The "pick of the week" for long term investors: Casino stocks.
We used to think that casinos were recession-proof. But this time, casinos have seen a major slowdown in the industry.
What happened?
In previous years, most big casino companies made major investments using high leverage to build pharaonic projects. Unfortunately, a major slowdown in business along with major debt payments have pressured these companies.
Casino stocks used to be cash cows through three sources of revenues :
- Conference / Seminar / Sports Event: Corporations used to motivate their staff with seminars in Vegas. Major tech events or business events were held in the conference centers of big Vegas hotels. Big sporting events are also often held at casinos. These events generate revenues through use of the casino. The corporate people usually come to Vegas for free (as their company covers the cost of the trip) so they can then overspend in the casino.
In this crisis, public relations played a part as events in Vegas were not well received by Main Street. So we have seen a major drop in corporate events. Also, with the process of controlling costs underway for most corporations, the number of conferences have slowed. This has directly impacted casino returns.
- California : A big chunk of Vegas revenue traditionally comes from citizens of California. But California has been strongly hit by the crisis. Californians have had to cut their spending and Las Vegas is no longer a priority. In previous recessions, California has stepped up but this time it was at the center of the storm.
- Tourism in general : No more credit means less consumption, so less spending by tourists, which lead to less revenues for casinos.
What are the risks now ?
Here are the major risks that the investor has to keep in mind:
- Length of the crisis: This crisis is different than all the preceding ones casinos have faced. We can probably bet on the fact that as soon as growth comes back (even slow growth) casinos will see a pick up in their business.
- Liquidity: Casinos used to be cash cows, but a big slowdown in their business along with huge investment commitment risk has created a cash crunch. Management tried to respond to the crunch with major cost controls and suspension or limitation of their investments. They are also restructuring their debt to reduce short term payments. Casinos are betting on a quick return of growth to allow them to cover long term debt payment.
- Debt exposure: Most casinos are highly leveraged right now. They are facing major payments that increase bankruptcy fears.
- Dilution: In order to clean up their balance sheets, casinos have issued tons of shares. This has created a major dilution for current shareholders. Now, will we face future dilution to improve balance sheets in order to cover future investment commitments?
What are the advantages?
To see the long term potential of casino stocks we need to ignore the short term effects of the recession and focus on what makes these businesses different than others:
- Cash cows: Casinos usually generate major positive cash flow. So generally their debt exposure isn't an issue because they can easily face coupon payments during normal economic times.
- Strong long term margins: Usually casinos enjoy solid margins during normal economic conditions. Growth margins are very impressive because remember: Casinos always win at the end. Don't forget that over the long term, debt pressure will decline and margins will improve from that.
- Expansion in Asia: Many casinos are starting to reap returns on their Macau investments. With the development of Macau, we can expect very strong growth outside of Las Vegas that should be very solid. We can compare Macau to the early stages of Vegas when The Strip first began to grow.
- Human Nature: Let's be honest, most humans are naturally gamblers. Who doesn't want to bet on the outcome of a sports event? Or play poker or roulette or craps? Most people are always attracted to gambling. (The level of addiction is, of course, different in each person, but still demand is clearly there)
- Long term growth: Long term growth of the industry is clear. People will always go back to their old vices, like gambling.
- Cost Control: Thanks to the crisis, casinos are finally taking into account cost controls. We can now expect that these cost controls will have a very positive long term impact in the P&L. In the past, there was a lot of overspending and no real cost control. Now with the recession, managements are finally handling their expenses. This will have a very positive effect over the long term.
- Gambling Laws: This business is directly exposed to government decisions. Laws could have a good or bad effect on the casino business in the long term.
Potential good picks?
- Wynn Resort (WYNN) : This is clearly the best company in the industry in terms of balance sheet and management. Wynn has managed its cash. Its market is the high income gambler and it has a great brand name with this type of customer. Wynn has a strong presence in Las Vegas and in Macau. The dilution for shareholders has been very low if you compare it to other big casino players. It is clearly the best long term pick.
- Las Vegas Sands (LVS): Las Vegas Sands has a major advantage over the long term in comparison to its competitors : Its casino in Singapore is the only casino allowed there. This casino will probably provide huge revenues when the economy picks up. Now, we shouldn't forget the high dilution the stock has already had. But for new shareholders, this dilution shouldn't have a major effect as we don't expect further stock dilution. What remains to be seen is how management will handle the debt exposure because LVS committed itself to huge investments before the crisis. We also need to see if LVS will be able to finish all of its projects after the recession. This should provide very positive long-term rewards.
- MGM Mirage (MGM): MGM made huge investments right before the crisis hit (its Citycenter project, for example). This brought major pressure to MGM's balance sheet and bankruptcy fears have been very high for this company. Now it seems that it has been able to restructure its debt and find financing to cover future payments and finalize its projects. If the economy picks up and Las Vegas returns to the growth people expect, MGM Mirage is strongly exposed and should be well rewarded. The stock has already experienced dilution, and more could be in store to provide for future debt payment. But if the company makes it through the crisis without going bankrupt, long term growth is very attractive.
- Melco Crown Entertainment (MPEL) : This casino stock is less well known than the previous three but the company is involved in some very interesting long term projects that could offer strong rewards for its shareholders. Its balance sheet isn't great but it isn't also in worse shape then MGM and LVS. Crown has high exposure in Australia and in Asia so it will be directly impacted by the long term growth of Asia's gambling market. It could be a very interesting underdog that could provide a surprising upside for its investors.
So what do we do ?
I think casino stocks strongly correlate to the economy. There are many positive elements for long term investors.
Right now, I think that the current rally will end and we'll have another leg down (or two) before moving to a new bull market. Casino stocks will probably dip again before rallying too. Timing in this investment is important.
I would invest in casino stocks as soon as I see any serious recovery in the economy. I will monitor the credit markets and if I see a real pick up in this area of the economy. I will then pick casino stocks to hold for a long time. I don't need to be worried about dilution because when the economy grows again, hotels will generate plenty of cash to help the development of their business. The upside will then be huge when you consider long term development potential for Vegas, Macau and Singapore.
When the economy really starts to grow again, these stocks will outperform the overall market (in the next bull market).
Disclosure : No positions
