Note to Readers: This report contains substantially new material. Subsequent editions will have new or revised material highlighted.
Overview
MGM Mirage (MGG) has announced its intention to acquire Mandalay Resort Group (MBG) for $71.00 per share. Recently, the outside closing date of the MBG merger was extended by MGG to June 30th, 2005 from March 31, 2005. MBG shares have, since the time the merger was announced in June 2004, traded largely on the basis of the deal rather than on fundamentals. On December 10, 2004, at the MBG annual shareholders’ meeting, MBG shareholders voted to approve the takeover by MGG that will create the world’s second largest gambling company, assuming that the 2Q 2005 acquisition of Caesars Entertainment Inc. by Harrah’s Entertainment Inc. takes place as scheduled.MBG is, however, still awaiting approval from the Michigan and Illinois gaming boards, which is expected to come by the second quarter this fiscal year. In Illinois, the appointment of additional members to the Gaming Board last week will now allow the new, fully-constituted Gaming Board to act on MGG’s application. Under Michigan law, MGM Mirage was required to sell one of the combined company’s two Detroit casinos in order to effect the merger. In satisfaction of this requirement MBG’s 53.5% stake in MotorCity will be sold to its minority partner, Marian Ilitch, for $525 million.
The combined entity (MGG and MBG) will have estimated revenue of $6.5 billion, will control 28 gambling properties in Nevada, New Jersey, Illinois, Michigan, and Mississippi and will own about half the 72,000 hotel rooms on the Las Vegas Strip. Although approvals from various gaming commissions are still pending, it appears that the U.S. Federal Trade Commission will approve the takeover without requiring the sale of any properties in Las Vegas. The comments in this Research Digest report refer to MBG as a standalone entity.
Mandalay Resort Group (MBG) is one of the four largest hotel and casino operators in the U.S. It owns twelve casino resorts and four joint ventures. Half the company’s revenue is derived from casino operations and one quarter is derived from the hotel segment. The core properties consist of three prime destination connected casino resorts at the south end of the Las Vegas Strip – Mandalay Bay, Luxor, and Excalibur. Of these, Mandalay Bay is the high end property with substantial pricing leverage in the hotel rooms and offers much in non-casino amenities. It is the strongest performer of the three.
MBG offers more amenities outside of gaming than any other casino operator in the industry. Twenty-five years ago, when the company was known as Circus Circus, it distinguished itself by holding free circus acts and playing host to the world’s largest buffet in order to attract customers, even though its primary source of income was slot machines. Today, MBG is not only focused on increasing demand through timelessly themed world-class resorts but has also found a way to profit from revenue streams outside of gaming. Nearly two-thirds of the company’s operating income is derived from non-gaming amenities making Mandalay Bay the most levered to Las Vegas hotel pricing. The company prefers to make money through premium priced rooms, top rank entertainment, and gourmet restaurants rather than to chance the customer relationship on a roll of the dice or a flip of the cards. The company has well-diversified consumer demographics with resorts catering to everyone, from middle-income families and conventioneers, to rock stars and high rollers. Smaller operations are located in the gambling centers of Northern Nevada, Mississippi, Illinois, and Michigan.
MBG reported a weaker-than-expected fourth quarter. Management cited the quarter results were hampered by record rainfall in Southern California and Nevada, which lowered profits in January. Furthermore, for the second consecutive year, fourth quarter results were affected by a low hold percentage on table games at Mandalay Bay. Results also reflected the impact of an increase in the gaming tax rate in Michigan, which was effective from September 1, 2004, and increased gaming taxes at the company's 53.5%-owned MotorCity Casino by approximately $6.30 MM during the quarter. Fiscal 2005 results were also affected by health care costs, which increased $17.8 MM due to rising medical costs, a surge in accident claims and an increase in the number of covered employees.
As a standalone entity analysts have identified the following issues as critical to an evaluation of the investment merits of MBG:
Strengths/Opportunities / Weaknesses/Threats1. Strong Cash Flow Generation – Management expects strong free cash flow growth to continue, given the rising revenue per available room (RevPAR) trends for premium Strip properties. Analysts with a favorable outlook for Mandalay’s future expect the company to continue to be able to distinguish itself through premium destinations and entertainment in a rebounding economic and leisure travelenvironment. /
1. Competition - Competition is the single largest negative factor weighing on MBG. The rapid expansion of casinos in nearby California and significant capital projects at competing Strip resorts threaten to dilute demand for the company’s mid- and lower-priced properties. Increase in supply is expected in California as the state is looking at gaming expansion as a means to narrow its budget deficit.
