Undervalued Gems

	Paul Tracy Street Authority.com
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How many times over the past year have you heard market pundits complain about a "bad" market? Chances are you've heard that phrase used countless times on financial television and seen it written repeatedly in business newspapers.

But what exactly is a "bad" market? Most likely, what the pundits are referring to is a market that's essentially flat. Although we've seen some dramatic swings to and fro, the broader market indices have barely budged for over a year.

And, as I indicated in today's opening commentary, the market is likely to face several major headwinds going forward. These will likely place a cap on any rallies. As such, I believe the broader market will continue to tread water throughout the next few quarters.

But the good news is that, in truth, there's no such thing as a "bad" market. Smart investors can earn impressive returns in any market -- even when the S&P 500 is flat or selling off. The trick is to invest in the most promising sectors and individual stocks. In short, there's always a bull market at work somewhere.

The key to finding those bull markets is careful stock selection. In today's article I'm going to focus on valuation levels. More specifically, if you're able to identify the most attractively valued securities in a promising industry group, then you should make solid profits as these firms' valuation levels return to industry norms.

While identifying the most undervalued stocks in a group isn't always as easy as it might sound, a detailed examination of valuation, profitability and growth ratios can clarify the situation.

Going forward, my staff and I will be performing just this type of analysis in all of our future "Sector Spotlight" articles. We'll run the numbers, present a table of the main industry players and then highlight in greater depth the stocks that look most undervalued in each group.

In today's issue we'll offer a preview of this analysis. In the process, we'll examine two interesting industries -- gambling/hotel casinos and oil tankers -- and will attempt to determine the most promising candidate from each group.

Gambling/Hotel Casinos
The gaming industry is estimated to be a $60-billion-dollar a year business. It includes casino operations, state lotteries, pari-mutuel wagering, charitable gaming and gaming-equipment manufacturing. Half of all gaming revenues come from casino winnings. The other half comes from entertainment, hotel rooms and restaurants. About 65% of gaming revenues come from slot machines, which are preprogrammed to pay out certain amounts. According to industry experts, gaming generates more revenue than spectator sports, recorded music, theme parks, and cruises combined.

Gaming companies continue to aggressively expand in both new and existing markets. Whereas only Nevada and New Jersey allowed gambling 14 years ago, casino gambling is now legal in more than 20 states. The geographic expansion of casinos and lotteries has been fueled by a desire on the part of state governments to create jobs, boost tourism and generate more tax dollars. Also assisting the expansion is the federal government's passage of legislation that allows Native Americans to own or operate casinos in various states.

According to a recent study, there are an estimated 51 million-plus casino gamblers in the U.S. As a group, these gamblers make about 300 million trips to casinos each year. About a quarter of the adult population has gambled at a casino at least once in the past 12 months. State lotteries have also helped boost interest in gambling. Lotteries are now conducted in more than 30 states.

The aging and growing Baby Boomer generation continues to spend money on leisure activities such as gambling. This demographic alone could provide a solid long-term foundation for revenue growth, as the number of people over the age of 55 is projected to double over the next 25 years. This older generation tends to have more free time and more disposable income to gamble with.

Another trend that seems to be picking up in the gaming industry is the development of "racinos." Racinos involve a combination of racetracks with slot machines. Many states -- including Massachusetts, Maryland, and Maine -- are now considering allowing racetracks to develop gaming rooms with slot machines on the premises. Gambling equipment makers could see a surge in business in the coming years thanks to new demand for slot machines from racinos.

In addition to adding new jobs to the local economy, casino gambling is recognized as a means of stimulating state economies through the addition of new tax revenues. It's that recognition that has spurred the expansion of gambling throughout the country. Meanwhile, international markets could also provide a huge catalyst for future industry growth. For example, the U.K. is considering deregulating the use of slot machines. Only a few thousand slots are in use there now, but with less regulation, the long-term potential in that market could be enormous. And finally, gaming equipment makers are constantly working to create new slot machines and other games. The introduction of popular new slot machines, as well as cashless machines, should also fuel industry growth in the coming years.

