Profitability of MGM’s Mirage purchase in doubt

David Strow

Thursday, Jan. 18, 2001 | 11:19 a.m.

In the end, it's a bookkeeping change, a shifting of a continuing expense on MGM MIRAGE's balance sheet.

But this shift, a change in how the company reports interest payments on hundreds of millions of dollars in debt, will reduce MGM MIRAGE's reported earnings by as much as 25 cents per share annually for the foreseeable future.

And that, an analyst said Wednesday, could make MGM Grand Inc.'s $6.4 billion buyout of Mirage Resorts Inc. dilutive to earnings in 2001 -- even after $117 million in annualized cost savings that billionaire Kerk Kerkorian's MGM MIRAGE has squeezed out of the combined companies.

The change revolves around the "Boardwalk" land parcel -- a 55-acre plot of land south of the Bellagio on the Las Vegas Strip that includes the small Boardwalk casino. MGM picked up the land as part of its purchase last year of Steve Wynn's Mirage Resorts Inc.

Until Wednesday, MGM MIRAGE had been actively discussing development opportunities for the land, including a potential "Generation X"-oriented casino.

Since MGM MIRAGE had been considering development of the land in the near term, interest payments on debt incurred to buy the land weren't immediately expensed, but were deferred until a property actually opened -- a process known as "capitalization of interest."

"Some have been critical of MGM for capitalizing interest on land that hasn't been identified for development over the near term," said Jason Ader, gaming analyst with Bear Stearns. "The effect of doing that overstates their earnings."

That changed Wednesday, when MGM MIRAGE identified its land holdings in Atlantic City, not Las Vegas, as its top development priority. As a result, MGM MIRAGE said it would stop capitalizing interest on the Las Vegas land.

That won't change MGM MIRAGE's cash flow, but it will reduce earnings per share by 20 cents to 25 cents per year -- 11 to 13 percent of the company's projected earnings in 2001.

"If you're in the development stage, even if it's preliminary, you're required to capitalize interest related to that land," said MGM MIRAGE Chief Financial Officer Jim Murren. "Until such time as you can decide ... where you're going to build or where, you have no choice.

"Mirage Resorts had always capitalized interest related to the 55 acres here because they had no choice. We carried forward that accounting approach to the land, at a considerably higher value per acre."

Murren said the company considers the parcel "the single best development site on the planet."

In a research note issued Wednesday afternoon, gaming analyst Robin Farley of UBS Warburg wrote that the land's value is booked by MGM MIRAGE at more than $700 million. That would account for about one-tenth of the price MGM Grand paid for Mirage Resorts.

The company isn't publicly releasing the number it's using to value the land parcel, though analyst estimates range between $600 million to $700 million and up.

At $700 million, MGM MIRAGE would be valuing the land at $12.7 million an acre. By comparison, when Mirage Resorts acquired the Boardwalk and the 12 acres of Strip frontage land in 1997, it paid $135 million, or $11.25 million an acre.

The number is also far higher than land valuations used in the financing of other recent resort projects. In 1998, Las Vegas Sands Inc. reported that the 45-acre land parcel now occupied by the Venetian was appraised at $225 million; this value was used to help compute Sheldon Adelson's equity contributions to the project. That's about $5 million an acre.

Also in 1998, the Sommer Trust valued its 35-acre land parcel, used for the construction of the Aladdin, at $150 million or $4.3 million an acre.

"I would say they (MGM MIRAGE) may be a little high on that valuation," said hotel-casino broker David Atwell, who is handling the sale of a 16-acre parcel at the nearby intersection of the Strip and Harmon Avenue. "Our valuation on our property is in the $10 million to $11 million an acre bracket."

However, Atwell said, the Boardwalk hotel-casino itself could be valued at $100 million or more, since it is profitable. If that is backed out of the parcel's land value, the $600 million figure amounts to $10.9 million per acre -- in line with recent land valuations in the center of the Strip.

"Land values don't go down, they go up," Atwell said.

The land's value is important, because until recently, MGM MIRAGE deferred interest payments on an amount of debt equal to the land's value.

"MGM's capitalization (of the land) had been shielding some of the interest expense from the $6.4 billion Mirage acquisition," Farley wrote. "Without that shield, the acquisition appears to be diluting (earnings per share) in 2001 down from 2000 levels.

"Whether MGM had allocated the ($700 million) amount to land or other assets, the interest on that amount is still a real cash outlay for MGM and will now be recognized as such with this 25-cent (per share) reduction to EPS."

If the company had used the new accounting method in the fourth quarter, Farley said the consensus earnings estimate for MGM MIRAGE would fall to 35 to 36 cents per share, "flat or slightly below last year's Q4."

The consensus analyst estimate for 2000 earnings is $1.65 per share, though the company has said it expects to beat fourth-quarter estimates; before Wednesday's announcement, the 2001 projection was $1.85.

Ader, however, said he believed even after adjusting for interest capitalization, the merged company "is very strong and ahead of expectations."

Murren argued that cash flow is the critical factor in determining what MGM MIRAGE's true value is.

"Casino companies have always been valued on cash flow, and this has absolutely no impact on cash flow, and therefore no impact on how we should be valued on Wall Street," Murren said. "We bought the best company on the planet for gaming, at a very attractive multiple. We have dramatically increased shareholder value. There's no way even the most pessimistic person could think this acquisition was not a big benefit to everybody."

Smedes Rose, analyst with Robertson Stephens, agreed with Murren's view.

"This makes the Mirage acquisition probably neutral to earnings this year, but the strategic positives are clear for this acquisition," Rose said. "The accounting just kind of falls into place. I think investors are more focused on (cash flow)."

But earnings per share can't be overlooked, said gaming analyst Jeffrey Logsdon of Gerard Klauer Mattison, who downgraded MGM MIRAGE from "buy" to "neutral" on the news.

"The value of most gaming companies is based on an enterprise value to (cash flow) multiple ... unfortunately, though, they get judged on quarterly earnings performance," Logsdon said. "There's a potential, and I underline potential, that MGM will have some down earnings comparisons in the next few quarters as it works through the higher interest expense that it's recognizing.

"If you're going to push out a project from Las Vegas ... and you're going to have negative earnings comparisons, we didn't see a lot of near-term catalysts that make this stock go up."

Logsdon shied, however, from branding the Mirage transaction dilutive.

"You'd be comparing apples to oranges to say that," Logsdon said. "In reality, you'd have to take that out of the numbers before (to draw true comparisons)."

MGM MIRAGE stock closed Wednesday at $29.13, off 19 cents.

Murren said Wednesday's decision didn't have anything to do with a change of heart about developing the Las Vegas land parcel.

"It's not because we like Atlantic City more than Las Vegas ... but because from a supply-demand standpoint, Atlantic City looked to be the current favorite," Murren said. "We clearly will not build two major properties at once.

"That's not to say if we get some world-beating idea next month or next year, we can't change that. But right now ... we don't have a firm idea that's worthy of that land."

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