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Fool On The Hill

Friday, February 19, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Investors Warming Up to Lady Luck

Casino stocks such as Mirage Resorts (NYSE: MIR), MGM Grand (NYSE: MGG), Harrah's Entertainment (NYSE: HET) have been out of favor with investors for quite a while. After hitting highs in June 1996, these shares have been big losers, and investors who stayed away have probably been pleased with their decision. While the Standard and Poor's 500 Index has been racking up 20%+ annual returns, these stocks have lost as much as half their value. Since the end of January, however, a rebound of 20% or more has hit these stocks.

And over the past couple of days, these stocks have actually moved up quite a bit. Both Mirage and MGM Grand moved up 9% yesterday and 6% today. Harrah's followed suit, moving up a total of 18% over the past two days. Volume has also been extremely heavy. Mirage's volume of 4.6 million shares today is more than three times average volume over the past 50 days. Volume in the other two stocks was similarly high.

Fueling this boom is news that visitor volume in Las Vegas jumped 6.7% in December, helped by the October opening of Mirage's 3,005 room Bellagio Resort, the most expensive hotel ever built, costing roughly $1.8 billion. Bringing new visitors to Las Vegas is extremely important because the gambling mecca is expected to add roughly 21,000 rooms over the three-year period starting with the opening of Bellagio. During 1999, three new mega-resorts with about 3,000 rooms each (Mandalay Bay, the Venetian, and Paris) are scheduled to open. A lot of new visitors will be needed to keep those rooms filled and the cash flowing at the gaming companies.

Historically speaking, casino openings in Las Vegas have led to increased visitorship to keep the rooms and casinos full. Analysts and investors have been concerned, however, that the magnitude of new rooms planned has been so great that visitorship would not rise sufficiently to keep occupancy rates up. If that were to happen, the lower occupancy and the resulting increase in competition would reduce profitability.

This first bit of news that Bellagio has increased visitorship has been extremely welcome. Of course, one month's data does not make a trend. This increase in visitorship will need to continue (and grow) over the next year as the new properties open. Even more important than an immediate surge in visitorship will be the sustained levels that these resorts experience after their first year of operation. (Most casinos have extraordinarily strong results during their first year as gamblers check the place out.)

Even if all of these casinos are successful in attracting new visitors, investors will need to scrutinize the returns that the casinos earn on their recent investments. As the cost of new projects has skyrocketed, the returns are expected to be lower. While Las Vegas casinos have traditionally been looking for cash-on-cash returns of 20% or more, most of these new projects are likely going to be somewhere in the mid-teens. One securities analyst estimated that Bellagio will only yield a cash-on-cash return of 13.2% in its first year because of its high cost.

Although Mirage's properties are more glamorous and exciting, I find Harrah's to be the most interesting of the gaming companies. (Our resident gaming aficionado, Paul Larson, also selected this company as a gaming company to watch in Industry Focus 1999.) What I like about Harrah's is its diversity of operations, as well as its very successful loyalty program, Total Gold. I believe that Harrah's attempt to create a nationwide brand will allow it to continue to grow its business in the years ahead. In the meantime, the company can still be picked up for about 13 times earnings estimates for the year ahead.

Harrah's operates casinos across the country where gaming is legalized. In addition to properties in the major Nevada markets and Atlantic City, the company has riverboats in Illinois, Louisiana, Mississippi, and Missouri. Harrah's has leveraged off of this broad distribution by creating Total Gold, where gamblers earn points that can be redeemed for prizes at other properties. This means, for example, that a gambler in Joliet, Illinois, can win rewards to stay in one of Harrah's Las Vegas properties. Total Gold has proven successful at increasing play across Harrah's facilities in different markets.

Harrah's diversity means that it isn't fully exposed to the Las Vegas market. While the company has three major properties there (including the recently acquired Rio), a significant portion of revenues and earnings comes from other venues. Increasing competition in Las Vegas would hinder results, but would not be as devastating as at other companies with more exposure there.

Consolidation is still occurring in the gaming business, and Harrah's has shown a keen interest in acquiring the companies that want to sell. Last year's announced purchases of Showboat and Rio enhanced the company's position in both the Las Vegas and Atlantic City markets. As more smaller players decide they would benefit from the resources of a larger player, Harrah's could pick up some additional assets.

Creating a company-wide loyalty program has given Harrah's an advantage over its rivals when looking at acquisition prospects. Beyond the normal synergy such as corporate overhead reduction and lower financing costs, the company has an opportunity to enhance revenue growth by branding the property. If the company can successfully boost revenue where competitors cannot, Harrah's will have a significant advantage when seeking acquisitions.

The gaming business is not for every investor. While cash flow tends to be high, the companies also have commensurately high levels of debts. More debt lowers the overall cost of capital but increases the risk to equity holders if unexpectedly poor results occur. In addition, the companies are subject to all kinds of regulatory and legal risk.

This summer, a Congressionally appointed panel will report on the effects of gambling. Currently, the panel is expected to propose that Congress ban Internet gambling and put curbs on Indian gaming, two positives for existing casino companies. If Congress doesn't follow these recommendations or decides to impose stricter regulations, gaming companies could be adversely impacted.

If, despite the risks of the industry, you are interested in taking the plunge in a gaming stock, Harrah's would be my choice for a long-term investor. You won't get the excitement of a new mega resort, but you might get better performance.



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