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Stock Strategist

Three Casino Stocks to Roll the Dice On

We highlight some of our favorite names within the gaming industry.

Recent worries over a consumer spending slowdown have knocked some of our favorite casino stocks down to near bargain-basement prices. Though we think that some short-term concern is warranted, we hardly expect the demise of the American gaming industry and would encourage investors to consider the opportunity that the market has presented.

Earlier this month, the Nevada Gaming Control Board reported a 3.5% drop in Nevada gaming revenue for the month of June 2006. Atlantic City revenue saw a similar drop--5% in July. The Nevada numbers represent the first negative monthly growth for the state in two years and have sparked fears of an industrywide slowdown. Certainly, $3 per gallon gasoline, a weakening housing market, and higher interest rates have all taken a chunk out of the average Joe's gambling budget, and we see little over the next few quarters that could ease this pain.

A confluence of company-specific factors has also pressured casino stocks lately.  Harrah's  shares, off more than 25% from their 52-week high, were recently punished, possibly because the company announced that it increased the costs associated with researching potential expansion into new regions, such as Europe and the Caribbean. We find it short-sighted (and downright silly) that investors would fret over a few quarters worth of extra spending, especially when the expenditures should improve the company's growth prospects over time.  Boyd Gaming's (BYD) shares, along with  Station Casinos , have been plagued by worries of a hard landing in the Las Vegas real estate market. Together, these two firms control the majority of the lucrative Las Vegas locals market, which caters to residents that shy away from the more-touristy destinations on the Strip. We're not overly worried by these issues, though, since long-term trends point toward the industry's ability to weather short-term speed bumps.

According to the American Gaming Association, total domestic casino revenue has grown by about 6.6% annually since 1996, with not a single year of negative growth--even when travel fell off a cliff after the 9/11 terrorist attacks. During this time, weakness in the tourism-dependent Las Vegas Strip was more than offset by growth in other markets, including Illinois and the Gulf Coast region. Casino companies with properties across the country, like Harrah's and Boyd, are generally less susceptible to downturns in any one specific market. Further, regions outside the Strip are more dependent on local business and less on tourists, thus decreasing exposure to macroeconomic factors. For example, Illinois saw a 5.6% increase in gaming revenue in June 2006, bucking recent trends in Nevada and Atlantic City. In our opinion, these regional dynamics highlight the importance of geographic diversity.

We also think the long-term growth story for the Las Vegas locals market remains intact, despite potential for a weak housing market in this region. Clark County, home to Las Vegas and its surrounding area, has seen its population grow by around 5.5% annually since 1996, compared to around 1.1% for the entire U.S., and it is expected to grow by 5% annually through 2010, according to the UNLV Center for Business and Economic Research. Much of this growth will likely come from the almost $20 billion in planned development on the Strip over the next five years. We think population growth plays a more important role than housing in the success of the locals market, so as long as more people continue to move to the Las Vegas area, we like the prospects for casinos that serve these residents.

Our Picks

Harrah's Entertainment 
Harrah's Total Rewards customer loyalty program is the envy of the industry. We also think the company is poised to increase cross-market play following its megamerger with Caesar's. From the  Analyst Report: "Harrah's takes a unique approach to operating casinos. Unlike peers such as  MGM Grand (MGM), whose lavish, amenity-rich casinos draw high rollers and conventioneers, Harrah's focuses on small-time, frequent players. These avid gamers are less costly to lure, which is a large reason Harrah's returns on capital score among the industry's best."

Boyd Gaming (BYD)
Boyd's several growth projects should boost the company into the major leagues of casino operators. From the  Analyst Report: "Boyd has accumulated a very nice set of properties. The firm has a strong position in the attractive Las Vegas locals market, a 50% stake in the thriving Borgata, and a massive project in the works that should capitalize on the rejuvenated north end of the Strip."

Station Casinos 
In 1997, the Senate passed a law restricting the amount of off-Strip land approved for casino development. Station has scooped up most of this land, providing a narrow moat to protect itself from new entrants. From the  Analyst Report: "Station Casinos has leading positions in two very attractive niches: the supply/demand-imbalanced locals market and the high-return management contract business."

Sumit Desai, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.