Investors looking to double down on gaming stocks should look for rising earnings guidance when casino operators release first-quarter earnings this week, or take profits and find a new sector to bet on.

Optimism and bullishness has reigned supreme since Caesars Entertainment ( CZR), which reports on Thursday, raised guidance on March 10 . In the five weeks since, earnings estimates and analyst ratings on many gaming stocks have been rising along with share prices. Through last Friday's close, the Dow Jones Casino Index was up 23.2% year to date, the fourth-best performing sector of the market and far better than the S&P 500.

But with optimism high, investors may opt to sell on the earnings news, especially with companies that have already guided higher, and shift their investments toward sectors where valuations aren't so tight. MGM Mirage ( MGG), the world's largest gaming company, and Harrah's Entertainment Group ( HET) are set to release on Wednesday, giving investors their first look at the large-cap gaming space.

Judging from Tuesday's first-quarter earnings release from Station Casinos ( STN), gaming stocks could be in for even better news ahead. Station, which caters to the Las Vegas locals' market, beat analyst estimates and guided higher for 2004.

The initial market reaction to Station's earnings indicated investors were willing to buy on the good news. Station was up $1.72, or 3.6%, to $48.99 Tuesday on more than 800,000 shares traded, nearly double its average daily volume of 422,000.

"Given the gaming revenue results reported thus far, we suggest that there is significant potential for first-quarter earnings to surprise to the upside across the board," said William Schmitt, gaming analyst at CIBC World Markets.

Betting on the Economy

With operators already reporting strong monthly results in the first quarter, gaming earnings are starting to accelerate as the economic recovery appears sustainable. But this week, investors should look for proof of the trend, in the form of rising guidance or positive comments on room rates, group bookings and occupancy levels.

Great Expectations for Gaming
With one exception, gaming operators are expected to show large gains in earnings per share.
Company Release Date 2004 Q1
EPS Est.
2003 Q1
EPS Act.
% Change EPS Est.
Station Casinos Tuesday $0.51* $0.23 +122%*
Harrah's Wednesday 0.66 0.74 -11
MGM Mirage Wednesday 0.46 0.39 +18
Caesars Thursday 0.18 0.14 +29
IGT Thursday 0.32 0.24 +33
Boyd Gaming Thursday 0.29 0.28 +4
*Actual result Source: Thomson One Analytics, TSC Research

Early signals show gaming earnings are piggybacking on the economy's solid expansion. Two weeks ago, Mandalay Resort Group ( MBG) raised first-quarter earnings guidance for its June 3 release, citing strong convention business, rising room rates and a new hotel tower. But even more impressive was the fact that room rates rose even as Mandalay boosted the number of rooms by 25% -- a signal of how strong convention business has been.

"Now, the convention business is responsible for about 35% of total room nights at a property generating total revenue per room, per day, in the $550 to $560 range," said Daniel Davila, analyst at Stern, Agee & Leach, a New Orleans-based brokerage. Davila noted that rates have jumped even though Mandalay added 1,125 rooms in the past year.

With Mandalay saying that its first quarter is no longer the company's strongest, analysts are optimistic that the gaming rally is ready for a second leg fueled by business travel and higher room rates. Investors should keep an eye on revpar, a key metric that analysts say will be key to higher stock prices.

"So long as revpar trends remain strong, we believe there will be no bad entry points," said Davila. "Clearly, the strength evident in the market appears to verify our opinion."

Priced to Perfection?

But as has been the case lately, higher earnings estimates will need to be increased again to offset fears that the group is getting overvalued. Eight of the 13 components of the Dow Casinos index are within $1 of a 52-week high and the sector has already more than doubled in the last year, prompting bullish analysts like CIBC's Schmitt to concede that "the bottom line is that we are somewhat cautious, given the strong run-up in the group in March."

Indeed, large-cap gaming companies like MGM Mirage trade at about 9 times 2004 estimates for earnings before interest taxation, depreciation and amortization, much higher than the long-term average of 7.4 times EBITDA. The same goes for gaming equipment makers like International Game Technology ( IGT), which reports on Thursday. This segment trades at 14.2 times 2004 EBITDA estimates, nearly double its average multiple of 7.4 times estimates.

According to estimates from CIBC, a 15% boost to earnings guidance would push valuations down closer to their historical levels, but with Caesars, Station and Mandalay all talking up expectations, investors may have already made this assumption. (Perhaps it's worth noting that Station's solid results and raised guidance didn't spark a wider rally in gaming stocks on Tuesday, with the Dow Casinos up 0.7%.)

Ultimately, if gaming earnings aren't as high as investors expect, and lodging companies, which also release earnings this week, begin boosting expectations, the gaming rally could cool. The Dow Jones Hotel Index appears relatively undervalued, up 7.3% year to date, the 44th-best performing sector, and is driven by many of the same trends that have caused casino earnings to outperform.

The end result could be a sector rotation, where investors and institutions put more money to work ahead of the cyclical recovery in the hotel industry, which is also seeing revpar and occupancy rates rise.

"Lodging stocks have dramatically underperformed relative to gaming stocks over the last two quarters," said Marc Falcone, gaming analyst at Deutsche Bank." Gaming stocks are now generally trading above historical peak multiples and we believe some investors may become cautious on valuation."