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Annual Model Portfolio

2012 Portfolio

2012 was a terrific year for the gaming industry and to be a gaming sector investor�. as long as the year ended in March. From January 1st through March 31st whether it was Macau or Pennsylvania, everything seemed to go the right way. The much anticipated VIP slowdown in Macau had not materialized by the December 2011 gaming revenue results so investors decided it was just not going to happen. The very cautious expectations for 2012 looked just plain silly when January, February and March results came out, prompting analysts to boost expectations. In the United States, the warmest winter on record occurred in the first quarter of 2012 and when compared to extremely weak results from one of the worst winters in 2011, it was easy for investors and analysts to suggest the caution from the end of 2011 was not warranted and that the economy may be better than expected.

Gaming stocks rose to their highest point in March/April, spurred on by the stronger than expected first quarter. The typical speculation and frothiness that always seems to accompany extreme gaming stock rallies showed up in March, with the red flag really being waved with the reaction to the �mistaken filing� of an 8K with the SEC by Wynn Resorts� law firm, �mistakenly� saying WYNN�s approval from the Macau government for their land application on the Cotai Strip would be published in the official gazette of Macau. The signs that something was not right were apparent even in the filing as it gave a date of January [*] but investors didn�t seem to care. Even after WYNN shares were halted for the announcement that the 8K filing was a mistake, shares briefly dipped on the resumption of trading, only to rise even higher than the previous 6 point rally. The common opinion was that investors believed WYNN�s lawyers must have had the document ready for a reason and that they were only waiting for the date to be officially given. We should note that the gazetting wound up being a second half of 2012 event and by year�s end, WYNN was still not at full construction on Cotai.

Even though Macau was competing with the freakishly strong regional gaming revenue results for the first quarter months in the United States, this was still the group that dominated investor attention. We don�t know if the WYNN 8K fiasco was the key event of 2012 which should have been the reason for investors to call it a year or it was the sudden change in bullishness by Hong Kong gaming analysts, followed by their United States counterparts, but the reality is that it seems like analysts and investors chased the shares, both up and down in 2012 instead of the other way around. In late 2011 we were highly critical of investor reaction to a Deutsche Bank Hong Kong report suggesting VIP growth was slowing. In March of 2012, that same Deutsche Bank Hong Kong reported that VIP growth had resumed and upped their growth target, setting off a chain of events which had the analyst community move from 10-15 percent growth expectations for Macau gross gaming revenue to 25-30 percent with some boldly even predicting 35% growth. We should note that the 10-15 percent range looks like that is exactly where growth will turn out in 2012.

Looking back on what happened in the first quarter of the year, it was kind of a perfect storm, one that had investors believing that all their worrying in 2010 and 2011 about the economy and competition in the United States, and about the Macau and Chinese governments turning off the spigot in Macau, was for naught. What happened in January through March of 2012 was the perfect confluence of events from perfect weather in the US to a complete head fake in Macau, causing investors to stampede back into gaming stocks, shrugging off the weak 2011. By the beginning of April, our 2012 Model Portfolio was up 29% and we were taking profits every time we spotted the slightest hiccup.

The gaming world started 2012 with so much optimism. The expectations were that by the end of the year we would have legalized widespread Internet poker, at least one major new integrated gaming resort area (Florida), casinos would be licensed and under construction in Massachusetts, VLTs would be in a good portion of bars and restaurants in Illinois along with new casino licenses authorized, at least one more Asian country would legalize integrated resort casinos and Cotai casinos approved early in the year would be under full construction with clarification on who will get tables and when. Talk about your all time backfires!

Looking at that list and seeing what actually happened in 2012 gives you an idea that things went south pretty quickly in the last 9 months of the year. Throw in a pair of Hurricanes which hit the south and Northeast including a bullseye on Atlantic City, a Nor�Easter, global economies that looked like they were heading for a double dip recession and you have to wonder how we could even end the year with gains in the Model Portfolio. The reason is because we saw the frothiness and took the profits along the way. Uncertainty is what caused stocks to underperform but the first few months of 2012 were just too weird for us and as we continued to say throughout the second quarter, we were in unfamiliar territory with the first quarter being the strongest, instead of the weakest 3 months of the year for gaming stocks.

