Is bigger better in gaming?

Gary Thompson

Monday, April 21, 1997 | 11:59 a.m.

Bally Entertainment Corp. Chairman Arthur Goldberg was enjoying a quiet Thursday night at home last May when the ringing of a phone interrupted his reading.

The caller was Steve Bollenbach, the new Hilton Hotels Corp. president who had cemented his reputation as an aggressive, acquisition-oriented business executive by engineering the $19 billion Capital Cities-ABC merger shortly before joining Hilton last February.

Hilton, Bollenbach said, was interested in acquiring a top-flight gaming company and Bally seemed a perfect match. The benefits for both companies and their shareholders would be enormous, he said, and he'd like to meet Goldberg to discuss them in person.

Goldberg had taken control of Bally in 1990 as the company teetered on the brink of bankruptcy. In just two years, he'd refinanced its debt and led a turnaround that brought Bally's Atlantic City and Las Vegas hotel-casinos back to profitability and the company's stock back into Wall Street's favor.

"By the end of 1995," Goldberg recalls, "everything was going well. But I started to think about where we wanted to be in five years. We were in a growth mode, planning the Paris project for Las Vegas, and the only thing lacking was our ability to borrow money at 5 or 6 percent."

ITT Corp. executives had discussed a possible merger with Goldberg, but the two sides couldn't agree on terms. Bollenbach's phone call opened up new possibilities.

"We decided to meet at the Newark Airport on Saturday. Steve outlined his proposal and by the following Thursday we'd agreed on the terms," Goldberg says.

The $3 billion merger was consummated last December, giving Hilton prime assets in two major gaming markets, adding experienced management and offering opportunities for costs savings that would translate into a higher stock price for Hilton.

Gaining a well-known brand name was also important to Bollenbach. So were the efficiencies a merger could produce.

"We've saved $60 million a year in corporate expenses by putting the two companies together," Goldberg says. "We'll save another $40 million in reduced interest expenses for Bally.

"When you put a reasonable multiple such as 10 on that $100 million, you get $1 billion in increased value, which works out to about $4 per Hilton share.

"The big issue wasn't size," he says. "It was the efficiencies, and the ability to capitalize on momentum as we go forward."

Bollenbach asked Goldberg to join Hilton as president of the expanded company's gaming division, and the two wasted little time making sure that momentum continued. A month after the Bally merger was completed, Hilton announced a $10.5 billion offer for ITT, owner of Caesars World resorts and Sheraton hotels.

ITT opposes the merger, refuses to negotiate with Hilton executives and reportedly is considering acquisitions of its own as one means of thwarting the takeover. If consummated, the merger would create the world's largest gaming-and-lodging company, one boasting a total capitalization of nearly $22 billion, 30 casinos and 655 hotels owned, operated, managed or franchised.

More mergers expected

But the Hilton-Bally-ITT maneuvers illustrate a trend toward consolidation among gaming and lodging companies that many securities analysts and industry executives expect to continue.

It's a trend fueled by shareholder demands and customer expectations. On Wall Street and the Strip, it's all about growth.

Growth-oriented companies command high stock multiples, low-cost capital and loads of political muscle. They offer brand names that engender customer and investor loyalty, boosting the goodwill that's such a valuable asset.

In an era featuring conflicting economic indicators -- market saturation and limited expansion opportunities for the domestic casino industry, but rising disposable incomes and increased travel and leisure spending worldwide -- strategic alliances and mergers have become key elements in maintaining growth.

And the single biggest factor in growth is ready access to low-cost capital, which enables the largest companies to pursue their expansion strategies efficiently and effectively, says UNLV Professor Bill Thompson, who has conducted many studies of the gaming industry.

Another industry expert is Shannon Bybee, director of UNLV's International Gaming Institute.

"Right now, the spread between Treasury bills and the debt of the largest gaming companies is the narrowest it's ever been," says Bybee.

"That enables the six biggest companies to raise money very inexpensively on a comparative basis. They have a cost of capital in the 6 to 8 percent range. The next group pays 9 to 12 percent, and the rest are above that -- if they can borrow at all."

The difference in capital cost can make -- or break -- a company, as Stratosphere Corp. found out last year. Saddled with 14.25 percent interest on $203 million of long-term debt, the company wasn't able to generate enough cash flow to maintain mortgage payments and is now in Chapter 11 bankruptcy.

Wall Street's view

As the price of acquiring land and building new properties increases, the cost differences become more critical. A company borrowing $500 million at 7 percent pays $35 million a year in interest. A company borrowing the same amount at double the rate pays $70 million.

That means the 7 percent borrower has $35 million of profit before the 14 percent borrower earns its first dollar. Guess which company earns Wall Street's favor?

