implodes, China falters, and President Romney lays off three-quarters of federal employees. None of that matters, if we are right in our thesis that WYNN is a better stock than MGM.

As such, the pairs trade is especially useful for investors who have inside information on an industry. (Note to the SEC: I said “inside,” not “insider.”) If an investor can correctly identify a trend in the gambling sector, and its effect on the industry’s players, he can use a pairs trade to profit from that knowledge.

A second benefit of the pairs trade is that it provides a hedge against losses. As I noted previously, gambling stocks are notably more volatile than stocks in other sectors. But the neutral nature of the pairs strategy lessens its volatility. If we are short MGM, the stock could easily rise 50%, costing us a substantial amount of money. But if MGM rises, it is highly likely that WYNN – our long position – will rise as well, given the correlation between the two companies and their stocks, mitigating our losses on the short sale of MGM. Granted, the strategy also lowers the upside to the long position, but such upside requires not only a correct play on the gambling sector but on the broader economy as well.

So where do we start in looking for pairs trades in the gambling sector? Let’s start with Macau, since the gambling industry in 2012 will revolve around that island more than anywhere else. This is not news, of course – Macau’s revenue is now five times that of Las Vegas, and it continues to grow, with February showing a 22.3% increase year-over-year. But the market does not seem to understand that, at least not on a valuation basis. Stocks like Las Vegas Sands (LVS) and Wynn Gaming (WYNN), both of which have operations on the island, are trading at roughly similar earnings multiples to US-only operators such as Penn National (PENN) and Isle of Capri (ISLE). Yet Penn and Isle of Capri have no hope of approaching anywhere near the growth in the States that Sands and Wynn will enjoy in Asia.

The trade here is simple: long Macau, short US. Investors can choose their favorite stocks from Macau and the weakest in the US. One way I would recommend is to go long WYNN – on which I remain bullish – and short ISLE. ISLE is up 36% year-to-date, including a nice bounce last week after posting strong third quarter earnings. And yet, at Friday’s close of $6.37, ISLE still has nearly $30 per share in net debt (total debt less cash on hand). Over the past twelve months, taxes and debt interest alone equalled some 35% of its net revenues – money out the door before a single cent is spent on marketing, maintenance, and labor. Isle of Capri has earned just 15 cents per share over the last twelve months – giving it a P/E over 40, compared to WYNN’s still-pricey 26 – and total revenue grew just 1% year-over-year for the first nine months of fiscal 2012 (ending in June). True, Wynn has its own problems right now; but its exposure to the growing Macau market and the strength of its Vegas properties give it growth potential that far outstrips that of Isle of Capri. On every measure – valuation, growth, geography, and execution – WYNN looks far superior to ISLE. If it performs that way going forward, a pairs trade between the stocks would provide a nice return.

There is another interesting – but riskier – way to play Macau against the US: through pairing US stocks with their publicly traded Macau subsidiaries. This can be done by shorting WYNN and buying its Wynn Macau subsidiary (1128.HK), or doing the same with LVS and Sands China (1928.HK), and  MGM and MGM China (2282.HK). These trades do add currency risk to the equation, as the Hong Kong-listed shares are denominated in HKD; all else being equal, a strengthening US dollar will negatively impact our trade.

Still, the trade is hedged by the fact that much of the value in the US-listed companies comes from their ownership stakes in their Asian operations. MGM’s stake in MGM China, for instance, is equal to roughly half of its total market cap of about $6.7 billion USD. As such, a 10% rise in the Hong Kong subsidiary would, irrespective of any other factors, result in a 5% rise in the US-listed MGM stock. In our pairs trade, we would make a 2.5% gain simply on the upward movement in the Chinese subsidiary.

Why not simply buy MGM China stock? Again, the two benefits of the pairs trade come into play. First, we are hedged; if MGM China falls 10%, we lose just 2.5%, as the corresponding 5% drop in MGM creates a gain in our short position. Secondly, we are, again, betting that the Macau operations will outperform the US operations. It’s entirely possible that Macau will stay strong, while US economic worries drag down MGM’s Las Vegas properties, creating a larger gain for our overall trade. Should global economic worries cause a slowdown – or market anticipation of a slowdown – in Macau, those same worries will hurt MGM. Given that the US-listed company has nearly $14 billion in net debt, while the Chinese company actually has positive net cash, we are betting on a high-growth company with a strong balance sheet, and betting against a low-growth company with debt that is more than double its market value. These three trades – long Macau operations, short US business – are pure plays on the strength of the growing Asian market, versus the still-tentative recovery here in the States.

The “long Macau, short US” trade appears to be one of the most interesting, and most potentially profitable, strategies in the gambling sector. But it’s far from the only one. Investors with a feel for the gambling industry can use pairs trades to match stocks all over the sector. In Macau itself, pairing Wynn with a short position in Las Vegas Sands (or the same trade through the Hong Kong-listed subsidiaries) is an interesting contrarian play. Yes, Steve Wynn’s feud with Kazuo Okada is making the news, and Wynn stock has struggled over the last few months. Meanwhile, Las Vegas Sands is at a three-year high, closing Friday at $56.38, up 32% since the first of the year. But Wynn has traditionally outperformed Sands, and LVS got the dreaded “kiss of death” from CNBC’s Jim Cramer last week. Cramer called LVS “my favorite casino company,” an unsurprising choice given his usual stock selection process. While I enjoy Cramer’s opinions and antics, and in the interest of shameless self-promotion full disclosure have opened for him on his college tour, the TV personality has two weak spots in his choice of stocks. First, he is a classic momentum player – with LVS rising almost without interruption in 2012, it is a natural play for him. Secondly, Cramer’s remarkable breadth of knowledge of the stock market requires a sacrifice of depth. Yes, Sands is already strong in Macau, with its Cotai Central project coming online this spring – but the market already knows that. The market also knows that Wynn’s own follow-up project is not yet licensed – despite an erroneous SEC filing to the contrary. That is why LVS has been far stronger than WYNN over the last six months – and why contrarian investors might bet against that trend continuing.

