Casino Stocks Have Lots of Downside

"A looming capacity expansion in hotel rooms and casino space, rising gas prices, an uptick in airfares, the possible peaking of the Las Vegas residential real-estate market, and the ongoing risk of global terrorism make the stocks of major casino operators good candidates for shorting." --- Steve Birenberg, StreetInsight.com, Long/Short Investor, 8/24/2005

OK, so I was one year too early.

Last summer, I suggested shorting Station Casinos (STN), Boyd Gaming (BYD), Las Vegas Sands (LVS), and (WYNN). In the same article I mentioned these trends were negative for MGM Mirage (MGM) and Harrah's Entertainment (HET).

As it turned out, 4 of those stocks are well below the price on the date of that post: BYD, -29%; STN, -20%; MGM, -12%; and HET, -9%. LVS and WYNN have defied gravity and risen sharply, however: LVS, +80%; WYNN, +40%. The later two have benefited from an unusually favorable growth profile as they open new casinos in international markets. I think their time is up and the decline of the last few days is just the beginning. Both remain at huge premiums to the more mature operators even on earnings a few years out when all their new projects will be open. In the current market environment, I don’t think the premium can last.

As for the general theme of being short gaming stocks, I believe that each reason I initially outlined a year ago remains in place. In fact, I think that you can drop the qualifiers like "possible" and "ongoing". Today's reality is that capacity expansion is hitting just as demand is turning lower. Funny how it always seems to work that way. The capacity expansion will remain above trend for several years so don't look for any sustainable rebound in casino stocks. They are just going lower.

New Development on Las Vegas Strip Creating Headwind for Casino Stocks

Casino stocks responded negatively to news earlier this week that Boyd Gaming (BYD) was closing its Stardust property on the Strip and would build a new $4 billion development that would contain several hotels, a casino and a convention center.

Casino stocks have been strong recently, recovering their sharp losses from last summer when concerns about gas prices and hurricane damage on the Gulf Coast drove the stocks down 10% to 20%. Last summer, I first expressed concern about the group due to a report by Dave Anders of Merrill Lynch on the sharp pickup in hotel rooms due to occur in Las Vegas beginning in 2007. This fact coupled with a peaking of the convention business made me think that multiples on the stocks would contract throughout 2006 as fears of overbuilding took hold....

Room Growth Could Create Pricing Risk

The announcement from BYD has brought those fears back into investors' minds. According to a note out on Wednesday from Steve Kent at Goldman Sachs, other new hotel developments include 3,025 rooms from Las Vegas Sands (LVS) in the second quarter of 2007, 2,000 rooms from Wynn Resorts (WYNN) in mid-2008, and 6,400 rooms from MGM Mirage (MGM) in late 2009. Including BYD, that makes 17,000 new rooms over the next five years. I searched the Web and found a link that showed Las Vegas currently has 124,000 rooms. That figure probably overstates the capacity from a competitive perspective as these new hotels will be completing mostly with currently open high-end properties. In any event, room growth is set to rise at a mid-single-digit annual rate after several years of very low growth. This could create risk to room pricing, which has risen sharply the past few years and been a big boost to the bottom line of casinos. Several analysts already feel room rates are flattening out.

Conventions Drive Demand, but Hotels Rooms May Outpace It

BYD's new development will include a sizable new convention center. Growth in conventions have been a big driver of hotel demand in Las Vegas due to expansion of convention space, which has allowed more visitors. BYD must expect that convention space will be tight again by the time their new space opens, but you have to wonder if all the hotel rooms will overwhelm convention demand between now and then given that conventions often book several years in advance.

As mentioned, the stocks brushed off capacity, fuel price and hurricane concerns once already. However, with the calendar five months closer to the initial new capacity and 2007 now on the radar screen for investors, I think that the capacity headwind will prove formidable. Add to that the potential shocks that could still come from a slowdown in consumer spending and the casino stocks still look overvalued to me. Maybe the timing is right to look again at shorting casino stocks or cutting back on current long positions.