2 Sectors Are Becoming Big Gambles

05/30/2012 12:52 pm EST

Focus: STOCKS

Igor Greenwald

Chief Investment Strategist, MLP Profits

Suppliers of gambling technology and firearms are riding unsustainable booms, while their stocks have already begun to crack, writes MoneyShow.com senior editor Igor Greenwald.

With ten-year Treasury yields at a record low and Europe in a state of near-terminal decay, it’s probably more useful to discuss short ideas than to get burned pulling apparent bargains from the equities bonfire.

Which is too bad, because the US real estate market is really turning. Once the recovery is firmly entrenched and universally acknowledged, many of the related consumer stocks I’ve recently discussed will have nowhere to go but up.

But they’re going nowhere but lower in the near term, while Spain, Italy, and Greece struggle to stay afloat in a fiscal and monetary straitjacket of German design.

So short ideas seem more prudent than speculations on the long side at the moment. And despite widespread disgust with stocks in general, a couple of unsustainable boomlets are likely to result in sharply lower prices for the participating shares in the long run.

Gambling is one. Over the last 20 years, it’s spread from Las Vegas and Atlantic City to the increasingly ubiquitous Native American casinos, then the Mississippi delta and Midwest riverboats, and now pretty much to every state with a revenue hole to plug and residents frittering away their hard-earned cash across state lines—which is to say pretty much everywhere. New York, Ohio and Massachusetts are only the latest jurisdictions to seek their share of the jackpot by legalizing commercial casinos.

This has created a golden opportunity for those selling shovels to the gold-rush hopefuls—in this case, the manufacturers of slot machines, video terminals, and other equipment used to separate bettors from their cash. The stocks have responded accordingly: Shuffle Master (SHFL) has doubled since October, while Bally Technologies (BYI) is up 80% over that span.

There’s a lot more business on the horizon, too, with new casinos slated for New York and Massachusetts and the stiffer competition forcing incumbents to invest in ever brighter lights and louder bells and whistles to stand out.

Shuffle Master’s revenue was up 28% year-over-year in the latest quarter, while Bally enjoyed a 20% jump. Based on those numbers, the forward price-to-earnings ratios of 18 for Shuffle Master and 15 for Bally don’t look out of line.

But of course, those growth rates aren’t sustainable, because the underlying gambling revenue is growing much more slowly. Once all those casinos are built and competing with each other, they won’t allow their technology suppliers to grow 20% a year indefinitely while overall gambling spending rises by, say, 3%, as it did at commercial casinos last year.

While incomes stagnate, spending on gambling and other discretionary entertainment is likely to grow only slowly, if at all. Casino visitors already skew older than the general population, and while the younger set might opt for such variations of the vice as online poker, that only requires some software, and it doesn’t even have to come from the gaming-equipment manufacturers.

Although Bally and Shuffle Master shares have been technically strong, the latter now looks vulnerable below its 20-day and 50-day moving averages. The 200-day moving average is 20% below SHFL’s current level.

For an illustration of how quickly it could come into play, look at what’s happened to Las Vegas Sands (LVS) in the last month, as the growth pace in Macau has come into question. And as for what can happen when growth actually stalls, consider the plight of International Game Technology (IGT), one of the market’s weakest stocks.

You can’t keep selling ever more shovels to prospectors once enough prospectors have gone broke. For casino equipment suppliers, that prospect is drawing ever closer.

The firearms industry is also expanding unsustainably, as gun sales boom. Reliable national statistics are hard to come by, but California firearm sales rose 20% last year. The current growth spurt dates back to the election of President Obama in 2008, and the industry has profited handsomely from conspiracy theories about his plans to abrogate the Second Amendment and send hunters to reeducation camps.

The boom has coincided with economic privation, and it just might be that guns give some buyers the sense of control that they don’t have at work or home. More practically, Americans have seldom been less interested in gun control, and the proliferation of concealed carry laws has undoubtedly persuaded some grannies to start packing heat at the bingo hall.

But Obama won’t serve as a bogeyman forever: only one state has yet to pass a concealed carry law, and the economic insecurity that’s driving some of the sales just might be starting to ebb.

While California sales gun sales were up 62% since 2007 last year, they were still below their 1993 high-water mark, after which sales halved over the next decade.

Shares of gun makers Sturm Ruger (RGR) and Smith & Wesson (SWHC) have experienced significant corrections since peaking a month ago, with Sturm Ruger down 31%. This came despite the fact that the company temporarily stopped accepting orders, unable to cope with burgeoning demand. If the stock performs like this when the demand couldn’t be better, how will it fare when it inevitably cools off?

Sturm Ruger is at least priced at just eight times trailing cash flow and 13 times forward earnings, and has experienced, proven management. Smith & Wesson remains a pricier turnaround story, with a much more recent record of financial success. It too has fallen below 20-day and 50-day moving averages, but sits a scary 28% above the 200-day, leaving lots of potential downside.

Guns and gambling aren’t going away. But for suppliers of the barrels and the one-arm bandits, this is as good as it gets. Their shareholders are taking quite a gamble.

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