These are just a few examples of possible pairs trades in the business; investors who truly understand the global gambling industry have a wealth of possibilities. If you believe, as I do, that the effect of online poker legalization in the US has been overblown, you can pair a long position in Betsson AB (BETSB.SS) with a short position in Bwin.party Digital Entertainment (BPTY.L). This is a bet on the more mature, more stable Betsson, with its emphasis on economically solid Scandinavia and a 5% dividend yield, over the over-hyped, possibly over-valued Bwin.party, whose stock has soared based on potential US profits that seem unlikely to materialize any time soon. Regional US players such as Penn National and Ameristar Casinos (ASCA) can be paired off based on investors’ beliefs in valuation, competition, and cannibalization in the increasingly crowded US market outside of the legacy meccas in Las Vegas and Atlantic City. US slot machine leader International Game Technology (IGT) has competitors such as Bally Technologies (BYI) and small-cap upstart Multimedia Games (MGAM) nipping at its heels. Will IGT rebound and re-take market share, or do Bally’s new games and Multimedia Games’ tribal presence make them better choices going forward? Investors can use pairs trades to play their thesis.

The beauty of the pairs trade is in its simplicity. It is simply one stock against another, with no “noise” from the broader market, world economy, or other factors. It is simply a question of picking the better stock. For investors with a good read on the gambling industry, pairs trades offer a lower-risk way to turn that knowledge into profits.

Business News

1. MGM Reports 2011 Earnings

MGM reported full-year 2011 earnings on Wednesday morning, disappointing investors, as the stock slid 4.5% for the week. MGM lost 21 cents per share on an adjusted basis, an improvement over the previous year’s fourth quarter, but below analyst expectations of a 20 cent per share loss.

There was some good news, particularly on the top line, as the continuing rebound in Las Vegas tourism helped MGM properties, which include the Bellagio, Mandalay Bay, and CityCenter operations. REVPAR (revenue per available room) rose 13% in Las Vegas for the full year compared with 2010, as MGM filled more rooms at better rates. Casino win, entertainment revenue, and food and beverage sales all rose modestly as well.

The star for MGM was its new MGM China joint venture, which contributed $1.5 billion in revenue – nearly 20% of MGM’s full-year total – in just seven months. For the full year, EBITDA (earnings before interest, taxes, depreciation, and amortization) from the property was 27% of the company’s total. MGM owns 51% of the joint venture, with Pansy Ho – daughter of Macau magnate Stanley Ho – owning a sizable stake and the remainder floated on the Hong Kong Stock Exchange. (Its ticker symbol is HK.2282.) MGM China plans to build another location on the Cotai Strip, at an estimated cost of between $2 and $2.5 billion USD, according to its fourth quarter conference call.

Management was certainly very optimistic on that call, even if Wall Street did not seem to share their rosy outlook. CEO Jim Murren mentioned strength in the convention business, in both slot and table gaming play, and agreed that “mid to high single digit” growth in 2012 REVPAR was a “reasonable” target. “The market will have a better year” in 2012, Murren noted at the end of the Q&A session, pointing to higher visits and higher revenue per visit for the Las Vegas market as a whole.

Beyond the good news, though, there are still major issues with MGM stock. The 2011 loss was the fourth straight for the stock on an annual basis, as the company still works to recover from the effects of the 2008-09 recession. The company’s debt load continues to be a worry, closing the year at $13.6 billion, or twice the company’s market capitalization at Friday’s close of $14 per share. MGM has been cash flow positive since 2009, but has not generated nearly enough cash to cover the interest on its debt, let alone to reduce the debt balance. The company has managed to refinance much of its debt at slightly lower costs, but the company still paid over $1 billion (with a ‘b’) in interest alone in 2011.

There is a still a long road ahead for MGM to overcome its past mistakes, notably the disastrous CityCenter property, which was constructed as the Las Vegas market was collapsing. The $8.5 billion property, in which MGM owns a 50 percent stake, continues to struggle. The property lost $500 million in 2011 (half of which is attributable to MGM) after a $1.1 billion loss in 2010. So many of the development’s condominium units remain unsold that MGM has turned to leasing them out; Chief Design Officer Bobby Baldwin touted that strategy in the conference call, noting that 405 units were leased for total monthly revenues of $751,000. The fact that management is even mentioning a $9 million annual revenue stream in a nearly $9 billion project, whose interest costs alone were $190 million in 2011, show what a disappointment CityCenter has been.

Analysts are still very bullish on MGM stock; according to Reuters, 19 of 30 analysts covering the stock rate it a “Buy” or better. As CalvinAyre.com’s Jamie Hinks noted this week, Deutsche Bank analysts reiterated their own “Buy” rating on Thursday. “We continue to believe the 2012 recovery story is intact,” wrote Carlo Santarelli and Kelly Knybel.

The analysts may be correct; but a 2012 recovery will not be enough to create value for shareholders. Even given that recovery, and continued growth in Macau, few analysts believe MGM will be profitable in 2012 or 2013. The problem is that a stock like MGM is perfect for the models often used by Wall Street analysts. High leverage and solid top-line growth play well with Wall Street, which can extrapolate those numbers to argue that by 2015 or 2016 the company will return to pre-crisis earnings levels.

