Annual Model Portfolio
2009 Model Portfolio - Introduction
In the past two Gaming Sector….Yesterday, Today and
Tomorrow reports, we warned of coming problems. From the
heightened competition on the East Coast of the U.S., the
“addiction” Las Vegas casino companies were having to
non-gaming revenue and the confusion of just what type of gaming
market Macau really is, we warned that there could be problems.
In 2006, investors ignored this, sending gaming stocks up to
unrealistic levels, setting them up for a dramatic correction in
2007. The entire sector was rescued by the private equity craze,
actions by well known investors such as Kirk Kerkorian and a
completely unrealistic view of Macau and just how deep and
profitable the market could be.
We expressed a lot of concern about these things last year
but felt that gaming stock valuations had already begun to come
down and most of these things were fixable. What we, nor anyone
else, could have ever predicted was the destruction of the U.S.
economy caused by a combination of the banks era of easy
lending, and a private equity bubble burst coming together to
cause one big massive disaster when the price of oil surged to
an all time high and never expected levels. We can argue this
until the cows come home but we spent the first half of 2008
warning subscribers that if oil jumped over $100 a barrel for
too long, both the gaming sector and the economy were in big
trouble. Just like when Las Vegas Sands traded over $140 and
Wynn Resorts over $170, it was clear to see that something was
not right in valuations. The difference was we could sell the
shares of LVS and WYNN, there was not much we could do about how
much oil impacted our daily lives except stay home. That kind of
tells you why things like casinos, malls, hotels and anything
else which needed people to visit had such a horrible late
summer/fall.
A spike in oil prices to over $140 a barrel followed by a
decline to under $40 sounds like something that would take place
over a couple of years and couple of cycles. Instead this
happened in just two seasons, spiking to the highs during the
all important summer vacation months and plunging into late
fall. Obviously all time high prices of gasoline would hurt the
travel and leisure business segment but what it seemed like
everyone forgot is that the high gas prices impacted everything
and the cascade effect just brought economic growth to a
screeching halt, tipping the housing market over, destroying
financial firms and sending consumer confidence plunging.
Rather than rehash the painful impact on the overall stock
market in 2008, let’s take a look at where we are today and
what investors should be looking for. If you cut out July
through September we would not be in bad shape as gas prices at
$1.50 a gallon is a terrific sign for regional gaming operators
in drive-to markets. The low oil prices should help the airlines
but the problem is the activities that occurred during those
three months in 2008 resulted in the highest unemployment, a
credit market that froze up for three months and now could take
six months to defrost. In terms of gaming, the drive-to
convenience gambling markets should do fine but it could take
anywhere from 6 to 18 months for Las Vegas to start showing any
type of turnaround.
There is no quick fix for Las Vegas as the mistakes of the
past are coming back to haunt them. We were not kidding when we
warned about the “Newbies” that were taking over the Strip
and now you see the results. The dependence on non-gaming
revenue, implosion of the majority of low rolling properties,
artificially inflated real estate values and the Newbies who
thought there was nothing wrong with overpaying, the
construction of billion - instead of hundreds of million -
dollar developments caused an ethnic cleansing of the tourists
and a reliance on business and convention customers and upper
class to complete whales as customers.
The casinos are now kissing up to the tourists but at a steep
price as room rates drop, comps go up and profit margins fall
into an abyss. For some reason there are still plenty out there
who cannot figure out how casino/hotels in Las Vegas can still
run at 90% occupancy yet operating profits have disappeared. The
reality of the situation is that, just as we warned over the
years, there was too much leverage in that non-gaming revenue
and the casino companies turned the Strip into a cyclical
environment, sort of a macro version of the U.S. economy.
The locals market suffered from the fall-out on the LV Strip.
The combination of Las Vegas becoming the poster child for the
subprime mortgage mess, declining home values and foreclosures,
to the cancellation of development projects putting construction
workers on furlough, gave the first dose of problems to the
previously impervious locals operators. Once new properties such
as Eastside Cannery and Aliante Station opened, the camel’s
back found too many straws on it. Unfortunately, even if we see
some stabilization of the housing market and home values, there
is still more capacity coming online with the upcoming opening
of the billion dollar M Resort. The LV Strip will see the
opening of CityCenter, supposedly by the end of 2009 but we
think there is a 30 to 40 percent chance it winds up being
delayed until 2010. This will give Strip operators an entire
year, from the opening of Encore from WYNN in late December
2008, to try to figure out how to fix the problems affecting the
Strip. The comfort is in the fact that Las Vegas has always
rebounded no matter who was involved. The only warning we can
give is that the Las Vegas Strip of today has no resemblance to
anything in its past. The casino operators are basically in the
put up or shut up mode and investors will have to keep their ear
to the ground to see who has the management, financial savvy and
experience to make it through this.
