Fund Dumps U.S. Casino Stocks, Buys in Asia

BOSTON (TheStreet) -- Rising prices at gas pumps have put the brakes on a rally in casino stocks, including Las Vegas Sands (LVS) and MGM Resorts (MGM).

Jeff Middleswart, manager of the Dallas-based Vice Fund ( VICEX), says investors shouldn't be enticed to buy at these lower prices. The fund is known for buying so-called sin stocks such as tobacco, alcohol, gaming and defense.

The four industries tend to thrive regardless of how the economy is performing, Middleswart says. In the recent stock-market turmoil caused by uprisings in the Middle East and the earthquake off Japan, the Vice Fund has shielded investors more than its rivals have. The fund has fallen 2.1% in the past month, compared with 5.8% for the S&P 500. As stocks rebounded last year, the Vice Fund also outperformed the benchmark index.

In addition, those sectors have historically produced high cash flow and dividends, making the Vice Fund attractive to investors who want long-term defensive growth. For that reason, the Vice Fund has a concentrated portfolio of about 30 equities.

Middleswart says the portfolio emphasizes dividend-paying companies with positive cash flow and adequate debt-service coverage, while it avoids those with red flags in financials, burdensome pension obligations and recurring write-offs. The debt issue is a key reason he says he's shying away from domestic casino names, but Middleswart is also concerned about the rising fuel costs for individuals in the U.S.

With political unrest in the Middle East sparking violent protests in oil-exporting countries like Libya, the price of crude oil has surged above $100 a barrel. Experts predicted that gasoline prices will hit $4 a gallon in the U.S. this summer; a 15% spike in gas prices already this year may mean $4 gas sooner rather than later. The impact of higher gas prices in the U.S. is expected to curb consumer spending, putting the economic recovery in jeopardy.

For many, gaming is the epitome of discretionary spending, and the impact of higher gas prices will surely be felt on related companies as gamblers put more quarters in the pump than the slot machine.

"That's definitely a part of it and it feeds into the concept of feeder markets and people having to travel, like, from Ohio to Indiana," Middleswart says. "As you have higher gas prices, that makes the long trip even more unlikely to happen."

For that reason, the Vice Fund owns no U.S. casino stocks. Instead, some of the fund's top holdings lean toward tobacco makers like Philip Morris International ( PM) and Altria ( MO), and defense stocks such as General Dynamics ( GD) and Raytheon ( RTN). Philip Morris alone accounted for more than 12% of the fund's $73 million assets as of Dec. 31.

That's not to say there aren't attractive opportunities in gaming-related stocks. Middleswart breaks down the gaming sector into four groups and gave TheStreet his view on each as well as potential investment ideas for those looking to increase exposure to the sector. Each group, from domestic and Asian casino operators to gaming-equipment companies and race-track owners, are detailed on the following pages.

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U.S. Casinos

Las Vegas Sands ( LVS) has been the biggest winner over the past year, as the stock has rallied 90%. It's no surprise to see investors taking money off the table considering that run. For example, hedge fund Shumway Capital Partners, based in Greenwich, Conn., dumped nearly 10 million shares of Las Vegas Sands in the fourth quarter, one of many institutional investors to sell stakes in the company last quarter.

Other U.S. casino stocks performed strongly as well over the previous 12 months. Penn National Gaming ( PENN) shares have jumped 40% and Wynn Resorts ( WYNN) are up a whopping 63%. MGM Resorts ( MGM) and Boyd Gaming ( BYD), on the other hand, have been laggards, up 4% each over the past year.

Middleswart says it's not shocking that many of these stocks rallied, but he doesn't see the potential for larger gains due to a confluence of issues the group faces.

"The domestic gaming side has had its huge run but, quite frankly, there's still a lot of debt on the balance sheets for most of the companies here," he says. "That's owed to both leveraged buyouts and construction that they were doing as the market was destroyed in 2008. They are carrying just a ton of debt."

Middleswart notes that there hasn't been much expansion in the U.S. over the past four years. Normally, casino operators replace equipment every four or five years to update machines, but many haven't seen replacements for seven or eight years, Middleswart says.

Another negative impact on domestic gaming companies has been a new building boom as many U.S. states look to gaming revenue to cover shortfalls. "You're seeing the expansion of gaming in Ohio, Maryland, Illinois and other places," Middleswart says. "That's going to destroy other markets. You're not going to increase the size of the gaming pie. You're just adding more players to it. The number of customers isn't going to rise by 20% because you built 20% more casino spaces."