2. Leverage to an improving economy - Analysts note MBG’s leverage to rising room rates in an improving economy. Revenue is expected to increase not only from rooms but also from the gaming floor, the restaurants, spas, and the stores. / 2. Higher Gaming Taxes - Increases in gaming taxes in Illinois and Nevada will have a modest negative effect on earnings with the potential for additional negative impact, if strained state budgets compel unfavorable legislative changes.
3. Premium Destination Resorts – Presently, a robust demand for rooms on the Las Vegas Strip, the opening of THEhotel, the convention center, and a rise in leisure travel arouses positive expectations. The company has a strong portfolio of well-known premium resorts with lasting themes targeted for specific consumer segments. / 3. Supply Risk - Analysts with a negative outlook believe rising competitive threats and higher expenses will restrict upside potential for Mandalay properties. The analysts cannot rule out the fact that a slowdown in the economy could lead to consumers cutting back on discretionary spending.
4. Strong Performance at New Convention Facility - The new convention facility at the company’s flagship location has shown early signs of success leading to higher room rates and occupancy levels. Analysts anticipate further gains from THEhotel.
More information on the company is available at its website: www.mandalayresortgroup.com
Mandalay Bay Resort’s fiscal year ends January 31.
Sales
Please refer to the accompanying Consensus Income Statement for more details on current analyst sales, margin, and valuation estimates.
Net revenue during the quarter increased 6.9% to $645.6 million (including earnings from unconsolidated affiliates) from the $604.1 million during the fourth quarter of fiscal 2004.
Sales estimates for Mandalay Resorts remain varied. Consensus estimates for FY’06 is $2.9 billion, roughly 4.1% ahead of 2005 results. Analysts expect growth to be driven primarily by the company’s Las Vegas properties. The southern Strip properties are expected to benefit from demand for convention facilities, a new retail center linking the Mandalay Bay and Luxor resorts and the company’s new all-suite tower, aptly named THEhotel. One analyst (UBS), however, differs on the earnings potential of THEhotel after MBG anniversaried the Dec '03 opening of the property. The analyst believes this will hamper RevPAR at THEHotel as it will suffer from tougher comps.
Consensus estimates project low single digit growth for FY2006.
Margin
During the fourth quarter 2005, EBITDA declined 5.5% to $129.2 million from $136.7 million in the corresponding quarter last fiscal year. EBITDA margins declined 260 bps to 20.0% from 22.6% in 3QFY04. Net interest expense increased 11.5% to $48.3 million from $43.3 million in the prior-year quarter.
Analysts project modest margins expansion going forward. Consensus operating margins are expected to slightly improve from 21.8% in 2005 to 23.7% by the end of January 2006. Consensus net margins are expected to expand from 8.2% in 2005 to 9.7% in 2006.
On a comparative basis, MBG comes in at the middle of the pack. The company is able to achieve higher relative margins than some of its large cap peers but fails to achieve as high a level as very efficient local players like Station Casinos. MBG should see relative margin gains in a rebounding leisure travel market, accented by higher room rates, given its industry leading leverage to non-gaming revenue streams.
Earnings Per Share
For the fourth quarter, MBG reported earnings of $.23 per diluted share, compared to $.35 per diluted share in the prior- year quarter. For the full fiscal year 2005, the company reported net income of $3.31 per diluted share versus $2.31 last fiscal.
The average of consensus EPS estimates by the analysts in our survey with published forecasts is five cents below the Zack Consensus number of $4.02 for the current year ending January 2006. On average, analysts in our survey anticipate better than 13% EPS growth with individual estimates ranging from $3.58 (Thomas Weisel) to $4.43 (Harris Nesbitt). The analyst with the lowest EPS projection (Thomas Weisel) is disappointed with the poor RevPAR growth during the fourth quarter. The analyst at the top end of expectations (Harris Nesbitt) opines that fundamentals remain quite strong, especially on the Las Vegas Strip. The analyst expects incremental earnings growth from rising room rates and higher occupancy, led by the new convention facility.