While investors have every reason to feel concerned about Las
Vegas, and Atlantic City for that matter, they are once again
failing to give credit to those companies operating in certain
regional markets. This is not anything out of the ordinary as
with the exception of a few brief and spectacular months after
9/11, investors have always viewed the regional markets and
their operators as going the way Las Vegas goes. This is the
reason why there are so many Newbies on the LV Strip and why
companies like Pinnacle Entertainment, Ameristar Casinos and
Penn National Gaming have indicated interest in the past at
getting on the LV Strip. Investors always seemed to give higher
valuations to LV Strip companies, at least until 2008. At the
same time, common sense will tell you that in times of economic
and geopolitical distress, gamblers and other travelers stay
closer to home. This is what happened after 9/11, after various
natural disasters, outbreak of war, disease and anything else
that captured the attention of America.
That being said, there are certain pockets of the United
States which have just too many gaming positions in too small of
an area, sharing feeder markets and resulting in lower returns
for many different operators and states. We tend to pick on the
eastern part of the United States mainly because that is where
many states realized the party was going to end soon and had to
jump on the gaming bandwagon, casino executives failed to
accurately forecast what might happen and gaming regulators and
political officials showed their complete lack of knowledge of
anything to do with the gaming industry or human nature. Build
it and they will come worked as long as the there were untapped
feeder markets. Too many states legalized casino gambling in the
feeder markets to keep the money from crossing the border and
racetrack and casino operators were only too happy to allow them
to tax them to death.
We believe the best markets in 2009 will be Missouri,
Pennsylvania, Louisiana and Iowa while the worst performing
markets, at least in the first half of the year will be
Illinois, Atlantic City, the locals market of Las Vegas and the
same store Southern Indiana casinos. While Las Vegas and
Colorado will start out the year in poor shape, the second half
of the year could be a lot better. Illinois and Colorado will
have the anniversary of their smoking bans but a combination of
the weak economy and any type of unsettled weather could
continue their string of double digit declines in the first half
of the year. Colorado will have the advantage of having higher
betting limits and new casino games in the second half of the
year, giving them a lift off of those weak comps. Illinois will
be completing the auctioning of the 10th casino license and
quite frankly, we can’t understand how any Chicagoland
operator would even consider putting a dime into anything other
than necessary capex. All the Chicagoland operators will suffer
if another casino is developed in the area, just like the Casino
Queen and Alton Belle will continue to suffer as St. Louis
casinos ramp up marketing and business now that the loss limit
has been removed.
Missouri probably is the brightest spot in the gaming
universe right now. When we pushed to get the $500 loss limit
removed, we said that we felt it would justify the development
of such a lavish Lumiere Place in St. Louis by Pinnacle
Entertainment and in Kansas City, it would help them offset the
onset of competition from Kansas casinos in 2009. There will not
be any Kansas casinos in operation in 2009 competing with the
Kansas City casinos and right now we could be looking at 2010 or
further out if we have them at all. We fully expect the end
result in Kansas will either be only two or three operating
casinos over the next three years, as any move to change the
gambling law to give incentive to get the racetracks to open
again and add slots or get more operators interested will be met
with resistance by politicians. The result is that Missouri is
the gaming market right now in the best shape going into 2009,
followed by Louisiana and Iowa.
What happened in Kansas is a strong message to any
politicians who believe state owned casinos are the way to go.
What has happened in the United States in the past few years
between the expansion of gaming and the destruction of our
financial system has not killed the Golden Goose called casino
gambling but has definitely put it in intensive care. That being
said, investors will have to work a bit harder to make money in
this industry as the gaming stocks turn back to recovery mode.
It should have been clear that the reaction to 3rd quarter
earnings was a good sign that the bottom was being put in on
many gaming stocks. The problem with investing in gaming, or
pretty much any sector in 2008, was that every time it looked
like capitulation or signs of a bottom and reversal, another
unforeseen event occurred sending the overall stock market into
another sickening fall. As we head into the end of 2008 there
are clear signs of stabilization although the overall catalyst
for the U.S. stock market is still lacking.
In terms of gaming stocks, we feel investors will have to
play the recovery wisely and we have decided to break up this
year’s portfolio into different sections. The first is
basically the balance sheet, the casino companies in the best
fiscal shape to maneuver through the final months of the
downturn in this market. These next few months will result in
various bankruptcies, most likely the majority being companies
who do not have publicly traded equity. While Trump
Entertainment is the likely candidate to be the publicly traded
casino company to be the first to file Chapter 11, it is not
like there are not others out there who need the economy to
either improve or at least stabilize so they are completely out
of the woods.
We know our comments will probably be repeated in many places
and misquoted but the publicly traded company with the most
chance of being forced into Chapter 11 or even worse due to a
casino project is MGM Mirage with CityCenter. We are looking at
a worst case scenario here but the way we see it is, if this
current economic funk lasts to the long end of our range at 18
more months, CityCenter will open into an even worse economic
climate than Palazzo and Encore. If this does occur, MGM will be
forced to either cannibalize their existing properties to give
CityCenter a fighting chance or disaster will strike. Either way
it would not be a good thing for MGM. We hope that the low end
of our economic improvement timeline (6 months) is what really
happens and the billions of dollars being spent by our
government to fix these problems do the trick. If that happens,
we may have the complete opposite and CityCenter will then be
the catalyst that turns Las Vegas around. History is not on our
side regarding this as it was always Steve Wynn owned casino
openings that started the last few up cycles in LV casinos.
