Gaming stocks: how to shop smart

June 26, 2001 10:56 AM
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Finding the hot gaming stocks in a generally tepid market isn’t going to be easy in the months ahead. Here’s what the experts on Wall Street say investors should be looking for.

While prices haven’t reflected it in most cases this year, the major operators are generating more cash flow than ever, primarily because of a slowdown in new construction, says investment analyst Jason Ader of Bear Stearns. The top 15 operators will produce $6 billion in cash flow the next two years, he says.

"I think the key dynamic of the gaming industry has been its ability to perform much better than the hospitality industry as a whole in these hard economic times," he says.

With last year’s tech darlings on the outs with investors, Ader says a cycle is developing where large blocks of dollars could find their way into the gaming sector.

"Institutional interest is high right now," he says.

It’s this "cyclical flow of capital," as he terms it, that tends to support share values in the near term. But gaming investors may want to get on board now for the trend is likely to be short-lived, he says, lasting as long as it takes earnings in key sectors like high technology, telecommunications and health care to right themselves. He sees sluggishness in those sectors persisting for another six to 12 months with a general economic recovery expected to be well under way in 2002.

Scanning the gaming industry as a whole, the important trends to watch, Ader says, are: 1) stock repurchases, 2) debt reduction and 3) acquisitions that are immediately accretive to earnings.

Bear Stearns currently has "Buy" ratings on Harrah’s (HET), MGM Mirage (MGG), Station Casinos (STN), International Game Technology (IGT) and WMS Gaming (WMS).

For gaming analyst David Anders of Merrill Lynch, the current balance between supply and demand should push up share prices.

"Demand has been surprisingly strong, especially with all the bad economic news we’ve had," he says.

A key demand indicator in Las Vegas, revenue per available room, held steady in the single digits in the first quarter. "Relative to broader rates throughout the hotel industry, that’s pretty impressive," he says. But signs are this will not persist for the balance of the year, he says, as the effects of the national slowdown make themselves felt.

"We’re seeing softening in both weekend and weekday rates. We saw it show up in weekend rates first, which was a little bit of a surprise. It looks like leisure travelers are pulling in their horns a bit."

As for gaming revenues, the runaway popularity of multi-line, multi-coin nickel slot machines has developed into a significant trend, Anders says.

"Typically they have higher hold percentages, and this change in hold is actually what’s driving revenues right now," he says. "The cost of playing is going up. But the customer is willing to pay more. It’s kind of an innovative way to grow revenues."

In the manufacturing sector, investors will want to closely monitor Wall Street’s expectations, coming off a year in which the growth of Indian gaming in California sparked a huge surge in demand that is not expected to continue at 2000-2001 levels.

"We’re getting a little more cautious," he says. "While sales can still grow in the coming year, we may see a situation where some investors are shocked at the deceleration."

Currently, Merrill Lynch is posting "Buys" on only three stocks: HET, Argosy Gaming (AGY), which has proven itself an accomplished operator in the riverboat markets, and lottery giant GTech (GTK).

"For investors, we still like the supply picture, and longer-term we do like prices," he says. "But the near term, meaning the next two quarters, we’re faced with the challenge of a slowing economy. There could be some pressure."

The slowdown in new supply, while it can support prices in some instances, also has to be viewed as a mixed blessing, according to Robin Farley, gaming analyst at UBS Warburg.

"The industry has to rely on same-store cash flow, growing revenues from existing properties, and same-store cash flow growth has been an extraordinary challenge," she says.

She points to the fact that not a single property on the Las Vegas Strip or in Atlantic City has been able to grow cash flow in every year for the last five years - "and 85 percent of Strip properties have had cash flow declines in at least two of the last five years," she says.

So it should be no surprise, she says, if the current shortage of expansion opportunities works to hold down prices.

