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Rod Smith

Gaming Stocks Showing Decline

1 August 2006

NEW YORK -- Gaming industry investors found themselves snorkeling in July, as casino company stocks closed down for the third month in a row.

The Dow Jones U.S. Gambling Index, a Dow Jones & Co. industry index of 64 publicly traded casino companies, closed at 525 Monday, down 6.25 percent from 560 at the end of June.

Analysts said values declined both because investors were correcting for inflated values and are expecting weak results for the remainder of the year.

Bear Stearns analyst Joe Greff said gaming stocks have been on a downturn since at least mid-May because of broad concerns that the industry is weakening and because there has been little news to instill confidence.

He cited recent second-quarterly earnings reports by Boyd Gaming Corp. and Harrah's Entertainment in which the companies failed to meet market expectations.

The Dow Jones gaming index has dropped 16 percent in the past three months since hitting a high for the year in early May of 622.

For both July and the three months ending July 31, casino company stocks performed substantially worse than the Standard & Poor's 500 index, which closed Monday at 1,276.66.

This reversed a trend in which gaming stocks have generally outperformed the S&P 500 for the past four years.

"Investors are taking profits after a multi-year (market) outperformance by gaming stocks and rotating them into other sectors that have been beaten down," Greff said. "The fundamentals of the gaming industry are still strong."

Nevada-based gaming companies, the largest in the industry, all trailed the Dow Jones casino index.

Brian Gordon, a partner in the Las Vegas-based financial consulting firm Applied Analysis, said local gaming company stocks have seen some price run-ups in recent months and are now going through a minor midcourse correction.

The Applied Analysis Gaming Index, a weighted average of nine Nevada-based gaming companies, closed July at 353.36, up 6.1 points, or 1.7 percent, from June. When computed on a similar weighted average basis, the S&P was up 0.6 percent for the month.

The Applied Analysis Gaming Index includes Alliance Gaming Corp., Boyd Gaming, Harrah's Entertainment, International Game Technology, Las Vegas Sands, MGM Mirage, Station Casinos, WMS Industries and Wynn Resorts.

Gordon pointed out that while the daily average stock price was down modestly for the month, more dramatic devaluations hit toward the end of July, suggesting the downward trend will continue.

Investor concerns were heightened by rising fuel costs, speculation that industry fundamentals are deteriorating and concerns about the increased supply in the locals gaming market, he said.

But perceptions drove prices down in July more than any real problem with fundamentals, which Gordon said should remain strong this fall.

Matthew Jacob, senior gaming analyst with Wall Street-based Majestic Research, said evidence is accumulating that weaknesses in consumer spending are beginning to bleed into spending patterns at casinos.

Still, Morgan Stanley analyst Celeste Brown said in an investor advisory that because of the "entertainment" nature of the gaming industry, it should hold up better than "other discretionary segments."

Despite the possible strength of the gaming industry in the long run, Merrill Lynch analyst David Anders last month completed a study that found gaming company stocks generally overvalued.

The constant reinvention of Las Vegas and the extended bull market have led to overly optimistic valuations of casino stocks, he said.

Investors have been lackadaisical in valuing hotel-casino companies; simply adding together development projects' and existing properties' anticipated cash flow, or earnings before interest, depreciation, taxes and amortization.

Values have been established based on experiences in the rest of the hospitality industry without taking into account the need to raze or redevelop old casino properties, he said.

For example, many casinos that were open in Las Vegas in 1988 no longer exist, he said.

"We believe that for major hotels in central business districts, whose owners are willing to invest a sufficient amount to keep them competitive, cash flow increases over time and returns are maintained cycle over cycle," Anders said.

"Hotels that jump to mind are the Waldorf in Manhattan, first opened in 1931; the Palmer House Hilton in Chicago, 1871; the Ritz Carlton Boston, 1927; the Beverly Hills Wilshire in Los Angeles, 1928" he said. "In contrast, Las Vegas takes pride in constantly reinventing itself; however, this is likely to lead to declining property cash flows versus increasing."

The difference in the sustainability of earnings between the Las Vegas-based casinos and hotels in major urban centers explains much of the relative overpricing of gaming stocks, Anders said.

"We want to be clear that we see nothing wrong with paying for growth; however, figuring out the right price is a challenge," Anders said.