Those few companies with strong balance sheets may use the
upcoming peak of the downturn to their advantage. If more
bankruptcies occur and other companies try to stave off
bankruptcy with a sale of assets, a lack of financing
availability could result in fire sale prices on some of these
assets. Those with either strong balance sheets or management
teams of companies who can find sugar daddies can use this to
build up their companies and prepare for the rebound, bigger and
stronger than before. At the same time, those forced to sell at
these low valuations and are successful at avoiding disaster
will still enter the recovery a lot smaller and weaker than they
were 18-24 months ago.
The second type of casino companies we are looking at
favorably are the few that have growth prospects. Not
surprisingly, these companies primarily have operations in
Missouri, Louisiana, and/or Colorado, the markets we are looking
at favorably in 2009.
Despite being dragged down by a view that when your customers
are hurting, you must be too, the suppliers to this industry are
on the whole, in fine financial shape. Even IGT, beaten up and
bruised by failed investments and market share losses, still
throws off enough cash flow that they should easily be able to
retire their convertible debt when it gets put to them. Bally
Technologies and WMS are in share repurchase and free cash flow
mode with Bally refinancing their debt at a reasonable rate
during the height of the financing market deep freeze. Shuffle
Master, criticized for raising the money to retire their convert
a year in advance now look like a geniuse for doing it before
the financial markets went into a tail spin. It seems that only
Progressive Gaming and possibly FutureLogic are ending 2008 in
worse shape than they started. PGIC is basically on the brink of
a restructuring, a liquidation or a fire sale, the only supplier
company that became a victim of the casino crunch. FutureLogic
somehow got the short end of the litigation battle with TransAct
Technologies and although the terms were not disclosed, we
should get a handle on them when TACT files their annual 10K.
Either way, judging by the recent earnings report from TACT,
they have gained market share on FutureLogic and it appears that
FutureLogic has had to rethink their strategy.
Everyone knows that the biggest gains in gaming stocks can be
found when companies rebound. Historically this has been
primarily on the supplier side as anyone who has been investing
in this group for a long period of time remembers the profits
that were made investing in Bally, WMS and Progressive Gaming
early in their recovery. Many probably don’t know that in the
past 20 years, IGT has gone from under $10 a share to well over
$40 a share twice on a recovery from a decline in business and
market share. Only one time in modern day gaming stock history
has there been anything similar to this in the casino stocks and
that was in the mid-1990’s when casino stocks plunged 60%-90%
on fears of oversupply, overbuilding and bankruptcies. This
occurred in the first stage of the riverboat and regional gaming
expansion. The difference between then and now is that while the
equity prices of companies such as Ameristar Casinos, Argosy
Gaming, Casino Magic, Casino America (now Isle of Capri
Casinos), Hollywood Park (now Pinnacle Entertainment) and others
plunged 75% or more from their highs, their bonds remained
strong. This is a different environment now with bond investors
showing they think there is at least a 50% chance that most of
the casino companies do not make it without a restructuring,
which would be a disaster for equity holders.
What this means is that the risk is higher now but most
likely so will be the rewards if you pick the correct stocks. If
you purchase five of the casino stocks currently trading under
$10 a share and only one stages a dramatic recovery, three wind
up getting gobbled up by another company around the current
valuation or just stays at that price and only one goes under,
you’ve done very well for yourself.
The final section of course, will be the speculative section.
With stock prices where they are, speculative no longer means
low priced since just about every stock is now low priced, with
the exception of stocks like Google and Berkshire Hathaway. Our
Speculative section is for companies that are low priced, are
not in dire financial shape but are being ignored by investors,
or have been trampled by investors and have potential catalysts
in place. On the supplier side it is the ones who supply or
service the slot makers because if we feel the slot makers can
do better than the way their stock prices are reflecting, it is
a good chance that their suppliers will also rebound. On the
casino side, there are companies out there who have new
projects, are not in financial straits and also have a history
of making investors money when purchased on the down and out.
In terms of weighting, remember that things will change as
the year unfolds. Going into 2009 we would give a heavier
weighting to the companies with the stronger balance sheets, the
companies with better growth prospects and the suppliers. We
would have a lower weighting on rebound names and of course, not
more than 10% in speculative names. Remember that the rebound
and speculative names could have a greater return due to the
higher risk and lower prices and as always, we suggest you take
profits on extreme moves in any of these stocks while holding a
core position. We expect the volatility in the overall market
that was seen in the second half of 2008 to continue through the
first half of 2009.
Good Luck and Profitable Investing!!
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