In the table below my staff and I perform a comparative valuation analysis on the fast-growing casino industry based on several key valuation and operating criteria. Based on our analysis, the most undervalued stock in the group is Sands Regent (SNDS).

Each column of our table highlights a different evaluation criteria for the stocks in this industry. I've highlighted in yellow the three top performers in each category. For example, the three stocks with the highest earnings growth are highlighted in yellow; so too the three stocks with the lowest price-to-earnings to growth (PEG) ratio.

Sands Regent really jumps from this table. In all but one category, the stock ranks in the top three.

The company looks particularly undervalued on several valuation metrics. For example, Sands' Enterprise Value/EBITDA (Earnings before Interest Taxation Depreciation and Amortization) stands at less than 6 times, the lowest in the industry. Meanwhile, the firm's Enterprise Value/Revenue ratio is the lowest in the industry at just 1.06.

The company's PEG ratio is also remarkably low at less than 0.80. Any number under 1 is considered undervalued, but it's also important to read between the lines and figure out why a company has such a low PEG. For example, companies with extraordinarily high earnings growth estimates may well have trouble meeting those estimates in future. But such firms can sport low PEGs if P/E ratios are reasonably low. In contrast, mature companies with very low or moderate growth rates can score reasonably well on PEG if their P/E's are depressed due to poor business profitability or other problems.

In this case, Sands' PEG is supported both by a high projected long-term growth rate of +20% and a low Price-to-Earnings (P/E) ratio.

The one ratio where SNDS scores low is Operating Margin, a measure of profitability. At just a touch over 10%, SNDS is near the low-end of the industry group. But that's not much of a concern either -- the firm's margins have been depressed partly due to recent acquisitions and expansion rather than fundamental business problems. With these points in mind, let's take a closer look at the company.

SANDS REGENT (SNDS, $9.70)

Business Overview
The Sands Regent is a Reno-Nevada based gaming company. The firm's flagship property is the Sands Regency Hotel and Casino, located in downtown Reno. The Sands Regency has more than 800 hotel rooms, and boasts nearly 30,000 square feet of gaming space, including a sports book, poker room, and keno lounge. The property also features a health spa, several entertainment venues, and a large convention center.

Additionally, the company also operates the Gold Ranch Casino, a slot parlor and RV park located in the California border town of Verdi, Nevada. Its newest property is the Rail City Casino in Sparks, Nevada, which it acquired from Alliance Gaming in May 2004.

Competitive Advantages
While the big boys like Harrah's and MGM Mirage battle for supremacy on the glitzy Las Vegas strip and other high-profile destinations across the country, the Sands Regent is quietly raking in gamblers' money in some of Nevada's smaller markets. Considering many of the firm's slot and table players are locals rather than visitors, the firm is much less dependent on tourism than some of its larger rivals.

Should leisure and/or business convention travel slow down for any reason, the Sands Regent should be better equipped to weather the storm. It has cultivated a strong base of local patrons, and has also fostered a sense of brand loyalty through its regular promotions to keep them coming back.

Growth Drivers
While not exactly the gaming Mecca of Las Vegas, Northern Nevada is still one of the nation's larger gambling markets. Lake Tahoe is a magnet for tourism, particularly when snow skiers invade the area each winter, and many visitors choose to stay in nearby Reno. Furthermore, the region draws additional traffic from Sacramento, CA, which is only a short two-hour drive away. All three of the Sands' properties lie along the busy I-80 corridor, which connects Sacramento and Reno.

The area has been struggling in recent years to recover from the introduction of Indian casinos in Northern California. Harsh winter weather has also, at times, kept visitors away. In fact, executives representing many Northern Nevada casinos have held summits recently to discuss ways to reinvigorate sluggish growth.

Luckily, though, the long-term growth prospects for The Sands Regent are bright. The firm's new Rail City property -- which it acquired a little over a year ago for $38 million -- has been a boon. It is primarily a locals-only casino visited by residents of the greater Reno/Sparks area, thus making it somewhat insulated from poor weather or a downturn in tourism. Last quarter, while revenues generated from the Sands' other two casinos sank -7.1%, overall revenues company-wide jumped +40% to $18.4 million thanks to the addition of the new property. Likewise, Rail City helped the firm's overall operating income surge from $145,000 to $802,000. In fact, thanks to rising revenues and expanding margins, company operating income year-to-date has soared +158% to $5.3 million.