But MGM simply fails the common sense test. This is a company that will be unprofitable for six full years. It is a company whose interest costs are over 15% of its market capitalization. As a point of reference, 2011 interest expense alone was over $2 per share, and the current net debt load – total debt minus cash – is $24 per share. And just how stable is the company’s growth story? Given the still-tenuous global recovery, should investors jump headfirst into a tentative rebound in Las Vegas? And how will the company’s current Macau operations fare amid increased competition? The models will work – if MGM executes flawlessly. Given its recent track record, and the number of challenges facing the company, investors must be as optimistic as management to take that risk.

There is only one sensible way to play MGM – through its Hong Kong-listed subsidiary, MGM China. That stock escapes the debt load associated with the US properties: the company has $720 million in cash, with debt of just $552 million, according to MGM China CEO Grant Bowie on the conference call. The new Cotai property will no doubt change the balance sheet, but investors should choose a better-capitalized, less debt-heavy operation in Macau over a highly indebted company exposed to the still-uncertain Las Vegas market. MGM China is at a five-month high after strong year-end earnings of its own, yet still trades at just 16 times earnings and recently authorized a special dividend with a yield of 5.9%. Better balance sheet, higher growth, and income potential; MGM Grand is well worth the currency risk and (usually) higher expense associated with foreign stocks. Any way you look at it, the Hong Kong subsidiary is the better stock.

2. Wynn Buys Out Okada

The dramatic fallout between former partners – and friends Steve Wynn and Kazuo Okada reached a new crescendo as Wynn Gaming bought out Okada’s stake for $1.9 billion last weekend. Okada has filed a restraining order attempting to prevent the action but has been removed from his board seats on both Wynn Gaming and Wynn Macau.

Wynn stock actually rose 4.8% on the week, probably due to the fact that Okada’s $2.7 billion stake will likely be redeemed over 10 years for a total of just $1.9 billion. The $800 million difference is worth about $8 per share to the rest of Wynn’s shareholders, and likely accounted for much of the stock’s $5-plus move for the week.

The question going forward is whether the flap will reflect poorly on Wynn Gaming or its CEO, and whether the dueling investigations will cause any legal blowblack on the company and its stock. Right now, it appears unlikely. As Reuters noted, the cases against both Wynn and Okada brought by their rivals look unlikely to cause any real legal repercussions. Wynn’s $135 million donation to the University of Macau was hardly an “under-the-table” payout – the company announced the gift in a press release and held a public ceremony commemorating the occasion – while it’s unclear that Okada is even subject to the US anti-corruption laws he allegedly broke.

It seems likely that this episode, while entertaining to gambling insiders, is unlikely to have further material effect on Wynn stock. As the legal dust settles, a settlement between Wynn and Okada – perhaps a still-forced liquidation at a price closer to that of the market – seems the most likely outcome. Within six months, the Wynn-Okada duel will be just another line in the biographies of two of the gambling world’s more colorful characters. As I argued last month, WYNN is still one of the best plays in the gaming sector, and a solid long-term play on the growth in Macau. The feud between Wynn and Okada – though entertaining – seems unlikely to change that.

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Six-month chart of 32Red (blue), Betsson AB (orange), 888 Holdings (light blue), Bwin.Party Digital Entertainment (green). Right y-axis represents percentage increase in stock price. Chart courtesy businessweek.com

Indeed, stocks in the sector have a lot to offer investors. The major European companies are all profitable, with cash on the balance sheets, and, in some cases, solid dividend payouts (Betsson AB’s yield, for instance, is a solid 5%, above all but a fraction of US stocks in any industry). Revenue growth has been solid, while new geographic markets in Italy and Denmark (and potentially, the US) and new methods of delivery, such as tablets and smartphones, offer added revenue streams going forward.

Of course, there are a host of challenges facing the operators as well. As Mike O’Donnell noted on this site just last week, publicly traded gambling stocks have historically been volatile, unstable investments. The most notable example of the sector’s unpredictability was the passage of the Unlawful Internet Gambling Enforcement Act of 2006 (UIGEA) in the US, which knocked down the then-traded stock of PartyGaming by some 70%, while severely impacting other online gambling stocks as well.

But government regulation remains a key issue, as the murky legal scene in Europe makes future earnings nearly impossible to decipher. In October, Spain’s advocate general opined that individual governments must allow cross-border gambling licenses, in accordance with EU law. Two months later, Portugal, obviously disagreeing with its Iberian neighbor, banned Bwin.party Digital Entertainment (BPTY.L) from advertising sports competitions in the country, claiming that the company’s activities were illegal. Elsewhere on the Continent, Belgium and Serbia are targeting and/or blocking unlicensed operators.

Taxation remains a key issue as well, as cash-strapped European governments look to raise revenue in any way possible to head off the potential sovereign debt crisis there. Operators in Greece must hand over 30% in gross profits to its bankrupt government; the rate is 17% in Germany, while France’s taxation and return laws are so restrictive that the head of the country’s own BetClic Everest complained that French gaming law “does not allow us to exist.”

The European Court of Justice (CJEU) has come out against such monopolies in Germany and Italy; but both verdicts came years after the regulation was passed and enforced, leaving the supposed victims to legally enter a market in which they have either a) previously operated in the black or “grey” market (as in the case of Bwin.Party in Germany) or b) must create a presence in an established market with dominant brands.