"If you look at where the stocks have traded, 6 1/2 to 9 1/2 times cash flow in the last five to 10 years, you see that they’re trading now near the low end of the range. But in our view they should be trading at the low end because we’ve reached a different stage in the growth cycle."

Farley says the prognosis for cash flow growth in the near term, 2 to 3 percent, indicates that even paying down debt won’t be enough. In the absence of expansion, she does not expect prices to rise considerably.

"If you can’t open something new, and can’t get growth out of your existing properties, then acquisition is the only way to grow," she says. "We’ve seen a fair amount of that already, and we’ll continue to see more of the large caps buying up individual assets."

Harrah’s, which scooped up Harveys Casino Resorts for $625 million earlier this year, is on Warburg’s "Buy" list. MGG, STN, AGY and Mandalay Resort Group (MBG) also enjoy "Buy" ratings.

Brian Egger admits he’s something of a "contrarian," but he spies opportunity in the industry’s current low valuation levels.

"We’ve been more bullish on the sector than anyone on Wall Street," says the gaming analyst, for Credit Suisse First Boston, which has upgraded the entire sector to "Overweight" - because most of it is selling at bargain prices.

"The stocks are still relatively inexpensive on a valuation basis, and there is some opportunity to see them higher," he says.

Investors should be looking at four factors, he says: 1) the balance of supply and demand, particularly in Las Vegas; 2) the current negative level of investor sentiment; 3) valuation levels from a historical perspective; and 4) how "rational and prudent" the companies are in terms of how they deploy their cash flow.

"Even though demand was likely to decelerate, which is to say, it will grow more moderately, gaming has not decelerated as much as some expected," he says.

He disagrees with Farley on the need for expansion, at least in the more mature markets. "There’s no new wave of megaresorts, and there’s no justification for them in terms of return on investments," he says.

Instead, he looks to certain trends he says will spell good news for gaming investors. "More companies are using free cash flow to buy back stock and pay down debt and are making investments with high potential and low risk, like MBG’s new convention complex and Park Place Entertainment’s (PPE) expansion at Caesars Palace.

"Looking at all these factors in the aggregate, I’ve felt fairly positive this year," he says. "But it’s a volatile sector, and you do have to be flexible when it comes to taking profits and balancing your portfolio."

While shopping, here’s some for the cart

Though not the only gaming stocks to watch, analysts are giving this group especially high grades lately:

HARRAH’S (NYSE: HET)

”¡Most diversified company in the business, safe from downturns in any single market.

”¡Total Rewards programs bolsters same-store sales growth.

”¡Smart acquisition of Harveys Casino Resorts.

Monday close: $36.18

MGM MIRAGE (NYSE: MGG)

”¡Dominant Las Vegas franchise.

”¡Premier management team.

”¡The support of Kirk Kerkorian’s balance sheet for possible acquisitions.

Monday close: $28.82

PARK PLACE (NYSE: PPE)

”¡Planned expansion at Caesars Palace.

”¡Claridge acquisition.

”¡Relatively low valuation.

”¡Low earnings expectations already factored into price.

Monday close: $11.66

ARGOSY GAMING (NYSE: AGY)

”¡Dominant Midwest riverboat operator.

”¡Smart acquisition of Joliet Empress, which is strongly accretive to earnings.

Monday close: $25.71

STATION CASINOS (NYSE: STN)

”¡Last three quarters "transitional" as company absorbs Fiesta, Reserve and Santa Fe casinos in Las Vegas.

”¡Growing Las Vegas population makes the franchise increasingly valuable.

Monday close: $14.99

INTERNATIONAL GAME TECHNOLOGY (NYSE: IGT)

”¡Wealth of new products.

”¡Growth of Indian gaming.

”¡Slots have been the strongest gaming sector the last 18 months.

Monday close: $61.80

WMS GAMING
(NYSE: WMS)

”¡Exciting line of new products, highlighted by the acquisition of Survivor.

”¡Growth of Indian gaming.

Monday close: $29.81