Markets & Stocks
The house wins again
Casino operators have laid down winning hand after winning hand. Is it time investors got cautious?
April 21, 2004: 3:31 PM EDT
By Mark Gongloff, CNN/Money senior writer

NEW YORK (CNN/Money) - When most gamblers get on a hot streak, they have to worry about it coming to an end. Shares of the biggest U.S. casino operators, on the other hand, have been on a winning streak since -- well, forever -- with little sign of stopping.

There seems to be no end to their days of hitting royal flushes, though some of the biggest names in the industry seem to be opting for caution when making forecasts. The ones which reported first-quarter earnings Wednesday that stomped all over expectations, were slightly less enthusiastic about the rest of the year.

Casino stocks were cheap a year ago, when war and terrorism fears, along with the outbreak of SARS in Asia and some concerns about U.S. tax laws affecting gambling winnings, hammered an industry trying to recover from the 2001 recession.

Safe bets?
Casino stocks have hit the jackpot. Can they keep the winning streak going?
Company12-month price gainEV/EBITDA ratioProjected revenue growth, 2004Projected EPS growth, long-term
MGM Mirage63.3 percent10.45 percent15 percent
Harrah's57.1 percent8.78 percent14 percent
Caesar's95 percent7.6unchanged10 percent
Mandalay Resort135.3 percent11.29 percent15 percent
* All data as of April 19

Since then, though, big casino operators have been raking it in and that included the first quarter of 2004.

MGM Mirage (MGG: Research, Estimates), which owns the Bellagio, the MGM Grand and other Las Vegas casinos, reported record first-quarter earnings Wednesday that nearly doubled the consensus Wall Street forecast compiled by earnings tracker First Call.

Harrah's Entertainment (HET: Research, Estimates), which operates 26 casinos in 13 states, including six in Nevada, also reported record earnings Wednesday that trumped analysts' estimates.

Great pocket cards, but the flop was mediocre. MGM Mirage said consensus estimates for second-quarter earnings looked "reasonable." Harrah's said it was "optimistic" about the coming year, but didn't offer any specific guidance -- something that could make investors nervous -- though nobody seemed to be worried.

"I said [MGM Mirage] would beat the Street by 13 cents, and they beat me by 11," said Lawrence Klatzkin, analyst with Jefferies & Co. "I think they'll definitely beat expectations in the second quarter."

Shares win big

Still, shares in both firms were anemic Wednesday, possibly the result of a bunch of short-term momentum investors hopping out after good news, according to Deutsche Banc analyst Marc Falcone. Though momentum players might cause some short-term volatility in casino stocks, however, Falcone was generally positive about the sector's prospects.

"It's difficult to find a lot of negativity toward the group," Falcone said. "Clearly, the fundamentals are very strong, and I expect that to continue."

Shares in these firms, both of which have market capitalization above $6 billion, making them the biggest in the industry, have seen price gains of about 60 percent in the past year and they're not even the best performers in the sector.

Caesar's Entertainment (CZR: Research, Estimates) and Mandalay Resort Group (MBG: Research, Estimates), the third- and fourth-biggest casino operators, have jumped 95 percent and 135 percent, respectively. Shares of the fifth-largest casino operator, Station Casinos (STN: Research, Estimates), have jumped nearly 120 percent in the past year.

Should this hot streak have analysts alerting the pit boss that something fishy's going on? Not exactly -- though they do expect the companies to start laying down more pedestrian hands this year. Three of a kind, say, instead of straight flushes.

"The gains over the past year have been exceptional, and no one should consider them continuing at quite that rate," said Dan Ahrens, co-manager of the Vice Fund, which has given gaming stocks a bigger weight in its portfolio than alcohol, defense or tobacco. "That being said, I think that gaming in particular does have continuing upside potential because of pure supply and demand factors."

Gambling is in some ways a recession-proof industry -- people will gamble even when they can't afford it -- but even high rollers can't quite ignore the fear of terrorism, which made people less inclined to travel to Vegas and other gambling hot spots after the Sept. 11 attacks.

These fears have faded a bit, while the U.S. and global economies have improved, luring high rollers, domestic and international tourists, conventioneers and retirees to casinos. Many casinos streamlined operations during the downturn, enabling them to profit even more from the rebound.

"In general, gaming right now is very well positioned to take advantage of a resilient and improving consumer," said Joseph Greff, analyst with Fulcrum Global Partners.

What's more, though price/earning ratios are generally through the roof for many of these companies, with multiples in the 20s, 30s and 40s, they're generally matched by expected earnings-per-share growth for the year, and they aren't far from historic averages.

And analysts often use other measures of valuation for casino operators, such as price to free cash flow and enterprise value to earnings before interest, taxes, depreciation and amortization (EBITDA). EV/EBITDA ratios are no larger than 10 for the biggest companies.

"Valuations are getting near the high end of the range, but I think there's a fair amount of upside surprises possible throughout this year," said Dennis Forst, analyst with KeyBanc Capital Markets.

Analysts unfazed

Even the threat of rising interest rates doesn't faze gaming analysts. After all, some of the world's most dedicated gamblers are retirees on fixed incomes, and they've just been itching for interest rates to move up.

In fact, though many economists do expect rising rates to put a damper on consumer demand growth in the second half of the year, most gaming analysts think the run can continue, barring disaster.

"Two broad things could knock gaming now: a terrorist event, where people don't feel like getting on a plane, or a head-fake in the economy, [resulting in a broad downturn]," said Greff of Fulcrum Global Partners.

And there are some nit-picky negatives for the industry. Asian casinos are steadily improving in quality, keeping Asian tourists, long avid consumers of the U.S. gaming industry, closer to home. Tax laws have hurt revenue in some states, such as Illinois.

That could complicate matters for the industry, and some investors may head for the exits this year, content with their winnings; but many analysts say they'll stick around a while longer.

"When everybody's positive, that's the time to get out, isn't it?" asked Raymond Neidl, analyst with Blaylock & Partners. "But I'm positive, too. This industry is hot, hot, hot, and the economy's going to get hotter. And even if it doesn't, people will still like to gamble."  Top of page

Disclosure: None of the analysts quoted in this story own shares of the stocks discussed. While Deutsche Bank has a banking relationship with all five companies, the other firms do not.

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