To Middleswart, this is a perfect storm that U.S. casino operators must persevere through. Debt loads and increased competition are challenging enough, and these companies also must find capital to update and refurbish current casinos.

Middleswart says the fund previously owned Wynn but sold the company following the run-up. He says he's most bearish on Penn, MGM and Boyd, and that he sees some positives for Las Vegas Sands and Wynn because they have Asian exposure.

"They're going to get some benefit out of that, so those stocks are more higher rated to me than others," he says. "But they're also so expensive, it's a hard case to make to buy them."

Asian Casinos

While domestic casino stocks may be falling out of favor, Asian casino operators have been big winners.

Las Vegas Sands and Wynn offer U.S. investors some exposure to the Asian gaming froth, but other stocks like Hong Kong's Galaxy Entertainment Group trade on foreign markets, which can be prohibitive for some investors.

The Vice Fund owns three Asian casino stocks, including the aforementioned Galaxy Entertainment as well as Wynn Macau and Sands China. For Middleswart, these stocks have better growth potential at this point than U.S. counterparts.

"As much as they have built new casinos over the past few years in Macau and Singapore and even Australia, the difference is that they still have a very small amount of gaming capacity versus the number of people who are going to gamble," Middleswart says. "People in the Pacific spend a lot more gaming than Americans do. Americans have a surplus of casinos and they have a shortage."

Middleswart says the Asia Pacific region has a fairly small number of casinos per capita, which is why there is still decent growth potential. He also notes that there is strict control of the Asian casino market, where people are limited by the length of stay at the casinos as well as loss limits. He likens the situation to when Atlantic City casinos weren't allowed to stay open for 24 hours, or when Colorado had limited stakes gaming.

"Competition took away the loss limits and slowly opened the market further and further. You're still dealing with that in Asia," he says. However, Middleswart does not that some of the foreign issues are "certainly expensive at this point, but you could make a case that over time they'll grow into their valuations."

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Race Tracks

Middleswart may not think much of domestic casino stocks, but one race-track operator in the U.S. lands in the Vice Fund. Churchill Downs ( CHDN) is a thinly traded stock, but the company controls four of the largest race tracks in the U.S., a fact not lost on Middleswart.

"They built casinos in New Orleans and Florida and they have an online betting system for horse races," Middleswart says. "They have some growth there and they have assets that aren't leveraged. As race tracks add casinos, they'll get an extra operating facility that is next door that enables them to exploit some of their surplus real estate at minimal cost."

With casinos at the race tracks, Churchill Downs will be able to offer bigger purses for races, which will draw better horses to the company's tracks, Middleswart says. "The tracks that don't have casinos then operate at a disadvantage. That's a major positive," he says. "Given the tracks they hold, they have the Kentucky Derby, which is the biggest race every year."

Churchill Downs is comparatively better than other raceway operators, like Empire Resorts ( NYNY) or Penn National Gaming, thanks to that land ownership, Middleswart says. "You're buying it for a huge discount for even what the land is worth in today's market," he says.

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Gaming-Equipment Makers

Domestic casino stocks have had their rally, but the size of the gaming pie isn't growing enough. Because competition will force many of these gaming companies to upgrade their machines, there is potential to buy the equipment makers to capitalize on new construction and the refurbishment that has been delayed for so many years, Middleswart says.

Specifically, he singles out International Gaming Technology ( IGT) and Bally Technologies ( BYI), which he says the Vice Fund owns.

"Both of these stocks are reasonable plays because the new casino construction is going to force refurbishment and replacement demand from all the existing casinos," Middleswart says. "They're going to have to keep up and they're going to have to show they are staying fresh to keep people from the brand new casinos across the street. To the extent they see that demand, it should carry the gaming equipment companies for a couple of years."

That said, Middleswart warns that these companies won't see the same boom as in the 1990s and early 2000s as equipment makers face increasing competition from Williams Gaming ( WMS) and Australia's Crown Limited.

"They're all competing for the same contracts, so you're seeing a little more price pressure when they get deals done," Middleswart says. "But hopefully they can leverage the fixed costs a little bit and make some decent money."

-- Written by Robert Holmes in Boston.

>To contact the writer of this article, click here: Robert Holmes.

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