The above examples are just a small fraction of the regulatory and tax issues facing online gambling companies (a full accounting would require several volumes); but the end result is chaos, from an investment standpoint. It’s hard enough to choose among stocks in a given sector based on marketing power, leadership, valuation, and execution. Add in the political calculus required to assess the prospects in the 27 member countries of the EU, and the potential for regulation or judicial review at the federal level, and the average investor wants to just throw his or her hands up. As my colleague O’Donnell pointed out a week ago, the upcoming French presidential election is expected to have an impact on gambling regulation in that country (as it will likely do here in the US as well). Any parliamentary election – particularly in on a continent with revenue problems and a disgruntled populace – can equally change an operator’s business model, literally overnight. Ownership in online gambling stocks now seems to require a master’s degree in European politics, with an accompanying law degree focusing on the Treaty of Lisbon and its interpretation by the modern CJEU. This type of confusion hurts investors, lowers share prices, and requires that smart investors only enter in these companies at a discount to similar stocks in more stable, more traditional, and less government-reliant industries.

Unfortunately, the confusing European market is, with a few exceptions such as Australia, the only one available to investors. The US market, for all the New Year’s hype about the online poker “gold rush”, still appears set to be a fragmented, highly regulated, highly taxed, and slow-developing industry. Federal regulation still appears dead for at least 2012, and state movements have been delayed in California and reversed in the District of Columbia. There is also the matter of competition in the US; the partnerships between 888 Holdings (888.LN) and Caesars Entertainment (CZR), and Bwin.Party, Boyd Gaming (BYD) and MGM Resorts International (MGM) are not the only potential entrants into the US market. Facebook game producer Zynga (ZNGA) has signaled its interest in online gambling in the US. Slot maker International Game Technology (IGT) bought Facebook gaming company Double Down Interactive in January. IGT competitor Bally Technologies (BYI) recently released server technology for online gambling. And last week, racetrack operator Churchill Downs (CHDN) acquired Bluff Media, producer of poker content such as Bluff magazine and BluffMagazine.com. In its statement about the purchase, Churchill Downs noted that “the Company believes this acquisition potentially provides it with new business avenues to pursue in the event that there is a liberalization of state or federal laws with respect to Internet poker in the United States.” If and when the US (and/or individual state) markets open, it seems likely to face a flood of competition, which will likely require higher customer acquisition and retention costs, and thus profits perhaps below those expected by much of the market.

While regulation and taxation should lessen the euphoria about the US online poker market, there is another key question facing potential operators here in the States: just how big is the market? Multi-billion dollar estimates have been thrown around regularly, but, over in Europe, the online poker market continues to decline. Betsson AB (BETSB.SS) saw poker revenue decline 7% in the fourth quarter [pdf], over double-digit declines in each of the three previous quarters. Bwin.Party, owner of PartyPoker, saw poker revenues fall 10% in the first half, and earnings before interest, taxes, depreciation and amortization (EBITDA) fall 40%. (The company has not yet released second half earnings.) Smaller operators such as 888 Holdings and Betfair (BET.L) have seen growth – nearly 60% year-over-year in 888′s case – but the overall market appears relatively stagnant in Europe. Here in the US, where the “poker boom” has come and gone, similarly low revenue growth may be expected. Figures on the size of the US market post-UIGEA are hard to estimate, given the unlicensed nature of the industry at the time, the fact that leaders PokerStars and Full Tilt were privately held (and thus not required to release revenue figures), and the unreliability of some of the market’s operators (we’re looking at you, Full Tilt.) But, as an avid player at the time, anecdotally I can tell you that the poker market in the US matured, and quickly. In 2005, as the boom started, participation was higher, and the players were far worse. By 2008, the games – even at lower stakes – consisted mostly of skilled players passing chips back and forth; many so-called “professional” online players were showing breakeven results at the tables, simply living off the bonuses and rakeback programs afforded to higher-stakes players. Liberalization in the US will likely lead to a quick burst in revenues, but longer-term, weak players will fade away – as they did in 2005-06 – and it seems unlikely that the poker market in 2015 will be noticeably larger than it was 2007-08, even given strong, reasonable federal regulation and safe, trustworthy payment systems. A questionable future of high regulation, widespread competition, high taxation, and lower-than-expected revenue growth would seem to mean that the US market will not be the salvation that many equity investors anticipate.

On the other side of the world, in Asia, publicly traded online gambling companies essentially have no presence, as our own Calvin Ayre pointed out last year. Given that internet gambling is still banned in most of the Far East, it seems unlikely that online gambling companies – whose executives have been pulled off airplanes and arrested at press conferences in the West – are likely to be as brazen in flouting Chinese laws as they have been in Germany or the US. That market seems likely to be the world leader – as it is for land-based casinos – but, as yet, offers no entrance of any significance to investors.

With all the uncertainty and all the challenges facing the sector, the recent bull run in online gambling stocks seems to have priced in the most optimistic scenarios about online gambling legalization in the US, normalization of the regulatory structure in Europe and the sector’s reliance on a European economy that is already struggling and faces a potentially severe economic crisis. Year-to-date, 888 Holdings is up 35%; Unibet (UNIB.SS) 17%; Betfair (BET.L) 12%; Betsson AB 25%. (Ireland’s Paddy Power (PAP.L) and Bwin.Party are the laggards, though both performed strongly in the second half of 2011.) The resulting valuations – most of the stocks trade between 15 and 20 times earnings, with BPTY and 888 actually having negative trailing twelve-month profits – look fairly attractive, given the growth profile at most of the companies (888 saw revenue rise 26% in 2011, while Betsson, for example, continued to expand both revenue and profits). But investors right now seem to be forgetting that the industry must trade at a discount to account for the uncertainty and volatility in their business models. Can any investor, anywhere, predict with any degree of precision what, for example, 888′s profits might be in 2014? How many markets will it operate in? How much tax will it have to pay? How many competitors will it have? The answer is: who could possibly know?