Next up is the planned acquisition of the Depot Casino and the Red Hawk Sports Bar in Dayton, Nevada, which is expected to close later this year. This purchase will help the firm diversify its revenue stream and will give Sands two of the three casinos in Dayton. This is the largest town in Lyon County -- Nevada's fastest growing county, which has enjoyed population growth in excess of +16% over the past few years.

Valuation and Outlook
While Sands Regent may not enjoy the same financial clout or name brand recognition as its deep-pocketed rivals, it does have something that many of its peers don't -- a healthy balance sheet and compelling valuation levels.

While larger casinos have become increasingly leveraged, SNDS has been generating significant cash flows, which it has used to pay down debt. Long-term debt, which stood at $36.9 million at this point last year, has been reduced to just $21.4 million at the end of last quarter. The pending purchase of the two Dayton, Nevada properties, mentioned earlier, will be financed almost entirely in cash.

Furthermore, Sands Regent is one of the most affordable companies in the entire gaming universe. With earnings projected to grow at a healthy +20% compounded annual clip over the next five years, the firm is trading at a microscopic PEG ratio of just 0.78 -- the lowest reading for that critical metric in the entire industry. The shares also trade at reasonable Price/Book and Enterprise Value/Revenue ratios of 1.16 and 1.06 respectively -- again, both are at the low end of the spectrum.

With a firm foothold in several important gaming markets, a growing portfolio of properties, impressive growth prospects, and a rock-bottom valuation level, Sands Regent is an attractive company in a rapidly consolidating industry.

Oil Tankers
One of the most exciting growth stories in the world today is Asia. Asia's rapid transformation from an economic backwater in the 1980s to one of the world's primary manufacturing and financial powers today has major ramifications for the world economy.

Perhaps the most profound effect of Asian economic growth has been drastically increased global trade. Consider that China is now the world's most important source of many basic, manufactured goods while India is of growing importance as a provider of services like telesales and software programming. Both economies have opened up to foreign trade considerably over the past 20 years --China joined the World Trade Organization (WTO) back in 1998 and India abandoned its isolationist ways many years ago.

A combination of economic growth and increased trade flows has powered a rising middle class and increased consumerism in the region. Over half the world's population lives in Asia and some prominent economists have put the region's middle-class population at over 1 billion strong -- more than three times the size of the total U.S. population. Increasingly, these consumers are buying products such as automobiles, televisions and stereos just like their counterparts in the West.

Clearly, one of the most important consequences of burgeoning foreign trade and global growth is increased demand for commodities of all stripes. That includes oil and natural gas used to produce electricity and run factories and automobiles. And metals too have been in high demand. Whether it's copper used in electrical wiring or nickel used to manufacture stainless steel, Asia is consuming more of just about every basic commodity you can imagine.

But most of those commodities aren't being produced locally in Asia -- China and India, like the rest of the region, are relatively poor when it comes to natural resources. Instead, Asian nations are importing growing quantities of oil from the Middle East and metals from places like Australia and the Americas.

That's been a major boon for the global water transport industry. Demand for shipping services has increased dramatically over the past few years and the supply of ships available to transport goods has risen only slightly -- it takes years to build ships and bring new shipping capacity on-line. Not surprisingly, shipping day rates -- the amount water transport companies charge per day for shipping on their vessels -- have risen dramatically.

The table below offers a look at the competitive landscape in the tanker industry. Based on our analysis, OMI Corporation (OMM) is the most compelling value play in this group. While OMI doesn't score tops in every category on the table, the company is cheap in terms of its PEG ratio and price to gross profit. (FYI -- Frontline would be our favorite pick in this industry on a strict valuation basis, but for a variety of fundamental reasons, OMM looks like the better choice right now.)