Target Price/Valuation
Of the 12 analysts rating the stock, only one holds a positive outlook on MBG, while two view the stock as negative. The rest have a neutral rating on the stock.
Most of the analysts (Smith Barney, Lehman, Harris Nesbitt) have provided a price target of $71, while one analyst (Wells Fargo) has projected the valuation on the high end at $79. The average price target is pegged at $72.29. The analyst with the highest price target (Wells Fargo) uses a 9.0x FY’06 EBITDA multiple. The analysts at the lower end of projections have relied on varying multiple on forward EBITDA estimates. Published EBITDA multiple estimates range from a low of 8.9x to a high of 9.3x.
Positive / 8%
Neutral / 75%
Negative / 17%
Avg. Target Price / $72.29
Long-Term Growth
Mandalay Bay Resort Group’s ability to create timeless themes and provide the best in ancillary attractions bodes well for its ability to continue to maintain above average long-term demand in an increasingly competitive market. Customers are offered a vast array of entertainment options outside of gaming to ensure their return. MBG is the most successful gaming operator in the business at creating lasting destinations that capture the imagination of the targeted customer. If it can continue to offer a different experience to a wide variety of consumers, the long-term growth outlook will remain strong.
Notwithstanding the pending merger with MGM MIRAGE, analysts believe the company continues to have significant catalysts for growth in the near term. These include its convention center, which has the ability to expand capacity utilization, and THEHotel tower at Mandalay Bay as well as crossover benefits from the other Strip properties.
MBG’s most significant challenge in maintaining long-term growth is its ability to command premium rates for its higher-end properties and to maintain occupancy levels at lower-tiered resorts. Its profits are highly levered to the hotel business with nearly half of the company’s operating cash flow coming from room revenue. The company must continue to effectively deploy capital to meet the competition that can erode the company’s earning potential.
Individual Analyst Opinions
POSITIVE RATINGS
Wells Fargo– Buy - $79 price target
Expects pricing trends in FY’06 to moderate on a percentage basis, but is optimistic that higher casino spending patterns and Las Vegas popularity will continue escalating. Thinks Mandalay Bay, Luxor, and Excalibur— forming the Mandalay Mile on the south end of the Las Vegas Strip — should continue to reap benefits. Furthermore, integration into the MGM portfolio should yield marketing and cost synergies.
NEUTRAL RATINGS
Deutsche Bank– Hold – $72 price target
Goldman Sachs– In Line - No price target
Views the MBG and MGG merger to be favorable. Believes that in the longer term, MGG is well positioned with current properties and future development to take advantage of the strong Las Vegas demand.
Harris Nesbitt– Neutral - $71 price target
Believes fundamentals remain quite strong. Expects Mandalay to be accretive to MGM Mirage. Feels in preparation for the intended merger with MGM Mirage, the company will continue to use its free cash flow to repay debt.
Jefferies – Hold - $71 price target
Believes the company’s properties should continue to generate strong results going forward as the Mandalay Mile convention center, which completed its second year of operations, continues to be well utilized, and helps the company raise room rates at its Strip properties.
Key Banc – Hold - No price target
Rates the stock as Hold, as the analyst sees very limited upside to the shares in the near term. Thinks all the positives of the merger have already been discounted on MBG’s current price.
Legg Mason– Hold - No price target
Continues to be very bullish on the near-term prospects of Las Vegas. Demand continues to grow and supply is restrained, resulting in higher occupancy and room rates. The MGG merger deal would make the combined company the second-largest gaming company behind Harrah's (assuming its acquisition of Caesars is completed), with revenue of approximately $7.0 B.
Smith Barney – Hold - $71 price target
Despite lowering the estimates, the analyst has maintained the price target and expects MBG shares to trade at the buyout price by MGM MIRAGE.
Thomas Weisel– Peer Perform - No price target
UBS – Neutral - $71 price target
Thinks now that MBG has anniversaried the Dec '03 opening of THEhotel, this will hamper RevPAR as it will suffer from tougher comps.
NEGATIVE RATINGS
J.P. Morgan– Underweight – No price target
Expects margins to improve. Maintains Underweight rating due to the current valuation, which the analyst thinks leaves little room for upside in stock in the near term.
Lehman– Underweight – $71 price target