It wasn�t just a strange year for casino stocks as suppliers had a very odd time of it. The strongest gaming suppliers were Bally Technologies and Multimedia Games, riding a wave of earnings growth brought on by a combination of a relatively easier moving of the needle with slot machine placement growth, the continued woes of WMS Industries, and a view by the investment community that IGT was too focused on social gaming and online gaming, something investors could not get a grasp on. It was ironic that after so many years of pointing out how Shuffle Master, now SHFL Entertainment, was eventually going to capture investor interest again due to their rising recurring revenue stream that eventually would lead to earnings out performance, it was their announcement that they were going to buy an online poker network from bwin.party that sent the shares surging to nearly double the
price they started the year. IGT, on the other hand, agreed to buy a social gaming company, Double Down Casino, one of the hottest things on Facebook, utilized a strategy to buy back a bulk of shares through Goldman Sachs and shares plummeted nearly 50% from the price they repurchased the shares because of concerns over their move into Social Gaming. Following the realization that online poker in Europe was on the decline, SHFL called off the purchase of the OnGame poker network, causing their shares to decline while IGT�s results began to show validation of their social gaming strategy, only to see their shares continue to languish.

The list of new casino openings and VLT placement opportunities in 2012 would make a Rip Van Winkle gaming investor wonder just what was going on. If a gaming investor fell asleep in the late 1990�s or even early 2000�s and woke up in late 2012 and was told that casino/racino openings in 2012 included:

Kansas Star
Hollywood Kansas
Horseshoe Cleveland
Hollywood Toledo
Hollywood Columbus
Scioto Downs
Maryland Live!
Casino Miami
Oxford Casino (Maine)
Margaritaville (Biloxi)
Sands Cotai Central
L�Auberge Baton Rouge
Isle Cape Girardeau
Valley Forge (PA) Casino

We have a feeling they would be a bit surprised to hear IGT was ending November at $13, WMS at $16 and that conference calls were being dominated with questions about Double Down, JackpotParty.com, portal applications and online poker.

Reading that list of casino openings and adding on the startup of video gaming terminals in bars and restaurants in Illinois, video pulltabs in Minnesota and the massive VLT replacement cycle that has begun in Canada only makes the situation with slot makers even stranger. The problem with the slot business is not that there is not enough business, but that there are too many companies. If you had the number of suppliers to the industry today that you had back in the 1990�s the supplier stocks would have been much higher on investors� wish list than they are today.

Instead you have companies such as Multimedia Games who used to supply the grey area tribal gaming class 2 markets now licensed in most Class 3 gaming states, companies like Konami and Aruze getting near double digit percentage floor space, a whole host of companies run by former executives from the big 3 slot companies, suppliers to the industry from the United States having to compete with a whole host of Asian, Australian and UK companies and the OEMs from the United States not only having to compete with home grown companies but the major competition from companies in Korea and other Asian nations.

The best way to sum up what has happened with the number of suppliers is to describe what happened to the ticket printer business. While the two main ticket printer manufacturers, FutureLogic and TransAct Technologies, were busy fighting each other tooth and nail in court, JCM Global wound up becoming a major competitor to them.

With the exception of electronic shufflers, it does not seem like there is any product that is used in a casino that does not now have a quality selection from various companies. This is not the way it used to be as casinos would be wary of any new competitors because it always seemed like the big three slot makers or the biggest specialty suppliers like SHFL Entertainment or Gaming Partners International were proven to be of a much higher quality than any upstarts that tried to move in on their turf. Even in the slot business it would always seem to have one or two of the big companies having some sort of issue or the new competitors bringing out a product line that was soon copied and dominated by the larger companies.

We left the Global Gaming Expo 2011 with the view that we were seeing the best slot content ever in the history of the casino business and we wondered who they were going to sell it to. We left Global Gaming Expo 2012 thinking 2011 was not a fluke with the content and that the quality of product was here to stay. We left the last show wondering how much pressure ASPs would be under with the record high number of suppliers producing quality content.

The easiest way to describe 2012 for gaming is to give the high points and low points of the year. Sadly, the low points far outnumbered the high points showing you what occurred during the year to bring us to this point.



Good Luck and Profitable Investing!!

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