OMM's PEG stands at less than 0.50 -- a level that's rarely witnessed in any large-cap stock in any industry group. This PEG ratio reflects OMI's strong projected long-term growth of nearly +15% annualized. OMI's growth rate is also more assured than many stocks in the group because the firm has already contracted some of its ships out on longer-term time charter contracts at impressive day rates. These contracts offer more growth stability. But despite this strong future outlook, OMI still trades at a P/E of just over 7.

The company's price/gross profit ratio is also unusually low. Consider that with a P/GP ratio under 5, that suggests OMI will make enough money in five years to cover its entire market capitalization. With that in mind, let's review OMI Corporation.

OMI CORP. (OMM, $19.30)

Business Overview
OMI is an oil tanker operator that boasts a fleet of more than 40 oil tanker ships across the globe. In addition, the company has another nine ships under construction -- about half scheduled for or already delivered this year and the other half due in 2006.

The company's fleet consists of 27 "product carrier" ships -- vessels designed to haul refined petroleum products like gasoline and kerosene. The other 15 ships -- known as "Suezmax" carriers -- are designed to transport crude oil from production sites to refineries for processing.

Competitive Advantages
OMI's main competitive advantage lies in its modern, efficient tanker fleet. In April of this year new regulations required that companies phase out older so-called single hull tankers. With only one solid hull, even a small rupture can cause these single-hull vessels to spill millions of gallons of petroleum products into the sea, creating a major environmental disaster.

While some carriers still have a ways to go in meeting this requirement, OMI recently sold off its last single-hull tanker. What's more, the company has already purchased plenty of new ships to replace that old single-hull capacity. As a result, in sharp contrast to many of its peers, OMI won't have to make huge new capital investments over the next few years just to replace aging capacity.

Even better, the average age of an oil tanker across all shipping companies is over 10 years. By comparison, OMI's average tanker is only three years old. That means the company should face minimal expenses over the next few years to keep its fleet in good working condition. Meanwhile, the competition will be forced to spend millions to replace or repair aging older ships. And, in the company's most recent conference call management claims that it's getting far higher charter rates for its newest, most advanced ships.

Growth Drivers
Strong demand for the transportation of crude oil and refined petroleum products should fuel OMI's growth for years to come. Demand for crude oil has been extremely high over the past few years, thanks in large part to the fact that Asia has moved from a net exporter of oil a little over a decade ago to a major net importer. Fast-growing economies, most notably China, have been rapidly ramping up their purchases of oil to keep pace with domestic demand.

All that demand for imports has led to strong demand for oil transportation to key markets like China and the U.S. As a result, shipping rates increased four-fold from the beginning of 2003 to the end of 2004.

Turning our attention to the supply side, keep in mind that it takes several years to build new ships and to bring new shipping capacity online. Therefore, supply can only slowly adjust to strong demand in this market. This tight supply environment should lead to continued high pricing for tanker companies over the next few years. And for a company like OMI, which faces relatively low capital spending requirements during that time period, that higher pricing will drop straight to the bottom line.

Valuation and Outlook
Analysts expect OMI to earn around $2.93 in 2005 and to post long-term earnings growth of about +15% per year. Based on those estimates, the stock is trading at around 8 times forward earnings and with a P/E-to-growth (PEG) ratio of just 0.46. Given that PEG ratios under 1 are considered cheap, OMI is one of the least expensive stocks on a PEG basis that you'll encounter.

And there's potential upside to that growth estimate. Analysts have consistently underestimated OMI's growth since the beginning of 2003. The reason is that many analysts are projecting an eventual drop in crude oil pricing back towards the $30 level. However, the oil market has ignored those projections, and prices continue to trade closer to $60/barrel. If demand remains strong and supplies tight, then my staff and I believe OMI will deliver growth well in excess of +15% over the long term.

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I sincerely hope you've enjoyed today's look at several undervalued gems in two key industry groups. Please stay tuned for my next full issue, which is set for publication on Monday, July 4th. In it, my staff and I will identify several firms with "hidden" assets -- such as real estate -- on the balance sheet. In some cases, these firms are actually trading at a steep discount to the value of their land and buildings alone, making them exceptional investment candidates. In the meantime, good investing in the week ahead!

Paul Tracy will be available to take your questions until Thursday, July 7. Please use the form below to submit your questions.