The Chinese government’s crackdown on corruption, increased high-roller scrutiny and a partial smoking ban have put a serious damper on the Asian gambling mecca of Macau.

[ad#Google Adsense 336×280-IA]Gaming revenue in the former Portuguese colony fell for the eighth consecutive month in January, down 17.4% year over year.

February is expected to be much worse — the worst on record, in fact, with analysts anticipating a 35% to 42% decline over 2014 levels.

U.S.-based casino operators are also seeing lower gaming revenue from Sin City.

After four years of annual gains, gambling revenue on the Las Vegas Strip fell 2.1% in 2014, according to the Gaming Control Board.

While gaming stocks in general seem unattractive against this backdrop, one in particular already appears to be against the ropes with lofty valuations, high debt levels and poor technicals.

This makes it a prime target for a sell-off after next week’s earnings report.

MGM Resorts International (NYSE: MGM) currently trades at 40 times forward earnings, almost double its peer group average of 23. While companies that are growing earnings faster than their peers often deserve a higher P/E ratio, analysts are only forecasting EPS growth of 12.5% a year for MGM for the next five years.

A PEG ratio, which compares a stock’s P/E ratio to its EPS growth rate, of 1 is widely accepted to represent a stock at “fair value.” MGM sports a PEG of 3.2, signaling that it is overvalued.

The casino operator also carries $12.92 billion in debt, which is high at 5.95 times its annual EBITDA, compared to 3.91 times for its peers.

Exacerbating these issues is the negative effect of currency exchange rates. The U.S. dollar has been strengthening against most currencies over the past six months. This is problematic for multinational companies like MGM, as the dollars they earn overseas are worth less when they are converted into earnings here.

Negative currency impacts may have trimmed up to $12 billion from the revenues of U.S. corporations in the final quarter of 2014 alone, according to currency expert Wolfgang Koester.

MGM derives roughly one-third of its revenue from Macau. A little back-of-the-envelope math tells us how much this could affect its overseas profits. In the third quarter, MGM China generated adjusted EBITDA of $214 million. In the past four months, the U.S. dollar has gained roughly $0.14 against the Chinese yuan. Assuming adjusted EBITDA is flat in Q4, MGM could end up sacrificing close to $30 million in profits.

While we don’t know exactly what the impact will be, this gives us an idea of the potential effects. As the dollar strengthens and earnings increase, these currency losses will only grow larger.

A number of factors point to the continuation of this trend. As the U.S. economy and labor market improve, the Federal Reserve will eventually increase interest rates, strengthening the greenback. And with inflation at a five-year low in China and 2014 representing the weakest annual expansion in the country’s GDP since 1990, many experts anticipate more stimulus that would further depress the yuan against the dollar.

Shares of MGM are down 24% from their July high compared with a 5% gain for the S&P 500. MGM has also failed to surpass a single previous month’s high since July, spawning a bearish channel. The upper boundary of that channel, along with the 50-day moving average, should act as resistance.

A bearish wedge is also forming, which forecasts a big, downward move on a breakdown.

I believe the catalyst for MGM’s next leg lower will be the company’s upcoming earnings release, which is scheduled for Feb. 17. While MGM may meet analysts’ estimates, I believe guidance will be lackluster and investors will sell.

Based on options activity and how the stock has moved following previous earnings reports, we can expect a move of at least 5% after the announcement.

From that point, I believe it may take a few more months and possibly another earnings report to send shares down to my target of $18.30, which is the opening price from Dec. 17, when MGM made its 52-week low.

While that target sits about 12% below current prices, we can leverage that move using a put option strategy into a potential 43% gain without taking on the risk of shorting the stock.

MGM Put Option Trade

Today, I am interested in buying MGM Jun 24 Puts for a limit price of $4.

Risk graph courtesy of OptionsHouse.

This put option has a delta of 76, which means it will move roughly $0.76 for every dollar that MGM moves, but it costs a fraction of the price of the stock.

The trade breaks even at $20 ($24 strike price minus $4 options premium), which is 4% below current prices.

If MGM hits my downside target of $18.30, our put options will be worth at least $5.70. Once you enter the trade, place a good ’til cancelled (GTC) order to sell your puts at that price.

Recommended Trade Setup:

  • Buy MGM Jun 24 Puts at $4 or less
  • Set stop-loss at $2
  • Set price target at $5.70 for a potential 43% gain in four months

Jared Levy


Source: Profitable Trading