Larry Haverty, portfolio manager for GAMCO Investors in New York
Wahid Chammas, senior research analyst at Janus Capital Group in Denver
Joe Fath, portfolio manager of T. Rowe Price & Associates in Baltimore
With the increased cost of a tank of gasoline equivalent to the cost of a few cocktails, fewer tourists are driving to Las Vegas. With airlines cutting back flights to town, it will be harder to fill hotel rooms. And the Strip has grown posh, making it less attractive to the masses.
But that barely touches on why gaming stocks have lost more than $50 billion in value since their peak last year, when Vegas was hot, financing was easy and gaming outperformed most sectors of American business.
The bigger reason for the plummet is found halfway around the world, where profits by Las Vegas operators in Macau are disappointing some investors simply because they’re not as sky-high wild as they were initially. And back home, investors wonder whether Las Vegas is finally overbuilt.
Those are among the observations of a trio of portfolio managers who have followed the gaming industry for more than a decade.
We asked them to explain what has happened to gaming stocks and what’s on the horizon. Their conclusion: The gaming industry has a bright future — mostly beyond Las Vegas.
For this story, we posed the same three questions to Larry Haverty, portfolio manager of GAMCO Investors in New York; Joe Fath, portfolio manager at T. Rowe Price & Associates in Baltimore; and Wahid Chammas, senior research analyst at Janus Capital Group in Denver.
They manage millions of dollars for institutions such as foundations and pension funds that take a longer, big-picture view than Wall Street analysts, who focus on quarterly returns.
Q: Why have casino stocks lost more than half their value in recent months and what’s the longer-term outlook?
Joe Fath: There’s psychology in play. When there’s hubris and everyone’s excited, investors can drive these stocks up further than they should go. Now the opposite has happened. It makes no sense that this much value has been created and then destroyed.
The stories behind these companies haven’t changed much and yet a lot of short-term investors are piling on and shorting these stocks. These guys will eventually get washed out of the market.
The bottom line is you try to measure risk versus reward and when you have a good ratio, you can invest for the long haul. This other stuff is more cyclical.
Is Macau shutting down casinos? No. Are we like Japan, with an economic decline hampered by a difficult regulatory environment that plays out for many years? While there’s no catastrophe at hand, there is a lot of supply coming and you could have a bad situation get worse.
Larry Haverty: The real problem is inflated oil prices.
If airlines continue to cut capacity then Las Vegas will be overbuilt because people can’t fly in. The incremental price of gas is like one or two extra drinks at the bar, which is going to discourage people from driving but it’s not going to destroy the business.
Longer term, I don’t think the price of oil can sustain anything near $130 a barrel. It’s unleashed hell on the economy and something has to give. This isn’t being driven by demand. There’s plenty of oil to go around, but commodity speculators are driving up oil prices. Eventually there will be too much product and not enough demand and the speculators will drop out.
Also, the industry was too aggressive in raising prices on food and beverage, which need to come back to reality.
The bottom line is that operating profits are down 20 percent or so on the Strip, but they’re still generating lots of free cash flow and stocks are set to rebound significantly.
I think the sell-off is also a function of fund managers who tend to be young and inexperienced. It’s short-attention-span theater, with nearly every mutual fund in the industry turning over 100 percent of their portfolio in a year and hedge funds turning theirs over more than once a month. This can be a significant buying opportunity for the rest of us.
Wahid Chammas: Las Vegas needed to build enough properties to drive enough visitation and create the demand. That’s the first phase of growth.
When Las Vegas diversified away from gaming and transformed into a true destination resort town, that’s when it also bolstered profit margins, which is the second phase of growth we witnessed, starting in the late 1980s.
Las Vegas created a captive audience because, as visitation grew, everyone wanted to be there. Eventually people were spending more than three days per trip, hotels were cashing in on more profitable venues like rooms and spas, and more than 50 percent of revenue came from nongambling sources.
The third phase of growth occurred when land and asset values grew, securitization developed and companies could further leverage their assets. So you’re not just earning in your buildings, you’re using those buildings to raise money for new projects or pay down debt.
From the 1950s to 2007, these three phases propelled these stocks.
Other locations outside of the United States realize the magic of creating a resort destination model and that you don’t necessarily need to rely on hard-core gamblers for it to work.
Once demand returns, I think there’s also room to grow in America because there are many fewer people who gamble here than in other markets, like Australia and Scandinavia.
If we’re in a consumer recession, it’s going to be extremely difficult for Las Vegas operators to beat what they did before in phases 1 through 3, which is a tough act to follow.
Companies need to hunker down and focus on returns on invested capital, which may mean delaying projects or spending capital they generate in Las Vegas elsewhere, where returns are better.
Casinos are capital-intensive and don’t seem able to sustain returns in the long term as their fixed costs increase. Is this a concern?
Fath: As construction costs go up and projects get more complex, returns will drop.
Vegas is a saturated market. You can’t just be the new guy on the block. You have to be the next best thing — that’s how you beget more demand.
It wasn’t that long ago that you could easily make more than a 10 percent return because your cost of capital, after deductions, was so cheap. So you saw projects built at a lower cost structure that wouldn’t get built today.
If you’re new to Vegas, the odds are against you that you’re going to get a good return on your investment. That’s why investors are focused on emerging markets, like Singapore and Japan.
Haverty: The price of poker has increased. The price of entry in Las Vegas is probably $1.5 billion, which helps established operators. It would probably cost $4 billion to build Bellagio today. That means Bellagio’s return goes up over time but the return on the second Bellagio won’t be as high. The cost of financing is rising, but things like CityCenter and Echelon were financed last year at extraordinarily low cost.
Chammas: Returns have diminished in the United States. I expect these companies to use incremental dollars to invest in jurisdictions or in other ways, such as buying back stock, that give them better returns. So long as companies earn strong returns that exceed their cost of capital, they could be worthy of investment for years.
What’s going on in Macau and why should we care?
Fath: Macau is already bigger than Vegas in gaming — and growing at a 60 percent clip. The problem is, Wall Street wants instant gratification. The analysts will put out a hugely optimistic growth rate of 70 percent and if it comes in at 68 percent they think it’s slowing.
The May gaming numbers from Macau will probably be in the 30 percent range, but that’s coming off 70 percent growth a year ago. Some analysts complain about shrinking returns, but the fact is that they’re still phenomenal. Wynn Resorts is earning more than $500 million in operating profit in Macau, much stronger than anything in Las Vegas.
Haverty: Macau represents a mind-boggling growth opportunity. What’s troubling for investors is that too much cash is going into the hands of junket operators, who put up little money to bring high rollers to the casinos and skirt the rules of currency conversion.
That’s why some returns have been disappointing. Eventually regulation is going to become more investor-friendly and once Sheldon Adelson builds out the infrastructure on the Cotai Strip, Macau and Cotai are going to become fantastically successful propositions for investors.
Chammas: Growth in Macau and in other new markets like Singapore is a very big factor in the valuation of some of these stocks. Investors haven’t yet appreciated the profit potential of visitors who will eventually stay in Macau for longer periods of time, nor do they appreciate the potential of using these resort assets to finance additional capital and pay down debt. Macau is an island with very limited land availability — the real estate story is fantastic. Also, as Chinese currency appreciates against the dollar, profits in Macau, where casinos take in the majority of their money in renminbi, could rise significantly.
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