Within the sector, Betsson AB looks like an attractive play; its focus on the more economically and politically stable countries in Scandinavia and the aforementioned 5% dividend yield, both make the stock less susceptible to political and financial winds than its competitors. Mike O’Donnell recommended online casino game developer Net Entertainment (NETB.SS) earlier this week, which might be an interesting play on the supplier side. It is a bit pricy at 21 times trailing earnings but paid out a 3.14% dividend and is clearly taking market share from larger rivals Playtech (PTEC.L) and privately held Microgaming. Still, there seems to be no rush to head into these stocks – or any others in the industry. The focus on Europe means that volatility is almost certainly going to attack the sector’s stock prices, as fears of Greek default and weakness in the Continental economy persist. For right now, these stocks are trading at a premium. The market seems to have forgotten that the myriad challenges and pitfalls facing the industry require a discount.

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For multinational casino operators, it’s still Macau, Macau, and Macau.

According to Wynn Gaming’s fourth quarter earnings conference call, the Wynn Encore complex in Las Vegas set the all-time record for gambling win by a single casino in Nevada history, taking in a net $776 million in all of 2011. In Macau, Wynn won $944 million from just its VIP table game customers in the fourth quarter alone, according to its fourth quarter earnings release.

For competitor Las Vegas Sands, 45% of the company’s fourth quarter EBITDA (earnings before interest, taxes, depreciation, and amortization) came from Macau, with an equal percentage from the company’s Marina Bay Sands property in Singapore. Meanwhile, the company’s Venetian casino in Las Vegas accounted for just 8% of the company’s cash generation. Executive Vice President Robert Goldstein told analysts on LVS’ conference call that it was “raining cash” in Macau.

Melco Crown Entertainment (MPEL), meanwhile reported revenue growth of 45% and EBITDA growth of 88% for the year. In its earnings release, CEO Lawrence Ho noted the company’s emphasis on mass market customers, who currently drive a tiny fraction of the market – and the company’s – gaming win. Those customers will drive the next phase of expansion on the island, as the frenzied competition for high-rolling VIP players reaches a saturation point.

With rivals MGM Resorts (MGM), SJM Holdings (880:HK), and Galaxy Entertainment (27:HK) reporting later this month, the focus on Macau will remain. Indeed, WYNN stock struggled following its announcement, as its relatively slower growth sparked fears of lost market share in Macau, overshadowing its strength in Vegas. (The recent public feud between CEO Steve Wynn and its largest shareholder, Kazuo Okada, has obviously not helped either.) Meanwhile, Las Vegas Sands’ above-consensus results and bullish commentary drove the stock to a three-year high this week.

Going forward, Macau will continue to drive the stock valuations of the island’s major operators. Sands China CEO Michael Alan Leven put it best on the conference call: “I think that in spite of the fact that a lot of the press is talking about slowdowns in China and all of these kinds of situation, we are essentially seeing nothing that would indicate that Macau and Singapore will not continue on their present paths upward.” That growth is driving the relatively pricy stocks in the sector (most are trading in the range of twenty times forward earnings), and will do so for the near future. Operators who prosper in Macau – as LVS did in 2011 – will be rewarded. Those who cannot keep up will be punished.

For US operators, it’s all cost-cutting and margin enhancement.

Penn National (PENN) and Ameristar Casinos (ASCA) both reported 2011 earnings last week. Ameristar saw net revenues rise just 2.1%, with nearly all of the gain coming from reduced promotional spending. Its fastest growing property, in Council Bluffs, Iowa, saw top-line growth of less than 7%.

Penn, meanwhile, reported year-over-year revenue growth of 11.5%, all of which was created by the company’s operations in the Northeast, primarily in Maryland and eastern West Virginia. Those operations will be severely impacted by the summer 2012 opening of Maryland Live!, a massive casino complex just outside of Baltimore. Without the ability to maintain 2011 growth in the Northeast, the company guided for revenue growth of less than 2% for 2012, and a slight decline in earnings per share. This despite the fact that the company is opening three new casinos this year, including the Hollywood Casino in Kansas City, Kansas which opened earlier this month.

Both companies reported earnings increases in 2011, thanks to margin improvements of 200 basis points for PENN and 160 at ASCA. But improvements are coming from decreased promotional spending, and, according to Penn’s conference call, reduced labor expense. There is only so much fine-tuning these operations can do to increase bottom-line growth against a stagnant revenue base. Expansion into new markets simply creates new competitors and often cannibalizes existing operations. Reduced promotional spending and lowered capital expenditures for maintaining and updating facilities can aid earnings in the short-term, but have long-term effects as well. The pressures facing US operators remained unchanged in 2011 and look unlikely to improve going forward.

There may be a jackpot lurking in the stocks of slot machine manufacturers.

As I noted a few weeks ago here on CA, slot machine manufacturers may have some avenues for expansion going forward, even as domestic casino operators struggle to show growth. WMS Industries (WMS) president Orrin Edidin laid out the bull case in his company’s fiscal second quarter earnings conference call. Demand for new units will double in 2012, Edidin explained, due to a rush of new casino projects, with additional growth expected in 2013. Legalization initiatives in states including Kentucky and Massachusetts, along with several Canadian provinces, can provide momentum for the longer-term.

The question is: who will produce the new units? The most successful player in the industry of late has been small-cap Multimedia Games (MGAM), whose stock is up 178% from October lows. The stock jumped 34% in a day after releasing fiscal first quarter earnings and raising its full-year earnings guidance to 42 to 45 cents per share. The company’s focus on generic, lower-cost games for tribal casinos – its largest customer is Oklahoma’s Chickasaw Nation – has paid off, as the company continues to generate impressive free cash flow, some of which it has used to repurchase shares. At Friday’s close of $10.77, the stock is at a four-year high; but MGAM may still have room to run.

