(MONEY Magazine) – Until recently, gaming stocks were on a winning streak. When the economy began to slow late last year, investors rushed to casino stocks, betting that gamblers' passion for the roulette wheel and the craps table would not cool, even in a recession. Share prices in the gaming and casino sector soared nearly 50% during the first half of 2001.

Come summer, though, those same stocks were sinking. Alarms sounded when Harrah's Entertainment (HET), a bellwether stock and the sector's only representative in the S&P 500, warned in early July that its earnings would not meet expectations. Investors promptly slashed 25% off Harrah's share price. The slowdown was industrywide: For the first four months of 2001, visits to Las Vegas rose only 0.9% above the previous year--an ominous sign. Investors' sentiment turned so sour that even when casino operator MGM Mirage beat expectations on July 24, its share price slid 8%. Overall, the best names in the business fell by 25% to 30%.

In the wake of such a panicky sell-off, you can find good buying opportunities. The sector sports two topnotch stocks, Harrah's and International Game Technology (IGT), the world's largest manufacturer of slot machines. Larry Haverty, a senior vice president at State Street Research, which owns Harrah's and IGT, notes that top gaming stocks are still solidly outperforming most other leisure and entertainment sectors. Harrah's latest quarterly earnings, despite the downward revision, were still up 23% from the year before. International Game Technology's quarterly earnings were up 43%.

Numbers like that may be hard to sustain in a slowdown, but industry leaders like Harrah's and IGT look set to grow as much as 15% annually for the next few years. Gaming is "one of the most favorably positioned industries we can see," argues Kent Gasaway of Buffalo Small Cap Fund. His reason is simple: changing demographics. The fastest-growing age group in America is the 55-to-65 bracket. Casinos' most free-spending customers are 55 and older.

The boost from an aging population will reinforce a powerful trend. In 1989, 18 million visitors arrived in Las Vegas; in 2000, that figure was nearly 36 million. Last year, casino operators generated $37.9 billion in gaming revenue alone, reports investment bank Bear Stearns. Despite current bad times, State Street Research's Haverty believes that gaming companies will continue to generate "monstrous amounts of free cash flow."

Another trend helping these companies is consolidation. Between 1998 and 2000, the casino industry witnessed mergers and acquisitions totaling more than $14 billion, according to investment banking house Morgan Stanley. This year, Harrah's acquired Harvey's Casino Resorts, and IGT is buying Anchor Gaming, another equipment manufacturer. The merger wave should leave the sector with fewer, bigger, more profitable players.

Dealer's choice

Harrah's is everything a gaming company should be: geographically and operationally diverse, well managed and with a brand name that inspires customer loyalty. Although Harrah's is based in Las Vegas, its hotel casinos, Indian reservation operations and riverboat casinos spread out into other major markets, including Reno, Lake Tahoe and Atlantic City. The $3.3 billion company's recent woes can be traced in large part to losses at Rio Hotel and Casino, a Las Vegas venue that has been a headache for Harrah's since its acquisition in 1999. Yet Rio is just one out of 25 Harrah's properties. State Street Research's Haverty sees a nice little bonus in the works for investors: This January, the Super Bowl will kick off in New Orleans, and the local Harrah's casino could make a cool $20 million that week. Harrah's recently traded at $28, or 14 times estimated 2001 earnings; Haverty thinks that it will be in the $40 range in 12 to 18 months.

Hitting the slots

Over half a million gaming machines made by International Game Technology are in casinos today--not only in America, but in Australia, Britain and Japan. Last year, boosted by new orders from Native American casinos in California, the company's operating income rose nearly 25%.

This year, investors had expected IGT to push its revenues even higher with the introduction of cashless, multigame slot machines, which let gamers choose among video slots, blackjack and poker and which issue printed vouchers for winnings instead of raining coins. Industry observers believed that casino operators would rush to replace their old machines with cashless slots: They reduce maintenance costs (by eliminating coins' wear and tear on machines), and require fewer attendants. But in July, Station Casinos, a major player in the industry, dropped a bombshell by declaring that customers at a Texas casino didn't like the multigame machines. In the ensuing selling binge, IGT's stock fell 28% from its early-June peak to a recent $47.

Even so, Jason Ader, Bear Stearn's gaming analyst, believes that cashless machines will wind up in most casinos: "Over the next six years, cashless will become the primary way gaming machines dispense returns to the players," he says. If nothing else, worn-out machines will have to be replaced. Mark Greenberg, manager of Invesco Leisure Fund, which owns 700,000 shares of IGT, points out that Park Place Entertainment, a major operator, has put in an order for a minimum of 15,000 cashless machines, which he sees as the first in a wave of new equipment orders. At a current multiple of 17 times 2001 earnings, IGT looks attractively priced. State Street's Haverty sees the stock hitting $80 to $100 in 12 to 18 months.

--ARAVIND ADIGA