Casinos Are on a Roll

Going forward, as industry fundamentals improve, analysts expect these names to generate more cash, which can be used to fund operations, pay off debts or increase dividends. According to Joseph Greff, gaming analyst at Fulcrum Global Partners, the average free cash flow yield for large-cap gaming operators will rise from 7.8% in 2003 to 8.6% in 2004. Cash flow yields at small-cap gaming operators will grow from 10.1% in 2003 to 11.3% in 2004.

But with so many coming into the sector and with stocks continuing to rally, Greff warns that "at current levels, we see just a handful of attractive names in the gaming sector."

Indeed, after rising so much in 2003, gaming stocks are not cheap, especially when compared with other cyclical stocks -- the price-to-2004 earnings multiple on the Dow Jones Casino and Gaming Index is 18.7, according to Baseline, vs. 17.2 for the S&P 500. But with the overall economy recovering and the travel industry rebounding from its post-Sept. 11 slump, industry prospects look good.

For investors looking to dip their toes into gaming stocks, Hausler generally recommends companies that make gaming equipment, like IGT, Alliance Gaming (AGI Quote) and GTech Holdings (GTK Quote), because casino operators are in the middle of a replacement cycle, ridding gaming floors of old machines. In October, IGT announced that Harrah's placed an order for 11,000 slot machines, a company record, and has a backlog of orders for 2004 already in place.

"Overall, the equipment makers are the real winners. With great earnings visibility, you've got to pay up now," said Hausler. "You've got companies with strong balance sheets in the midst of a brisk replacement cycle."