Investing The Hard Way: What I Got Right – And What I Got Wrong

TAGs: Boyd Gaming, bwinparty, Double Down Interactive, Facebook, Galaxy Entertainment Group, international game technology, investing the hard way, Las Vegas Sands, Melco Crown Entertainment, MGM Resorts, PartyPoker, penn national gaming, Scientific Games, SJM Holdings, Vince Martin, Wynn Resorts, Zynga

As 2012 – and my first year as a columnist here at – comes to a close, I thought it would be a worthwhile exercise to review a year’s worth of analysis and predictions for gambling stocks to see what I got right, what I got wrong, and what can be learned from my successes – and failures.

Investing The Hard Way: What I Got Right And What I Got WrongMy very first column on the site dealt with the short-term boost in gambling stocks following the late December Department of Justice opinion that appeared to allow for legalization of Internet gambling in the US. In the wake of that decision’s release, Boyd Gaming (BYD) rose nearly 10%; Scientific Games (SGMS) rose 15%; and, overseas, bwin.Party Digital Entertainment (BPTY.L) rose a stunning 30%, as investors hoped for the return of former market leader PartyPoker to the States. But within days, most gambling stocks gave back their gains, as investors digested the hard truths about iGaming in the US. As I correctly predicted at the time, “online gambling in the US will be slower, messier, and most likely less profitable than many anticipated in the wake of the government’s U-turn.” Indeed, it looks like 2012 will close without a single dollar in revenue created under a legalized, regulated regime. And the stocks boosted by the Wire Act opinion have suffered as a result.

bwin.Party would fall some 40% from its early January highs, beset by weak quarterly reports and the tortoise-like pace of US legalization, while both BYD and SGMS have fallen back below their trading levels before the DOJ announcement.

After an early bout of optimism – punctuated by International Game Technology’s (IGT)disastrous $500 million purchase of Double Down Interactive – it seems the market has come around to the understanding that US iGaming will require patience, and likely create far less near-term revenue and profits than previously hoped. It shouldn’t have been that difficult to foresee in the first place – our own Calvin Ayre voiced similar skepticism in his predictions for 2012. On the other hand, it appears the market still hasn’t entirely learned its lesson. Just a week and a half ago, Zynga (ZNGA) rose 10% in trading late after announcing it was applying for an  online poker license in Nevada, a rise I questioned just a few days later. I argued that Zynga stock – as did bwin.Party in January, and as Zynga itself did after announcing a partnership with bwin.Party in the UK in October – would retreat once the news was digested. Indeed, history did repeat itself; Zynga fell nearly 5 percent in trading on Monday, as the “smart money” took advantage of the rise to sell the stock short or take quick trading profits. With Democratic Majority Leader Harry Reid (D-NV) admitting this weekend that his efforts to create a federal bill are “dead” for the year, the legalization process looks to be similarly slow in 2013. Investors should not put much faith in US politicians; aggressive traders can again look to short stocks that get a pop from potential, rather than actual, profits.

My second column also turned to be accurate, forecasting another key trend in the gambling industry in 2012: so-called “cannibalization,” or the impact of new casino operations on existing businesses. In covering the case of Dover Downs Entertainment (DDE), a casino operator in Delaware, I noted that the company’s fundamentals were strong, but the expansion of gambling in neighboring Maryland and Pennsylvania would surely hurt the stock. Indeed, DDE’s third quarter saw gaming revenue decline nearly 11%, a drop the company said “was primarily attributable to increased competition in the region.” DDE would fall to an all-time low after that release. This summer, in a more extended discussion of the cannibalization phenomenon, I recommended another short: MTR Gaming (MNTG). Like Dover Downs, MTR, which owns casinos in West Virginia and Pennsylvania, was facing new competition; in MTR’s case, new casinos in Ohio looked likely to pull customers from its existing operations. MTR does have a video lottery terminal (VLT) facility in Columbus, Ohio, but it also had a substantially weaker balance sheet than DDE, with about $18 per share in debt. Within two weeks, MNTG peaked; it has now fallen by 40 percent in less than six months since I recommended a short sale of the stock. The competition in the US market looks likely to increase going forward, with Massachusetts legalizing gambling, additional licenses available in Pennsylvania and Maryland, and expansion still possible in Kentucky and elsewhere. The struggles at both companies should be no surprise; going forward, investors need to beware of smaller operators like DDE and MNTG who do not have the political or financial clout to protect their territory.

