By most measures, the U.S. economy is in a steady recovery mode. The national unemployment rate fell to 9.4% in December and many cyclical industries, including airlines, industrial manufacturing and even automobiles are reporting improving operating trends. Home foreclosure rates continue to drop, as do credit card delinquencies.

The gambling industry remains in the dumps, though. While unemployment rates in the rest of the country are falling, they recently rose in Las Vegas, hitting 14.9%. Las Vegas is a bellwether for the gambling space, as it has the highest gambling revenue in the country, and conditions continue to look grim.

Ironically, for investors, this is a good thing. The stock market is said to be a leading indicator for the economy and as a result, the vast majority of companies in cyclical industries have already moved up in sympathy with improving business fundamentals. For the most part, gambling stocks have yet to move — but they will eventually.

The space will move significantly upward at some point and reward patient investors. This excludes a couple of large Las Vegas-based operators, including Wynn Resorts (Nasdaq: WYNN) and Las Vegas Sands (NYSE: LVS), which have seen big moves because of their foresight (as well as luck) in diversifying into Asian markets like Macau and Singapore. For the most part, these stocks have played out and are set to take a breather.

A more risky bet is through a couple of other Las Vegas-based resort operators: MGM Resorts (NYSE: MGM) and Boyd Gaming (NYSE: BYD). These companies get all of their revenue from the United States, and most of it comes from the Las Vegas market. As a result, they are a pure play on the eventual recovery in Vegas. MGM owns many casinos on the Las Vegas Strip, while Boyd caters to the local resident market and owns a number of off-Strip sights. Both depend on a rebound in tourist traffic, which drives gambling revenue and the local job market.

The downside for MGM and Boyd is that they have hefty debt loads. MGM recently completed the City Center project, which was one of the largest private construction projects in the country. Boyd was also on a building spree prior to the credit crisis and cancelled its upscale Echelon project on the Strip. MGM’s debt-to-capital ratio is extremely high at more than 83%, while Boyd’s is similarly lofty at about 70%. (Any ratio over 50% is generally too high.)

With the high debt levels, MGM and Boyd are leveraged to an upturn and could take off along with any recovery (just as buying a house with a small down payment and a big mortgage can pay off big when prices rise.) This strategy is very high-risk. A better bet is to go with stocks of companies that sell supplies to the gaming industry. The suppliers don’t have to build, run or maintain expensive and elaborate casinos and don’t need the related debt to fund these huge projects. Yet they have equal upside potential, given their businesses benefit as gambling revenue rises.   
    
Action to Take —> A compelling small-cap play I’ve discovered is Gaming Partners (Nasdaq: GPIC). Gaming Partners is based in Vegas and bills itself as a leading supplier of table game equipment. This includes items such as casino chips, playing cards, roulette wheels and related furniture. It reported $0.64 a share in earnings in 2006 before the market began to head south and is on its way to returning to those profit levels: for the first nine reported months of 2010, it has already posted $0.42 a share in earnings.

Gaming Partners’ cash flow is even stronger. Last year, free cash flow was $7.1 million, or $0.86 per diluted share. At a current share price under $6.50, the stock is trading at a very low multiple of free cash flow: about 7.5. Rival Shuffle Master (Nasdaq: SHFL) is also seeing an improvement of fortune, but trades at a multiple closer to 13. As such, taking a position in Gaming Partners could prove lucrative within the next 12-18 months and could even double your money.