Bally Technologies (BYI) also appeared to gain market share in 2011, as revenues were up 15% for the second half of 2011, improving on the gains made in the year’s first six months. The stock jumped 7% on the revenue beat and slightly raised guidance, hitting a 20-month high of its own, before retreating amidst a weaker market over the past week. With new wide area progressives (WAPs) coming along, an) the release of games featuring Michael Jackson and Grease coming online later this year, that growth could continue. Fellow second-tier player WMS Industries (WMS) showed signs of life as well, after its November earnings miss had led to questions about its ability to hold market share. It jumped 13% on the basis of strong earnings, though the stock price has still been nearly halved over the past twelve months.

The year’s big loser seems to be International Game Technology (IGT), the country’s leading slot machine manufacturer. IGT saw revenues fall modestly year-over-year in the December quarter, blaming the drop on “fewer casino openings in North America.” Yet the fact that all three of its US-based, publicly traded competitors saw revenue gains likely means that market share, rather than market size, was the cause for the top-line weakness. The company did reiterate guidance for its fiscal year (ending in September) of earnings between 93 cents and $1.03 per share. That, however, did not mollify the market. IGT slumped after earnings and closed Friday at $15.51, down nearly 10% in 2012 despite strength in the broad market and, in particular, the gambling sector.

The conference call offered some signs of rebound for IGT, however. CFO Patrick Cavanaugh noted that the company’s market share in Macau was below 20%, weakness the company was emphasizing in its development. CEO Patti Hart claimed that market share was fine, but that the disappointing sales figures came from below-expected replacement sales in North America. Those replacements will come online, given the amount of competition in markets such as Tunica, St. Louis, and Kansas City, not to mention gambling centers Las Vegas and Atlantic City. As such, the quarterly revenue troubles at IGT look like a short-term blip. Given the strength in its competitors, and the potential for growth in its market, owning the sector’s biggest player at less than 16 times forward earnings could be a smart play.

The market does not seem to understand any of the above lessons.

Valuations in the gambling sector are remarkably consistent at the moment. Nearly all of the market leaders – whether operators or suppliers, whether focused domestically or in Asia – are trading between 15 and 18 times forward earnings, despite the vastly different growth profiles facing the companies. Gambling stocks as a whole traditionally trade in an exaggerated lockstep with the market and, specifically, economic sentiment. As economic expectations improve, the broad market goes up, and gambling stocks go up a bit more, only to fall harder when fears arise and investors sell out of equities.

Yet, right now, that lockstep movement makes little sense. There is a vast difference in the outlooks of stocks in the sector right now. Investors who study the industry, and pick their stocks wisely, have the potential to do well with gambling stocks. Focus on Macau and casino suppliers; ignore companies who are tied to the over-regulated, under-performing, American market. Given that they are all priced relatively similar, that should be the big lesson from the 2011 results.

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It can be easy to forget while reading charts, running screens based on 50-day moving averages and stochastics, and reading footnotes from the 2008 10-K of a Chinese pig feet conglomerate, that life is supposed to be fun. And investing can be fun, too — if you choose the right stocks.

That’s why I’ve created the Portfolio of Ultimate Sin (cue the ominous thunder), a portfolio of companies with whom our hard-earned investment rewards can be exchanged for self-destructive, unhealthy, and ludicrously fun activities. Should you invest in the Portfolio of Ultimate Sin? Absolutely — as you long as you do your part to ensure that these companies stay profitable and healthy while significantly decreasing your chances of doing the same. What are you, chicken?

(Editors note: It could be argued that such a portfolio is a reasonable, defensive investment strategy against the backdrop of high unemployment and an uncertain economic recovery. Indeed, that is the strategy of the now-defunct PUF ETF and the Vice Fund. That is not the point of this article, however. This is not advice for protecting your wealth, this is advice for exposing your liver and other vital organs.)

1. Frederick’s of Hollywood (FOH) - Closing Price 2/3: $0.56

What, you thought I’d pick the Limited (LTD), owner of Victoria’s Secret? Victoria’s got nothing on Frederick. Victoria’s Secret is for elegant romantic nights with a loved one; Frederick’s is for trashy, late-night rendezvous (rendevzouses? rendezvi? I don’t know French) with barmaids and biker chicks in creepy motels on the bad side of town. Don’t believe me? Check the website . (Not if you’re at work. Seriously. There’s no excuse for being fired for looking at pictures of half-naked women while working, not when the Internet offers videos of fully naked women doing things illegal in most of the Western world for the same risk.) Frederick’s is unprofitable, loaded with debt, thinly traded, and volatile, with a beta over 2. Its book value – the value of its assets, less the cost of its liabilities – is negative. It’s a risky, dangerous stock – just the kind to turn us on.

2. Rick’s Cabaret (RICK) - Closing Price 2/3: $10.25

If you can’t find a woman to wear lingerie from Frederick’s, head over to Rick’s Cabaret. (And don’t check that website at work either. Or at home, unless you know how to clear your browser history. The old “I was just checking the Investor Relations section” line won’t work on your wife.)
Rick’s runs uh, gentlemen’s establishments, across the country. There’s probably one near you — they’re even expanding into Omaha. (Insert your own Warren Buffett joke here….)

Nudity aside, Rick’s actually looks like a Buffett stock; the company trades just over 1x sales, a bit over book, and less than 8 times forward earnings. But you don’t need numbers to make your case; how can you go wrong investing your nest egg in a strip club? Your buddies will LOVE it. If Rick’s goes bankrupt, you’ll have a great story to tell at the state-run assisted living home. And you can tell it every day, because most of your fellow residents will have already forgotten that you told it at lunch the day before.

