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Bets Turning Against Casino Stocks

Analysts are downgrading companies and the sector as guidance fails to justify new leg in 2004 rally.
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After a solid first quarter from casino stocks, some analysts are ready to cash out of the sector and take their winnings off the table.

On Tuesday morning, CIBC World Markets analyst William Schmitt lowered his rating on the gaming sector to market-weight from overweight, telling investors to reduce their positions because guidance from companies isn't nearly bullish enough. In addition to cooling on the sector as a whole, Schmitt downgraded four companies:

MGM Mirage



International Game Technology

(IGT) - Get International Game Technology PLC Report


Ameristar Casinos



Argosy Gaming



"Despite the strong results posted for the first quarter of 2004, most companies did not raise their guidance for the remainder of 2004," said Schmitt, in his research note. "In our view, this means they are either forecasting conservatively or they consider the first quarter an anomaly. We are taking the cautious interpretation."

Other analysts agree. Merrill Lynch Tuesday downgraded MGM Mirage and

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Mandalay Resorts Group


, citing the same rationale. In reaction to the downgrades, the Dow Jones Casino Index dropped 3.5%, led lower by Mandalay, off $3.61, or 6.1%, to $55.26; and MGM Mirage, off $2.87, or 6%, to $44.61.

Not including today's stumble, the Dow Casinos are up 17.4% since the beginning of the year, against a gain of just 0.5% for the

S&P 500

. As a result, valuations are getting stretched on the sector, which gained 53% in 2003. But ever since MGM Mirage and

Harrah's Entertainment


released record first-quarter results, while declining to give specific guidance for 2004, the sector has been weakening, with the Dow Casinos off nearly 8% against a 0.6% drop in the S&P.

With only near-term results to guide them, analysts like Merrill Lynch's David Anders warned investors that the lack of long-term guidance is a red flag -- especially with the industry trading at the high end of historical valuations.

"The current consumption of gaming has been enormous, unlike anything we have seen in the past 12 years since we have been following the group," said Anders. "The current environment falls nearly into the category of 'too good to be true.'"

Indeed, from a historical perspective, the gaming industry has always had a measure of difficultly giving guidance going forward, because heavy gamblers can throw off the amount of money taken in from the tables with a lucky, or unlucky, session. As Anders notes, the end result is that earnings expectations are overinflated in good times, understated in bad times -- and investors never see the turn coming.

"After following the group for years, we have learned that, although extremely challenging, it is always best to become more selective when the euphoria is peaking," Anders said.

And while there seem to be a number of growth catalysts for the gaming industry, many are hitting snags and being delayed.

In America, budget crunches have prompted many states to consider allowing gaming. But while Pennsylvania, Maine, Maryland, Nebraska, Texas, Kansas and New York are all weighing some form of legislation, many have died in the legislative branch and must be revived in order to be successful. And while Native American gaming is likely to spread in California and New York, both state governments are taking a more active role in the process -- likely adding another level of delays.

The international spread of gaming is also somewhat sluggish. MGM Mirage, which has eyes on the U.K. market, will have to wait longer than expected for the U.K. to ease its restrictive laws around gaming. Instead of 2006, many experts don't expect the U.K.'s laws to change until 2007. In the meantime, MGM Mirage continues to announce deals and agreements, which will do nothing for near-term results.

"Although we believe some new jurisdictions will exist in the near term, our confidence in this happening is diminished, which is one reason for our rating reduction on the group," said Schmitt. "The market has priced these factors into the shares of gaming stocks."