Rolling the dice on casinos

NEW YORK (CNNMoney.com) -- Wall Street is rolling the dice on casino stocks as they hope for more casino mergers. But investors may increasingly find that these bets are losing propositions.

A flurry of deals has lifted the shares of many gaming companies. Harrah's Entertainment is in the process of being taken private by buyout firms Texas Pacific and Apollo. Station Casinos is also being taken private. And last month, a group led by Fortress Group announced it was purchasing Penn National Gaming for a 31 percent premium.

Shares of several casino owners have surged this year as private equity deals have led to more buyout speculation.

Merger chatter has helped boost shares of Boyd Gaming (Charts) nearly 10 percent this year. Shares of Ameristar Casinos (Charts) have gained almost 15 percent in 2007. And MGM Mirage's (Charts, Fortune 500) stock has surged 44 percent.

To be sure, casino stocks have also benefited from decent long-term fundamentals. According to a recent study by PricewaterhouseCoopers, gaming revenue in the U.S. is expected to increase by 6.7 percent a year, on average, for the next five years and 7.2 percent a year globally.

But some analysts think these gains have led to unreasonable prices that are unsustainable if mergers don't pan out, particularly since some casinos aren't expected to put up strong results in the near-term.

To wit, shares of Trump Entertainment (Charts) plunged nearly 20 percent Monday after the company announced that it and its investment banker could not find a buyer. Revenues at Trump Entertainment, which owns three casinos in Atlantic City, New Jersey, are expected to slip 1.5 percent this year.

"We're not recommending any casino stocks right now," said James Hardiman, an analyst with FTN Midwest Securities. "We've seen valuations really take off at the same time that fundamentals have been flat to down. With that combination, it's tough to put a buy on these guys."

Hardiman argues that casino takeover activity may be reaching a peak since the remaining companies are a bit riskier, which would not make them top candidates for private equity firms.

Firms like Wynn Resorts (Charts) and Las Vegas Sands (Charts), in addition to casinos they own in Las Vegas, are also expanding in Macau, a lucrative market in China that is still in its early stages and could be more of a gamble for political reasons as well as concerns about overbuilding.

"Most of the easy candidates in gaming have been gobbled up at this point," Hardiman said. "In addition, some of these remaining companies are probably not as attractive given how far in motion the development of their casinos are. Private equity is looking for mature companies where it can cut costs. They are typically not huge risk takers."

Dennis Forst, an analyst with Keybanc Capital Markets, agreed that private equity firms may have a tougher time justifying casino deals in the future since prices have risen so much and it's also not as cheap to borrow money.

"There is certainly a fair amount of speculation in a number of stocks and there's been no shortage of deals for the past twelve months. But valuations are no longer overly cheap," Forst said. "Plus, money is getting a little harder to borrow at attractive rates. Private equity buyers may be getting a little more disciplined and more discriminating on what assets they buy."

Still, another analyst thinks that more casino deals lie ahead.

"You have to try and look at the stocks based on the fundamentals but it's difficult to ignore the takeover chatter," said Justin Sebastiano, an analyst with Nollenberger Capital Markets.

Sebastiano said MGM could wind up being bought, especially since Tracinda Corp, the investment arm of billionaire Kirk Kerkorian, recently indicated that he's not interested in buying the Bellagio and other properties from MGM.

Tracinda is a majority owner in MGM, and Sebastiano said that Kerkorian's decision to not bid for the Bellagio could be a sign that the whole company could be up for grabs instead.

Forst agreed that MGM could be one of a handful of casino stocks that could still be taken over. He mentioned Pinnacle Entertainment as another possible target.

Sebastiano thinks MTR Gaming Group (Charts), which owns casinos and racetracks in West Virginia, Pennsylvania and Ohio, could be taken over as well.

He quickly added that investors shouldn't just buy the stocks based on merger speculation, though. He said that in addition to the possibility of a buyout, he likes MGM and MTR because they have strong fundamentals.

As such, MGM's earnings are expected to increase by 18 percent a year, on average, for the next few years while analysts predict that MTR's profits will increase at a 29 percent clip over the next three to five years.

"MGM is the premier gaming asset in the world and it absolutely could be a takeover target," he said. "MTR Gaming is a smaller cap company that is less known. But the fundamentals are looking good and it could be a prime candidate for private equity."

But Sebastiano, like Hardiman, said there are some casino stocks that have gotten ahead of themselves on takeover talk and they should probably be avoided. He cited Ameristar and Isle of Capri as two companies that have a high takeover premium even though he doubts either will be bought anytime soon.

Analysts quoted in this story do not own shares of the companies mentioned. Keybanc has done investment banking for Harrah's, MGM Mirage and Pinnacle in the past twelve months. Other firms have no investment banking ties with the companies mentioned in this piece.