Is the casino boom played out?

By Michael Brush

When too many investors flock to a sector, it's probably time for you to get out. After all, when your grandmother is swapping tips about the latest hot stock, who is left to put more money in?

And there is one group that consistently arrives late to the party: Mutual-fund marketers. When fund companies launch a fund tailored to a specific sector, you can be sure the hype has peaked.

That happened last March when Daniel Ahrens, former manager of the Vice Fund (VICEX, news, msgs), launched a fund focusing just on casino stocks. It is called the Gaming and Casino Fund (GACFX, news, msgs).

As of the end of June, his fund had gained 1.8%, compared to a decline of 1.9% for the S&P 500 Index ($INX) over the same period.

Not bad. But is the launch of Ahrens' casino-specific fund really a sign that it's game over?

Ahrens, of course, doesn't think so. He points out that gaming revenues continue to climb despite fresh obstacles such as rising gas prices. "It's almost a no-brainier that this is a terrific growth industry which should outperform the rest of the market," he says.

I can't fault Ahrens for believing in his fund. But it's a good bet he's wrong. Here's why.

Economic ties

Companies that rely on the consumer, such as restaurants, retailers and cruise lines, all have been hit as investors worry about the impact of an economic slowdown and rising fuel costs. Are casinos -- to this point largely unscathed -- next?

Goldman Sachs Group (GS, news, msgs) says they might be. Goldman analysts looked back over the past 45 years and found a consistent link between economic trends and gaming revenue. When the economy slows, gaming revenue almost always drops. The only caveat for casino stocks -- if the economy really is about to slow -- is that the damage to gaming revenue varies.

Here's why economic downturns can be so damaging: More than 60% of a casino operator's costs are fixed, says Goldman analyst Steven Kent. That makes it harder for them to prop up earnings by reducing costs when times get tough. Casino workers typically are unionized, and a minimum number of workers are needed to keep the casino floors running and hotel rooms clean anyway, so cutting staff isn't much of an option.

Because of the link between economic growth and gaming revenue, investors view gaming stocks as trading vehicles. They rarely rise consistently over time, says Kent. "The shares trade in ranges depending on where we are in the economic cycle."

And this cycle could be worse than normal. Airfares are rising, and many gamblers get to casino meccas such as Las Vegas by plane, says Joseph Fath, a gaming and lodging analyst with T. Rowe Price Group (TROW, news, msgs).

Too many casinos

Casino companies appear to be flooding the market with new slots, tables and hotel rooms at precisely the wrong time.

The great growth the casinos have experienced in recent years has them itching to expand and rake in more cash. The problem is they are cramming most of their new projects into existing markets like Las Vegas and Atlantic City

Why the lack of new locations? Because the recent strength of the economy has increased tax revenues flowing into state coffers, so the states feel less pressure to approve more tax-generating gambling venues.

"There is a lot of construction in the pipeline," says Fath. "If all that new capacity comes on line when growth is slowing, it is going to get ugly. There will be pressure on pricing and margins."

Not everyone shares Fath's pessimism. Analyst Lawrence Klatzkin at Jefferies & Co. says that just 25% of Americans have visited a casino. "I don't think the penetration of gaming is close to what it should be," he says. Or will be, he says, as gaming becomes an increasingly acceptable form of entertainment.

And, to this point, Las Vegas has had little trouble dealing with its already rapid growth. "Every time they expand capacity, demand expands," Ahrens says.

But it could be different this time just because of the sheer size of the expansion. Over the next four years, the supply of high-end hotel rooms offered by casino companies in Las Vegas will likely double, with the addition of 26,000 rooms. "We remain concerned that this could lead to market dislocation," says Goldman's Kent.

Part of the challenge for casino companies is that their new projects cost so darn much. Older casinos like the MGM Grand Las Vegas, where gamers first rolled the dice in 1993, cost $750 million. Wynn Las Vegas, opened in 2005, cost $2.7 billion. Boyd Gaming's (BYD, news, msgs) Echelon Place, due to open in 2010, will cost $4 billion. And MGM Mirage's (MGM, news, msgs) Project CityCenter, where gamblers should be able to place bets in 2009, will cost $7 billion.

Competition, old and new

Meanwhile, Native American tribes continue to take advantage of the tax exemptions on their casino profits by opening more venues -- not good news for the publicly-traded casinos. In June, for example, Merrill Lynch (MER, news, msgs) analyst David Anders cut his earnings estimates for Boyd -- partly because the Pokagon Band of Potawatomi Indians in Michigan is opening a casino just a short hop away from Boyd's Blue Chip Casino in Indiana.

The arrival in Pennsylvania of "racinos" -- race tracks with gaming machines to be installed this year and next -- could hit growth at casino companies operating in Atlantic City, worries Thomas Graves, casino analyst at S&P Equity Research. Graves has hold or sell ratings on the casino stocks he covers.

So which casino operators stand to lose most? Those catering to the masses, such as MGM, Ameristar Casinos (ASCA, news, msgs) and Isle of Capri Casinos (ISLE, news, msgs).

Casinos serving the local market in Las Vegas also look dicey because of the expected damage to consumers from the weakening real estate market there. Two casino companies serving locals in Las Vegas are Boyd and Station Casinos (STN, news, msgs).

Harrah's Entertainment (HET, news, msgs) falls squarely in the mass-market category, too. But its purchase of Caesars Entertainment last year could save it from trouble. The combined company will benefit from cost-cutting. And Harrah's should see gains as it continues to entice Caesars Entertainment regulars to its own casinos with its popular Harrah's Total Rewards program -– a kind of frequent-flyers plan for gamblers.

High-rolling exceptions

Not all gamblers are hurt as badly by economic ebbs and flows. The high-income crowd will make its way to the gaming tables almost regardless of what happens to the economy. So Fath says investors interested in the sector should focus on the companies that serve the high rollers, such as Wynn Resorts (WYNN, news, msgs) and Las Vegas Sands (LVS, news, msgs).

Even these stocks, however, should be considered long-term buys, as the short term may get ugly for the entire sector. And the big upside hook for both stocks lies in long-term projects on the drawing board for Macau and Singapore. "With Las Vegas Sands, people are paying for a lot that hasn't happened and hoping that it comes to fruition," says Fath.

At the time of publication, Michael Brush did not own or control shares of companies mentioned in this column. Brush is an award-winning New York-based financial writer who has covered business and investing for The New York Times, Money magazine and the Economist Group. Brush studied at Columbia Business School in the Knight-Bagehot Fellowship program. He is the author of "Lessons From the Front Line," a book offering insights on investing and the markets based on the experiences of professional money managers.