Of course, I made my share of mistakes along the way. In Macau, I flip-flopped between Wynn Resorts (WYNN) and Las Vegas Sands (LVS) as my pick on the island. All along, however, the right choice would have been neither, as the island’s non-US operators saw significantly better gains than US-based Wynn, Sands, or MGM Resorts International (MGM). Galaxy Entertainment (GXYEY) continues to provide investors incredible returns, having better than doubled so far in 2012 and risen by nearly 800 percent over the last three years. I did eventually come around to Galaxy in April, but picking stocks on the island remains difficult. The impressive outperformance by not only Galaxy but SJM Holdings (SJMHF) and Melco Crown Entertainment (MPEL) would seem to have to end at some point. Of course, investors could have said that many times over the past few years.

As I’ve written a few times, most recently in November, Macau-facing stocks still look like a long-term buy, and even the lagging returns posted by Wynn and Las Vegas Sands over the past three years have handily beat the broad market. The concerns about slowing VIP revenue in Macau should be offset by growth in higher-margin revenue streams such as mass market gambling and the leasing of retail space. The exception remains MGM Resorts International (MGM), which I first recommended shorting in February. The stock has fallen 17 percent since then, as its high debt load and weak market share on the island have unnerved investors.

Indeed, the share prices of all three US operators are down since that point, having struggled after a banner first quarter. This is one reason I recommended using pairs trades to buy shares of the US companies’ Hong Kong-listed, Macau-facing subsidiaries – such as Wynn Macau and Sands China – while shorting the US-listed parent companies. The theory was simple: the Macau subsidiaries would outperform the parents, who would be weighed down by operations in the US, notably the still-recovering Las Vegas Strip. In the nine-plus months since that call, the trade has worked beautifully. Wynn Resorts is down 10%; its Chinese subsidiary has risen 2%. Las Vegas Sands has dropped a surprising 20%; but Sands China is up 12%, meaning a pairs trade would have returned a solid 16 percent. MGM, too is down 20 percent; but MGM China has eked a 5% gain. For investors interested in Macau, using parent-subsidiary pairs trades is a good way to play growth on the island while hedging against the possibility of a broad market decline. Such a decline would likely hit traditionally volatile gambling stocks on US market, resulting in a profit on the short sale of the US companies and mitigating losses from the Macau operators.

After all, this pairs trade is based on a common sense thesis: Macau will out-perform Las Vegas. And over the course of the year, I have tried to emphasize using fundamentals and straight-forward analysis of the industry to make smart investing decisions. I’ve repeatedly recommended avoiding high-debt stocks such as MGM, Isle of Capri (ISLE), and, most notably, Caesars Entertainment (CZR). Isle is down some 25% from its peak in the spring, while Caesars is down 22% from the $10 per share price offered in its manipulated February IPO. This despite a 77 percent gain bounce off its all-time low in just five weeks, driven in part by the company’s nearing an online poker license in Nevada. Given the company’s $20 billion in debt, and the possibility of a Zynga-like retreat after the online gambling euphoria subsides, CZR has given investors another opportunity at a potentially profitable short sale.

In addition to focusing on solid balance sheets, investors need to focus on solid management. In May, I chose “The Five Dumbest Stocks In The Market,” picking both Zynga (ZNGA) and Groupon (GRPN) mostly because of questionable management decisions. In seven months, Zynga has fallen 70%; Groupon has been halved, even despite a recent bounce amid rumors of its acquisition by Google (GOOG). I certainly did not predict the speed nor the depth of each stock’s decline; but the fact that both companies are struggling should be no surprise. Groupon repeatedly took liberties with its accounting leading up to and coming out of its IPO, while Zynga has doled out stock to its executives like Kit Kats on Halloween. In both cases, management was waving giant red flags to investors; those who were stubborn or naïve enough to ignore those warnings got burned.

Of course, the reason the stock market generates so much interest, so much excitement, and so much cash, is that investors never truly know what is coming. While I’ve made some good calls, there have certainly been a number of events I simply never saw coming. Before the widely anticipated initial public offering from Facebook (FB), I confidently predicted that Wall Street would support Facebook’s share price in the near future, though I argued that “only a fool would buy Facebook stock.” I was wrong on both counts; the stock plummeted soon after its IPO, but has slowly and quietly regained ground, closing Friday over $26 per share, up over 50% from its lows in late August.

But probably my worst-timed call came in discussing Penn National Gaming (PENN). To my credit, I did compliment the company, writing in October that “Penn National appears to be the best-in-breed [US] regional operator.” Unfortunately, I added that “at its current share price, it doesn’t look like that will be enough.” Of course, less than three weeks later, Penn announced plans to spin-off its properties into a real estate investment trust (REIT), sending the stock up more than 20 percent.

As they say, you can’t win ’em all. Fortunately, in the stock market, as in gambling, you don’t have to win them all. Being right a majority of the time is enough, particularly if you can limit the cost of your mistakes. The basic investing fundamentals I’ve espoused this year, and a continued focus on management, branding, execution, and balance sheets resulted in a reasonably successful 2012, and should maintain their value in 2013. Of course, the wonderful thing about the stock market is that you truly never know.


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