Casino Stocks: Hold or Fold?

The acquisition proposal for Harrah's has sparked interest in the subindustry, but Standard & Poor's is neutral on the group

A recent addition to the Industry Momentum List is the S&P 1500 Casinos & Gaming subindustry index. Its relative strength price chart is shown below. This subindustry index consists of nine large- and small-cap companies. During 2005, it fell 0.9%, vs. a 10.0% advance for the S&P 1500. So far this year, however, the group is up 17.2% to the market's 10.1% gain.

As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the subindustry index's 16-year mean relative strength.

Much of the recent interest in the group surrounds the Oct. 2 acquisition proposal for Harrah's Entertainment (HET). I asked Tom Graves, CFA, S&P's Consumer Discretionary Sector Group Head and Gaming analyst if he thought investors should look to this group as a promising momentum play. His take: Investors may wish to sit this one out.

Joint Venture Possibilities

Graves's fundamental outlook for the casinos and gaming subindustry is neutral. S&P's outlook on the subindustry reflects its belief that long-term growth prospects for some major industry participants are already fairly reflected in their stock prices. In Graves's view, the legalization or development of new U.S. gaming markets has been relatively slow to occur in recent years. He notes considerable interest by U.S. companies in overseas markets, including joint-venture possibilities.

In recent years, states have looked to generate more revenue, and there has been some movement toward increased gaming taxes, including higher tax rates for casinos in Illinois, Indiana, New Jersey, and Michigan. However, S&P isn't expecting gaming tax rates to increase much in 2006.

The analyst also points to additional industry acquisition activity in 2006, including the announcement, in October, of an proposal from two private-equity firms to acquire Harrah's. Subject to approvals, Graves would not expect an acquisition of Harrah's by these firms to occur any earlier than the second half of 2007. Also, in August, 2006, lottery company GTECH Holdings was acquired by Italian lottery company Lottomatica, and in May, 2006, Aztar (AZR) said that it had entered into an agreement to be acquired by privately held Columbia Entertainment. Subject to necessary approvals, the transaction is expected to occur by the end of 2006.

Growth in New Games

Graves notes that casino gambling is legal in more than 20 states. He sees a trend toward gaming machines being increasingly allowed at U.S. racetracks. Furthermore, a number of U.S. companies have expressed interest in overseas casino markets, including Macau and Britain. However, the pace at which new or expanded gaming markets are developing in the U.S. has contributed to S&P's wariness regarding the stocks of some gaming-machine manufacturers.

As for another segment of the industry, Graves says state lotteries are currently operating in over 30 states. For U.S. lottery-related companies, long-term growth, in S&P's view, is most likely to come from international markets, and from the introduction of new games in existing markets. Graves doesn't have stock recommendations on any companies that are primarily lottery-related or pari-mutuel racetrack businesses.

So there you have it. The recent jump in interest for the group was acquisition related, in S&P's view, and because of rich valuations, the group will likely only be a market performer in the months ahead. Of the stocks followed by S&P mentioned in this report, both Harrah's and Aztar are ranked 3 STARS (hold).

Source: Standard & Poor's

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Industry Company S&P STARS Price (10/27/06)
Agricultural Products Archer-Daniels-Midland (ADM) 4 $39
Broadcasting & Cable TV Comcast (CMCSA) 4 $40
Casinos & Gaming Harrah's Entertainment (HET) 3 $74
Department Stores Kohl's (KSS) 3 $72
Diversified Metals & Mining Phelps Dodge (PD) 3 $101
Fertilizers & Agricultural Chemicals Monsanto (MON) 2 $44
Independent Power Producers & Energy Traders Constellation Energy (CEG) 3 $62
Integrated Telecommunication Services AT&T (T) 3 $34
Investment Banking & Brokerage Merrill Lynch (MER) 5 $87
IT Consulting & Other Services SRA Intl. (SRX) 4 $32
Motorcycle Manufacturers Harley-Davidson (HOG) 3 $68
Railroads Burlington Northern Santa Fe (BNI) 3 $78
Steel Carpenter Technology (CRS) 4 $104
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