If that’s not enough, the company throws parties at its New York strip club in conjunction with its earnings reports. According to Rick’s, “the popular Due Diligence Ball gives investors the chance to see the company’s operations first-hand.” So write off that lap dance – you’re just trying to ensure the health of your children’s college fund.

3. Boston Beer Company (SAM) - Closing Price 2/3: $105.66

What, you thought we’d put Anheuser-Busch InBev (BUD) in our portfolio? You don’t drink that swill, do you? Start your night off right with a Sammy. Remember, the company told you that “it’s always a good decision.” You can’t say that about any of the other stocks in this portfolio.
SAM is debt-free, and trading at about 25x forward earnings. Yikes; it’s expensive. But we’ve got taste, and we’re sticking with Sam Adams, even if it is a little pricier than Budweiser or Molson Coors (TAP). (And try their blackberry-flavored beer for breakfast. It goes great with a Pop-Tart.)

4. Brown-Forman (BF-B) - Closing Price 2/3: $84.12

Let’s be honest — you can’t drink Sammy all night just by himself. He gets lonely. So why not let him party with Brown-Forman, maker of Jack Daniel’s whiskey, Finlandia vodka, and Don Eduardo tequila? They all go great together.
BF is at a 52-week high at $84.12, which of course means it is a must-buy. You don’t get in the way of a high-flying bender – just jump on, hang on tight, and enjoy the ride until the inevitable crash. No hedging, please.

5. Imperial Tobacco (IMT.L) - Closing Price 2/3: £2,389.00

When you do crash off your Brown-Forman ride, and you’re hungover the next morning, you can get some Phillies cigars from Altadis USA, a subsidiary of England’s Imperial Tobacco. And then you can, well, some people have told me that they…never mind.
IMT.L is trading at 13.5x earnings and sports a 3.98% dividend yield, which provides enough cash to pay for the Slim Jims and Orange Crush that go so well with that smooth Phillies taste. Research analysts are extremely bullish on the stock; with the market up 7% so far in 2012 despite the oncoming collapse of the European financial system, their opinions appear to be due to first-hand experience.

6. Abbott Laboratories (ABT) - Closing Price 2/3: $55.00

If you don’t want to make the effort to alter your cigars, or you don’t know how (check YouTube, I’m sure there’s 800 how-to videos using “oregano”), you can just take a few Vicodin, from the good people at Abbott Laboratories. They cure not only hangovers but severed limbs, marital woes, and bankruptcy. I would not recommend this strategy if you are a forklift operator or a hand surgeon, but if you’re an investment advisor it really doesn’t matter. It’ll take a lot more than Vicodin to put a $100 billion valuation on Facebook.
Abbott is trading at just 11 times forward earnings with a 3.6% dividend yield. And if you buy enough stock they might throw in a free prescription pad.

7. Google (GOOG) - Closing Price 2/3: $596.33

You don’t use Yahoo! to search “Angelina Jolie topless with donkey”, do you? Get with the times, man.
Google is trading for just about 10x forward earnings when backing out its billions in cash. So what if the Android platform has more bugs than a Louisiana swamp? (Did you check the link for Jolie and the donkey? You did, didn’t you? If you did, you need this portfolio.)

8. Wynn Gaming (WYNN) - Closing Price 2/3: $114.98

Wynn Gaming runs, of course, the Wynn in Las Vegas (and another location in Macau). Nothing says fun self-destruction like doubling down on 13 in the high-stakes room. At least the drinks are free. Plus, they have a freaking Ferrari dealership on site! WYNN reported disappointing fourth quarter earnings on Thursday, and finished the week down 3.4%, right after some idiot stock columnist recommended the stock as a buy. That’s all right. We’re down a little bit, but we’ll get it back. Just wait until the Asian dealers leave and it will turn around. I promise. I can feel it.

9. Sturm, Ruger (RGR) and Smith & Wesson (SWHC) - Closing Price 2/3: $42.87 (RGR), $5.32 (SWHC)

Yes, we’re including both gun manufacturers in our portfolio. Why? Because you can never have too many guns. We’ve got beer, booze, gambling, and women. Guns make all those things better. (Watch a pretty girl shoot a shotgun some time. Hell, watch an ugly girl shoot a shotgun. “Beer goggles” have nothing on heavy-duty firearms.) SWHC is at a 52-week high, is losing money, and has a small amount of net debt. RGR actually pays a small dividend, is solidly profitable and is also trading at its 52-week high. (The market appears to have anticipated that the 2012 election will drive many Americans to purchase additional firearms). But owning Smith & Wesson sounds much cooler. Dirty Harry didn’t carry a Ruger now, did he?

10. Denny’s (DENN) - Closing Price 2/3: $4.44

Because this is where great nights end: at Denny’s at 4 in the morning, trying to figure out what the heck just happened, where all your money went, and wondering what time the waitress gets off work and if the goiter will bother you when you turn the lights out. Nothing caps off a self-destructive night like Denny’s; for God’s sake, these people put bacon on a sundae! DENN is trading at only 12 times forward earnings, with a price-to-sales ratio below 0.9. Yes, sales are declining, but that’s only because their customers are dying from bacon-induced heart attacks. We don’t have to worry about that – we’re going to start exercising on Thursday, as soon as our hangover is finished. And, this time we mean it.

Additional disclosure: Please don’t take anything in this article as serious investing advice. Should you choose to invest in any of these stocks, however, rest assured that I will do my part in helping these companies meet or exceed their earnings forecasts.

