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By Joe Escalada

There is drama unfolding between Stephen Wynn and Kazuo Okada, key players of Wynn Resorts, Limited (NASDAQ:WYNN). WYNN shares depend on the Okada-backed Wynn Macau resort for profitability. A Nevada lawsuit filed on February 19 formalized the bad blood between Stephen Wynn and Kazuo Okada. As information and decisions regarding this dispute come to light WYNN shares are likely to fluctuate in price. Should investors jump on WYNN shares if they become cheaper, or should they stay away from the casino and resort industry?

Unfortunately, this industry is an investing nightmare beset with seemingly endless capital expenditures. Investors should steer clear of industries which require enormous cash outflows to attract the tourist traffic and the chance to compete for future cash inflows. This basic premise of discounted cash flow-based valuation is not consistent with firms that duel by building ever grander spectacles.

Industry Issues

Unfortunately WYNN and its rivals MGM Resorts International (NYSE:MGM) and Las Vegas Sands (NYSE:LVS) have experienced a decade of capital expenditures exceeding operating cash flows:

Free Cash Flows ($ Millions)

Year

LVS

WYNN

MGM

2002

-50

-77

528

2003

-143

-437

138

2004

-92

-1,123

126

2005

-271

-829

423

2006

-2,122

-462

-667

2007

-3,428

-391

-1,923

2008

-3,661

-854

-29

2009

-1,454

53

451

2010

-154

773

297

2011

1,154

1,332

374

Average

-1022

-201

-28

The last decade's long term free cash outflows are troubling. These developers are forced to compete against each by building bigger and better casinos other in order to draw business.

I should point out that many casino companies, in truth, are more real estate developers than anything else. They are excellent at raising money to build giant, eye-popping buildings. The main activity of these firms is spending money on real estate development, not the gaming business. This should scare investors.

This caution can be made clearer with by using the banking system as an analogy. Prior to 2007, many banks were originating and securitizing residential mortgage loans with loose underwriting standards. These banks were issuing loans based on boom-era real estate price increases. They were also used for less than 1% of their loans missing payments and becoming nonperforming loans. Before 2007, many of these nonperforming loans could be salvaged through profitable foreclosure sales into rising real estate prices.

Clearly, these banks had no experience dealing with meaningful mortgage credit risks and substantial losses until the market peaked. They were in the mortgage marketing business, not in the risk management or credit pooling business. They were not banks in the traditional sense because they did not manage credit risks to turn a profit. Investors slowly started to figure this out after real estate peaked.

Similarly, many big Las Vegas casino companies are not in the business of managing maturing casinos. Rather, they keep building new ones. These companies stay afloat by finding new lenders, issuing shares, and building monster casinos. This is what they do. Their success is much less about how well they perform as casino operators and more about clever financing and ever-bigger projects. Be skeptical of the ability of companies like these to turn a profit from aging casinos.

The House Doesn't Always Win

Despite popular misconceptions, it is possible for a casino to run an operating loss. It is a surprisingly tough business that requires a lot of labor: Servers and dealers service customers, security watches over gamblers, security watches over employees, and security watches over other security. This labor intensive business requires a lot of asset turnover to justify overhead. MGM Resorts (MGM), WYNN and Las Vegas Sands (LVS) each have had operating losses in at least one year since 2002:

Operating Profit ($Millions)

Year

LVS

WYNN

MGM

2002

87

-34

767

2003

137

-53

713

2004

373

-90

951

2005

590

-25

1,357

2006

-197

71

1,758

2007

365

429

2,864

2008

128

314

-130

2009

639

235

-964

2010

1,870

625

-1,080

2011

2,662

1,008

-1,087

Average

665

248

515

Even with amazing capital expenditures funding spectacular real estate development, there are still years with operating cash outflows. No, the business doesn't just take care of itself. "If you build it, they will come" seems to be fantasy.

Searching for Value Among Big Casino Stocks

Please think twice before jumping into WYNN based on price fluctuations. If somehow you are deadest on investing in the resorts and casino sector, note that WYNN is not cheap. At $121 per share this large-cap stock trades at a price-to-book ratio of 5.8, a price-to-earnings multiple of 24.8, and a price-to-sales multiple of 2.9 (trailing twelve months). Past returns to book equity have been blah: This past decade shareholders saw a mere 2.8% average annual return on equity.

MGM shares are less richly valued at about $14 per share, even after a 31.5% change in share price over the past year. At present, shares of this mid-cap stock trade at a price-to-book ratio of 1.1, a price-to-earnings multiple of 2.5, and a price-to-sales multiple of 0.9 (trailing twelve months). MGM has been beat up over the past decade. Shareholders sustained a -1.4% average annual return on equity. MGM has also diluted its ownership of its high-growth Macau operations, generating proceeds to help keep the company liquid.

Las Vegas Sands is richly valued near $55 per share. LVS shareholders have savored a 28.3% change in share price over the past year, inflating valuations. At present, shares of this large-cap stock trade at a price-to-book ratio of 5.1, a price-to-earnings multiple of 35.2, and a price-to-sales multiple of 4.3 (trailing twelve months). Of the three firms it has grown shareholder wealth the most. The past decade shareholders savored a 13% average annual return on equity. Like other firms in the industry it has been engaged in debt refinancing for its spending projects.

There are no attractive plays in this overbuilt, capital intensive industry. If you refuse to heed this warning and are compelled to betting on gambling stocks, bet on MGM. It is the most attractively priced.

Source: Should Investors Consider These 3 Gaming Stocks?