"That's why you see a very sharp businessman like Arthur Goldberg agree to the Hilton-Bally merger," Bybee says. "It gives him a lower cost of capital, a higher profit margin, and Wall Street values his company at a higher multiple. So he gets a triple whammy.

"Shareholders benefit in the same way as Goldberg," he says. "They enjoy higher multiples on profits and less stock volatility because diversification spreads the risk from particular market segments.

"Customers benefit from a big company's ability to raise capital cheaply and build the most attractive environment. A familiar brand name enables them to know what they're getting.

"Communities benefit because the capital investment creates jobs," says Bybee. "Megaresorts enable Las Vegas to compete with other gaming venues, offering more than just a nearby place to gamble.

"If you live near Tunica, Miss., you don't hop on a plane and fly to Las Vegas because we offer a 2 percent lower hold on slot machines. You come because of the whole experience.

Megaresort origins

"That's what Steve Wynn did with Mirage. He made gambling just part of an entire entertainment experience, which distinguished Las Vegas from other places. That broadened the market, bringing in people who gamble but also people who are willing to pay more for rooms, food and beverages."

Competitors took careful note of Wynn's $630 million gamble with Mirage, the first true "megaresort" that many naysayers thought would fail. Yet the elegantly themed property proved an instant success, sparked a sharp boost in visitor volume and paved the way for a host of new job-creating projects.

By late 1993, three new themed resorts -- Luxor, Treasure Island and MGM Grand -- had joined Mirage in transforming Las Vegas into a full-service destination resort. The next year saw 28.2 million tourists visit Las Vegas, up from 18.1 million in 1989.

The bulk of those tourists lost or spent their money at the newer resorts, a "rich get richer" scenario that is likely to continue as market saturation becomes an issue.

That isn't necessarily bad, says Thompson, if a rich company's capital is used for tourism marketing that benefits a community. But reliance on local residents can stifle a company's growth prospects and lead to other problems, he believes.

"This community's economic growth depends on outside money," he says. "The smaller, locals-oriented casinos operating on Boulder Highway and Rancho Drive don't serve the economy. They take money from older folks, and where's the growth story there?

"Some of the second-tier companies are making bad decisions around the country, going into areas where the markets are already saturated. Nobody's going to travel from Hawaii to a riverboat casino in the Midwest to gamble, so you're relying on locals. And that can be a costly gamble."

Small companies hurt

Small and mid-tier companies also suffer competitive disadvantages.

"If a new place like Detroit opens up for gambling, the big companies have the advantage," says Bybee. "The big guys can write a check right now, the smaller ones have to go out and raise the funds. The big guys have management depth, the smaller ones have to go out and get it. It's those kind of issues that makes it tougher for the small companies to compete."

Bybee and Thompson agree that the trend toward consolidation began after the rapid spread of legal gaming throughout the United States between 1989 and 1993. During that period, Wall Street was literally throwing money at the gaming industry, and small companies seeking to build casinos in new venues throughout mid-America enjoyed higher stock multiples than many of the big, established Las Vegas-based operators.

But when the legal brakes were applied to domestic expansion of gaming in 1994 and market saturation became a factor in some areas, growth opportunities dried up, prompting the sharpest operators to explore foreign markets and look for takeover targets at home.

"We get paid to win," Goldberg says, acknowledging that shareholders reward corporate executives with lucrative jobs and stock options only as long as the outlook for stock appreciation is rosy.

The next wave

For those properly positioned, it's rosy indeed. The biggest gaming companies are expanding far behind their traditional roots, using their financial muscle to capture a larger share of the expanding travel and leisure markets. Pressure to do that will likely speed up the pace of consolidation and change the face of the gaming industry.

"It makes strategic sense to create huge, worldwide companies that marry theme parks, movies, music and the entertainment megastores of the gaming industry," says Glenn Schaeffer, president of Circus Circus Enterprises Inc.

"The new customer to Las Vegas is more of a tourist than a gambler. That's OK, as long as you're in the entertainment megastore business."

"We expect the wave of lodging industry consolidations to continue through 1997 as companies seek opportunities to add value for their shareholders," says Bear Sterns & Co. securities analyst Jason Ader.

The right merger or acquisition can be immediately accretive to earnings, allowing the buyer to avoid the costly and time-consuming process of building new properties in strategic locations by purchasing existing profitable assets.

It also allows the buyer to reach "critical mass" -- the point at which it can satisfy all the travel and entertainment needs of its customers. It helps create brand strength and identity, enabling it to compete in the international arena for both customers and capital.

As the gaming-entertainment-lodging market becomes more global, the ability to attract high-spending customers and low-cost capital will be critical to success.

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