Casinos Are on a Roll - TheStreet

Sin was in at large investment houses during the third quarter, with many rotating into the casino sector.

An analysis of 13-F filings -- the quarterly equity holdings filed to the

Securities and Exchange Commission

by institutional investment managers with more than $100 million in assets -- shows that institutions boosted their net positions in the gaming space by 2%, or $623 million, in the third quarter.

"What's important is that institutions think that gaming is a good place to put money. A lot of the net buyers have been the big funds," said Eric Hausler, gaming and lodging analyst at Susquehanna Financial Group, which produced the research. "You've seen longer-term investors buying in big blocks with lots more volume." (Susquehanna makes markets and holds some of the stocks it covers, but doesn't seek investment banking from the companies it covers.)

Indeed, according to Hausler's research, institutions spent $3.7 billion on gaming and gaming-related stocks in the third quarter. But with the Dow Jones Casino and Gaming Index up more than 70% since its March low, institutions have been taking profits as well, selling $3.1 billion in casino and gaming stocks during the period.

"In a sense, what we've seen is a real rotation, but you need to look at this in two stages. People were buying in and around the Iraq war when these names were cheap and valuations reflected uncertainty," said Hausler. "Based on better earnings, people bought in. As you've seen, it's been a great performing sector, so you're also seeing some funds take some money off the table with the end of the year coming up."

More Than Just Las Vegas

Overall, Hausler said a number of the things that had investors spooked a year ago, such as fears that more states would join Illinois in drastically hiking gaming taxes, have not materialized. Meanwhile, the gaming industry has done a number of things to make itself more attractive to institutions, such as establishing dividends, locking in long-term growth plans and giving clear earnings guidance.

Increased diversity of revenue streams and larger market caps of gaming companies also have drawn in institutions, which realize there's more to gaming than Las Vegas. The slow spread of gaming is likely to continue, with the Lac Vieux tribe settling a lawsuit with two Detroit casinos last week, paving the way for Detroit to have permanent casinos in place when it hosts the Super Bowl in 2006.

Elsewhere, Pennsylvania is debating a number of proposals to introduce slot machines at racetracks, called "racinos," with Ohio and other states following suit. "States need revenue, and I'm of the mind that the expansion of gaming is a way to get into that," said Hausler.

Furthermore, the Department of Justice has filed an appeal with the Supreme Court surrounding the legality of Class II gaming devices, such as bingo machines, on Native American land. If the courts rule that the bingo machines are legal, game-machine makers like

IGT

(IGT) - Get Report

could see even larger growth in a few years. J.P. Morgan estimates that the potential market for such devices could reach 100,000 by 2006.

But the biggest near-term growth catalyst for the gaming industry could come from overseas, with the U.K. re-examining its regulation on the gaming industry. Recently, the Queen of England put gaming on her official agenda for 2004.

"We believe

the queen's announcement is a positive step for deregulated gaming in the U.K. and could set the stage for new legislation in 2004," said Harry Curtis, gaming analyst at J.P. Morgan. "This is good news for the American gaming companies, like

MGM Mirage

(MGG)

,

Harrah's Entertainment

(HET)

and

Isle of Capri Casinos

(ISLE)

, who, over the past few months, have been aggressively entering the U.K. gaming market."

Stocks That Pay You Back

Another catalyst behind the move in gaming stocks and increased institutional interest is that many of these companies have begun offering dividends. Many institutions and funds can't invest in companies that don't.

"Gaming stocks generate a lot of free cash flow, but until they changed the laws around dividends, these companies didn't pay them," said Hausler. "The introduction of dividends makes these stocks more compelling. There have been more growth and income funds coming in."

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) - Get Report

and

GTech Holdings

(GTK)

, 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."