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Going forward, it seems unlikely – or impossible – that the island can duplicate its recent growth rate (the 42% year-over-year increase in casino win in 2011 is projected to slow to a more reasonable 12-20% in 2012). But, as the business matures, new streams of profitability will emerge. The island’s emphasis on high-stakes VIP clients will diminish, as middle-class Asians are added to the client mix. 90% of the island’s revenues are driven by baccarat, and as new casinos (such as the Sands Cotai project coming online this summer) increase competition, operators will naturally diversify into other, lower-margin games such as blackjack, roulette, and slot machines. Non-gaming revenue on the island represents just 11% of total revenue, meaning hotel and casino operators should have the ability to grow food, beverage, and retail sales, particularly as the emphasis on high-stakes – and high win – customers decreases going forward. Continued strong growth on the mainland bodes well for the island, which looks set for years of growth, if not at recent levels.

Investors looking for exposure to Macau have a wealth of opportunities, from the six authorized casino operators to junket operators, who provide customers – and credit – for the island’s VIP rooms. Below are my three favorite stock picks for investors looking to gamble on Macau:

Wynn Gaming (US: WYNN) and Wynn Macau (HK: 1128)

Wynn owns the Wynn and Encore properties in Las Vegas, and properties under the same titles in Macau. The Macau subsidiary is directly listed on the Hong Kong stock exchange, though the US-listed parent company still owns some 72% of Wynn Macau’s outstanding shares. In a sign of just how critical Macau is to the fortunes of casino owners, Wynn Macau’s market capitalization – the market value of all outstanding shares – on the Hong Kong exchange is $14.1 billion USD. Wynn Gaming’s market cap on the NASDAQ is $14.9 billion USD. Wynn Gaming’s stake in Wynn Macau is worth, at current levels, over $10 billion, more than two-thirds of the total value assigned to the company by the market.

The stock was hit earlier this month by a lawsuit filed by Kazuo Okada, the company’s largest shareholder (a role he assumed after founder Steve Wynn and his ex-wife Elaine completed their divorce in 2009). Okada was disturbed by his inability to access company records, and in particular a $135 million donation the company made to the University of Macau. A week later, Okada nominated four new board members, escalating the tension. The stock dropped 5% on the initial news, but shrugged off the board fight and simply resumed its run-up from December lows, closing Friday at $119.07, up nearly 8% since the start of the year. As the Las Vegas Record-Journal noted, the board drama had echoes of Wynn’s exit from Mirage Casinos in 2000. That exit provided Wynn the capital to buy the Desert Inn, and eventually build Wynn Gaming. Nomura Securities analyst Harry Curtis told the paper the developments could, in the long run, “be positive for Wynn shareholders,” and over the last two weeks, the market has agreed.

In the meantime, both stocks appear to have solid growth prospects. Las Vegas gambling revenue and vistor traffic are improving, meaning that the market’s $4.8 billion valuation of the Wynn and Encore properties on the Strip may be a bit low. Wynn Macau offers a lower price-to-earnings ratio (about 15, compared to the parent’s 27) but there are some short-term questions about Wynn Macau’s ability to hold onto market share as the new Sands Cotai project opens and Wynn’s own Cotai project is years from completion, according to its most recent 10-Q. For US investors, the difficulty (and currency risk) involved in owning Wynn Macau directly on the Hong Kong exchange may lead to the safer, more diversified Wynn Gaming US listing. More aggressive investors looking for a pure Macau play can accept the (usually) higher commissions and higher risk associated with Wynn Macau stock. Both stocks are volatile momentum plays, both have been moving higher, and with the news out of Macau solidly positive for the last few months, each deserves a least a short-term flyer.

Asia Entertainment and Resources (US: AERL)

AERL is absurdly cheap by any measure, most notably its trailing price-to-earnings, which sits under 3 at Friday’s close of $5.79. Unlike other Macau plays, it has actually stalled out over the last few months, but is approaching long-term support at about $5.50/share, which would make for an excellent entry point for long-term investors.

What is keeping a lid on AERL’s valuation is clearly the fear of fraud at the company, which has been – so far unfairly – associated with Chinese reverse mergers, many of whom have caused huge losses for retail investors and lawsuits against the companies themselves. (Thursday’s raid of the offices of Benjamin Wey, one of the practice’s leading promoters, was one of the first law enforcement actions in the sector.)

In response, Lam Man Pou, the company’s chairman, told Reuters in July, “(E)verything is clear and transparent…Our balance sheet is real, our figures can be verified from casino owners.” The company’s chip turnover – essentially, the total amount bet by its clients – allows auditors to compare its own statements against those of its casino partners: global operators Las Vegas Sands and Galaxy Entertainment. As such, the possibility of fraud or illegal revenue and profit enhancement would seem lower at AERL than at any other similarly created Chinese companies.

The other issue facing the stock is the relatively opaque (some might say “shady”) nature of the junket business. Reuters reported in 2010 on the industry’s common links to organized crime, and later that year blogger Timothy Sykes wrote an interesting takedown of the stock. Like Reuters, Sykes emphasized the often shadowy nature of the business, which exists in large part to circumvent Chinese currency controls and the casino’s inability to collect on gambling debts under Chinese laws. The junket operators are exposed to the credit risk in attempting to collect from their clients, and some operators have used threats – and as the Reuters piece noted, outright violence – to collect their debts.

Add in the intense competition on the island, and there are real risks to the stock that, perhaps, justify its low valuation. However, the company is well-run; management owns a substantial amount of stock, aligning their interest with those of investors; and the company offers solid dividend potential. It paid out a 10-cent semi-annual dividend in September, with the promise of a raise for 2012. Those payments will equal 15% of the company’s adjusted earnings for 2011. Given that non-GAAP earnings were $1.50 per share for the first nine months of 2011, investors can expect in the range of 30 cents per share in dividends in 2012, giving a strong 5.2% yield. AERL is a high-risk stock, but at current levels it is clearly also high-reward.

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