December 7, 1998
SECTOR SCOPE by James Anderson


Drenched in the rays of the December sun, Las Vegas looks better than ever these days. Up and down the citys famous Strip, construction runs nonstop. New billion-dollar luxury casinos -- Bellagio, Mandalay Bay, and Venetian, to name three -- are sprouting like palms at an oasis. What better time, it would seem, to place a bet on casino stocks? The capital of the gaming industry -- the Shangri-La of slots -- is expanding ever farther into the Nevada desert and raking in a cool $8 billion annually.

Click over to Wall Street, though, and you'll find mainly fear and loathing of Las Vegas. While the Standard & Poors 500 has reaped an 18.5% gain so far in 1998, gaming and casino stocks have rolled snake eyes, retreating some 30% as of Dec. 3. Circus Circus (CIR), for instance, is down 40%, while Mirage Resorts (MIR) and Harrahs Entertainment (HET) have backtracked 30% and 11%, respectively. Slot-machine maker International Game Technology (IGT) has reeled to the tune of an 8% drop. The slump has left the industry trading at a discount to the market: Casino stocks fetch no more than 14 or 15 times earnings, compared with 26 for the S&P 500.

What gives? Analysts say the big casino operators, whove reaped a 100% increase in gaming receipts at their Las Vegas operations over the past 10 years, are acting a lot like rubes who just cant leave the roulette table: Theyre trying to push their luck too far. Projects such as Mirage Resorts billion-dollar Bellagio or Hiltons Paris may reap accolades for classy designs that could give Monte Carlo a run for its money. But look at the damage to the bottom line. In Las Vegas, where new projects are popping up faster than you can say "double or nothing," the big destinations are starting to pilfer each others profits. "Las Vegas is a growing market, especially with new projects coming on," says Standard & Poor's analyst Tom Graves. "But now the question is just how many pieces will come out of the pie."

ILL-TIMED GROWTH. Analysts say overcrowding on the Strip is cutting the double-digit earnings growth that casino companies have enjoyed there to more like 5% per year. "Not too long ago, a casino operator could expect a 20% or greater return on investment," says Jason Ader, gaming industry analyst for Bear Stearns & Co. "Today, that figure has fallen to the mid-teens."

A number of factors make Las Vegas rapid growth look ill-timed. The number of visitors to the desert mecca has peaked at a time when casino operators are scheduled to increase the number of hotel rooms on the order of 20% by 2000 to 127,000 -- more than exist in New York, Paris, or Los Angeles. More vacancies competing for tourists will likely put pressure on room rates and other hotel revenues, which for many casino operators equal the amount raked in from bets.

That isn't all. With Asian economies still wobbly, high rollers from the Far East have sat out 1998. And should the U.S. economy slow, the odds are roughly 100% that gaming margins will drop, and casino companies will have to drum up ad campaigns to keep vistors coming. They certainly had to during the last recession, in 1990-91.

NO JACKPOTS. Moreover, casino companies cant look outside Las Vegas city limits for much growth. In the early '90s, the industry got a boost when gambling took off on Native American reservations as well as in such states as Illinois, Missouri, and Mississippi. In 1999, however, theres only one major U.S. market set to open: Detroit. Projections are that the Motor City could take in as much as $1 billion a year in wagers, but not until 2002 or so when things really get rolling, says Bear Stearns' Ader. Atlantic City has shown signs of health recently, but not enough to counter Las Vegas competitive pressures.

In short, don't expect casino stocks, especially those with heavy exposure to Las Vegas, to hit any jackpots for the next year or two. S&Ps Graves recommends avoiding companies that have the biggest stake there, such as Mirage, while his investment opinion on Hilton (HLT), Harrahs, and Circus Circus, which have interests outside of Southern Nevada, is a lukewarm "hold."

One decent bet might be International Game Technology, which controls 75% of the market for gaming machines. After all, slot machines and their ilk generate some 75% of all casino revenues and take up as much as 80% of the floor space in gaming establishments. Bear Stearns Ader says some of Las Vegass big new attractions such as Bellagio, Mandalay Bay, and Venetian should snap up between 2,000 and 3,000 gaming machines each as casinos buy 80,000 gaming machines over the next five years.

NEW BANDITS. IGT may have a couple of other pluses. Salomon Smith Barney analyst W. Bruce Turner says new technologies for gaming machines plus normal wear and tear mean that one-armed bandits must be replaced every five to six years. Since there are more than 500,000 machines in use currently, up from 170,000 in 1990, that could be a boon for IGT. The company, meanwhile, has thought up another way to grow, by linking multiple slot machines to a common jackpot that often eclipses the average payout. "Progressive" gaming, as its called, has become so popular that it now accounts for more than half of IGTs business. And it should continue to grow, says Ben Sharav, an analyst with Value Line.

Despite such prospects, IGT has slumped along with its casino brethren, says John P. Miller of Ariel Capital Management, if only because investors havent looked at it more closely. Since plunging to the teens earlier this year, the stock has rebounded to about $23 a share, and could reach as high as $30 in the next 12 to 18 months, says Miller. Of the 12 analysts covering IGT, nine currently rate it a strong buy or buy, according to Zacks Investment Research. The stock is trading at a p-e of 15 times projected earnings for the fiscal year that will end in September, 1999.

Bear Stearns Ader says Sun International (SIH) also warrants a look, as a casino operator that has no exposure to Las Vegas. Instead, Sun operates properties primarly in Atlantic City and Connecticut. Ader says, though, that the market is holding its breath on Suns $600 million Atlantis casino in the Bahamas, one reason the stock is mired at a p-e of less than 13 times the consensus 1999 earnings estimate of $3 a share, according to Zacks Investment Research. Ader thinks Sun's earnings should rise at a 15% to 20% average annual clip, and that the companys shares could go as a high as $50 in the next 12 to 18 months.

By and large, casino-oriented mutual funds are hard to find. Typically, large funds have relegated gaming stocks to their leisure portfolios. But because of the bleak outlook for the group, you would be hard-pressed to find a fund with a significant weighting in gaming shares. One general-purpose fund with a sizable stake is the Ariel Capital Growth Fund (ARGFX), which has a 1.5% weighting in IGT. Ariel Growth has posted a an average annual total return of 22.44% over three years and 13.03% over 10 years. But, the fund is up just 2.33% in 1998.

All in all, investors could be forgiven if they'd rather spend their money playing craps than playing casino stocks.

Anderson, who teaches journalism at the City University of New York, writes Sector Scope every other week for Business Week Online

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