Notable Calls

Goldman Sachs is upgrading MGM Mirage (NYSE:MGM) to Buy from Neutral this morning with a $16 price target (unch).

According to the firm their upgrade is based on:

1) Their expectation that Las Vegas trends will start to get “less bad” over the next several quarters, 2) MGM’s earnings power currently being at trough levels, but even if it were to get back to the mid-range of its historic earnings potential, there is strong upside to the shares, 3) shares are undervalued on current and mid-level earnings, especially relative to those of its peers, 4) corporate finance activities could create a relief rally as balance sheet issues would weigh less on the shares, and 5) there will be little new supply in Vegas after current projects open.

Goldman notes thier upgrade offers both high risk and high reward, in that it is based on a Las Vegas recovery that is in very early stages and could stall out by a weaker-than-expected consumer or because they are underestimating the impact of room over-capacity. But they are lowering their MGM estimates: the firm now believe that earnings are close to trough levels and that valuation is closer to the mid-point of the historical range, creating great upside if there is a turn.

MGM, with its 40,000 Strip rooms (35,075 excluding the Las Vegas City Center) and approximately 27% market share, is the purest play on a Vegas recovery. The company has made a series of missteps that led the shares to underperform over the past two years. Notably, MGM did not rally in 2009 while nearly every other casino stock did, illustrating long-term investor concerns about the shares. MGM’s “mistakes” include 1) the build out of CityCenter which even in Goldman's best-case scenario will not make more than a 5% return initially; 2) basing cash flow and returns for City Center on selling high-end condos on the Vegas strip even while the city was facing an unprecedented building surge and after seeing resale weakness at MGM’s own Signature tower; and 3) not moving early to lower its debt load through a capital raise, which has left the company highly leveraged at 8.7X net debt-to-forecasted 2009E EBITDA.

Although some may view this as “water under the bridge” the firm notes they are not willing to give MGM “a pass.” To them, it illustrates the broader problem of Vegas developers in general that is not exclusive to MGM. For what has seemed like forever, casino executives have exhibited an extreme desire to build more casinos to “sustain growth” rather then trying to boost same store sales, improve ROIC/margins and return cash to shareholders to “create value.” Even with these broad-based concerns for all of the casino companies, they are upgrading MGM.

MGM is trading at a discount to its history along with LVS and Wynn non-Macau operations
MGM appears undervalued relative to other gaming equities. On Goldman's revised 2010 EBITDA estimate it has an 11.3X multiple, which is a discount to Las Vegas Sands and Wynn. More interesting is the comparison to Las Vegas Sands and Wynn looking at the implied value for non-Macau assets. Firm looked at Las Vegas Sands and Wynn and separated out the value of their free trading Macau equities and come up with a 16.6X multiple on Las Vegas Sands’ US and Singapore assets and a 13.7X multiple on Wynn’s Las Vegas assets. MGM’s multiple is several points below these data points. Even compensating for the higher leverage of MGM it seems that this discount is too high. They suspect this is due to investor concerns about the initial profitability of City Center, but given our long-term view that Las Vegas will recover with the broader economy, the valuation disparity just seems too wide.

MGM’s missteps over the past few years, coupled with its leverage, may have created a situation in which most investors have overlooked its earnings power. Furthermore, like Goldman, if investors want to benefit from a travel recovery they would rather buy the hotel stocks. Goldman agrees with this from a fundamental perspective, but given MGM’s discounted multiple and strong earnings power they are willing to take this risk given the potentially major reward.

Notablecalls: With a blessing from Goldman Sachs the shares of MGM can & probably will trade higher today. The futures are in the red in the early going (thanks Alcoa!) which may give you some decent fills in the pre market.

I expect MGM to trade up 5-7% today - $11.45-11.75 range.

Note that the short interest in MGM stands at a whopping 47%.

Goldman is also out somewhat positive on LVS & WYNN.