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    The Call @ Hedgeye Plus

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Let’s face it. Gaming stocks stink. The average gaming operator is down over 80% year-to-date and 90% in the last 12 months. Even yesterday, in an 11% market move, gaming stocks were flattish. The reasons for the underperformance are very clear in hindsight: gaming is a highly leveraged consumer sector that is overly reliant on housing (See “IT’S THE HOUSING STUPID” from 07/17/08). Certainly, not where you want to be in a credit crisis where cash is king, consumers are de-levering, and housing prices are falling off a cliff.

Having said that, gaming operator stocks are trading at all-time lows. Some, BYD, PENN, WYNN, and even PNK, have liquidity to ride out the storm. Free cash flow for BYD, PENN, and WYNN is actually accelerating. But I’ve made this point for a few months and there has been little divergence in the stocks.

When will gaming stocks start going up? There are signs that it could be soon. Not only soon, but the moves could be big. Gaming is now a heavily shorted sector in need of a catalyst. Consider the following:

• October vs September– In the regional markets, September was awful from a revenue standpoint and could mark a near-term low. Our channel checks in the regional markets indicate that October is much improved.
• High short interest – The first chart shows the heavy short interest in the space
• Getting toxic earnings and guidance out of the way – Expectations for Q3 earnings and forward guidance is appropriately low. So far, stocks have gone up following the releases.
• Gas prices – We’ve shown that gas prices are a statistically significant driver of gaming revenues in the regional markets. As the second chart shows, gas prices have come down considerably.
• Month end – Sell the losers into month end! Not many bigger losers than gaming.
• Macro November thaw call – Keith McCullough has gotten more positive on the market, due in part to credit spreads improving
• Winding down of selling by big, long-only funds
• All time low valuations – leaving plenty of upside

At the very least, it seems that staying short this sector right now could be a dangerous game. We still maintain a negative intermediate consumer call here at Research Edge as consumers de-lever and the savings rate escalates. However, the trade looks higher. The safer plays that would still offer significant upside in a short squeeze are probably those companies on the right side of the liquidity trade: BYD, PENN, and WYNN. BYD and PENN have already announced earnings.

If you believe me on the thesis, the most interesting play could be PNK. Earnings will be released next week on Thursday. I expect a less than toxic Q3. More importantly, management should be able to allay liquidity fears on the conference call. There are no covenant issues until possibly Q2 but the company has a lot of levers to pull to maintain the appropriate leverage including, cessation of construction in St. Louis, cost cutting, and a temporary cut in maintenance Capex. Secondly, we expect a fairly upbeat discussion of October trends versus September. PNK actually maintains exposure to the stronger performing markets.

There seems to be a lot of upside to a stock at $2.75 per share and with 20% of the float short if investors could be convinced that: a) business has not fallen off a cliff and b) the company is not going bankrupt.

Recipe for a short squeeze
Gas prices are a statistically significant driver of regional gaming revenues.