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Competitive Pressures

How the gaming industry has responded to massive increases in supply

Competitive Pressures

The gaming industry is entering new territory.

Las Vegas, always a competitive market, will see unprecedented new capital enter the market over the next few years. Atlantic City, the next largest domestic market, is reeling from new competition in Pennsylvania and New York as well as the impacts of an economic downturn and a partial smoking ban.

In the meantime, several new competitors are lining up to enter the Atlantic City market. Many riverboat markets have approached saturation, yet new capital, either at existing locations or in the form of new competitors, continues to come online. And in many tribal jurisdictions, success has led to competitive assaults either from commercial competitors or other tribal facilities.

Throughout the United States, gaming is moving from a scarce product, where investment if done correctly led to outsized returns, to a ubiquitous product, where consumer choice is leading to potential declines and business failure in many markets.

The premise of this article is that in many cases, gaming facilities have a limited life, and depending on the level of competition, property operators must start planning for their inevitable declines-or at least creating the classic strategic defenses that lead to sustainable outsized returns on capital for the longer haul.

We offer two case studies from the industry’s most competitive markets to illustrate this premise.

Las Vegas

Las Vegas is a good example of the trends befalling other gaming markets. In the 1980s, Las Vegas was hit by the multiple impacts of a sudden new competitor (Atlantic City) and a severe national recession. Revenues in Clark County, which had been growing at spectacular rates for almost a decade, suddenly hit a wall. In fact, real growth (adjusted for inflation) from 1980 to 1984 was actually negative.

As the country moved out of the early 1980s recession, the Las Vegas economy recovered, and the great wave of investment, starting with the Mirage opening in 1989, ushered in an era of unprecedented growth and innovation. However, this growth did not occur without its share of victims.

Several previously successful casino operators have experienced the impacts of the wrecking ball, while others have simply fallen into disrepair or have seen their profits and returns decline significantly. These victims include such venerable properties as the Las Vegas Hilton, the Dunes, the Desert Inn, the Frontier, the Sahara, the Aladdin, the Sands, the Stardust and several more.

Since the Mirage opened its doors in 1989, many other casinos have entered the market. Most of these new casinos have used product features as their overriding strategy. We have used the term “entertainment superstore” to describe this strategic positioning. As these superstores have entered the market, non-gaming revenues have surpassed gaming revenues. This basic strategic shift has transformed the market in Las Vegas, and those properties along the Las Vegas Strip that remained gaming-centric or that had inferior products have mostly suffered.

The timeline on this page depicts the rise of the entertainment superstore and change in strategy since the opening of the Mirage.

This timeline illustrates the shift from a gaming-centric model to that of an entertainment destination resort. In 1989, in addition to the Mirage, there were 12 other large (over $72 million in revenue) casinos operating along the Las Vegas Strip. Those casinos were generating approximately $577 million of EBITDA. Since then (through fiscal 2007) over $25 billion of investment has been deployed along the Las Vegas Strip, and EBITDA has grown by over $3.17 billion.

Interestingly, almost all of that growth is attributable to properties that did not exist prior to 1989. EBITDA from these newer properties was approximately $2.9 billion for the fiscal year ending in June 2007. Of the several properties that were open prior to the Mirage, only Caesars Palace, the Rio and possibly Bally’s have increased their cash flow significantly from those early days. Caesars has done so as a result of massive investment in rooms, retail, dining and entertainment facilities, and Rio from a similar expansion of rooms and entertainment assets. Most other facilities have either closed, been redeveloped (Desert Inn, Sands) or become second-tier properties (Tropicana, Flamingo, Las Vegas Hilton).

Interestingly, the Mirage, the oldest of the new generation of Las Vegas properties, has managed to remain a top performer, even after the entry of several newer and more varied properties nearby. The Mirage benefits from its location next to the Forum Shops and across from the Venetian. In addition, the Mirage benefited greatly in 2006 and 2007 from investment in amenities such as new restaurants and a Beatles-themed Cirque du Soleil show, LOVE.

The most important lesson that can be learned from the Mirage and other projects that have opened along the Strip in recent years is that new competition has been successful not by competing directly with the entrenched existing participants, but by carving out territory in previously uncharted areas. For Mirage, this meant creating a destination resort that was more about non-gaming than gaming per se. For Bellagio, this meant entering the super-premium niche at a time when experiential purchasing was just starting to take hold. For the Venetian, this meant becoming a business and convention-oriented property at a time when conventioneers were looked at unfavorably by gaming operators.

Presently, several new developments are under way along the Strip. These include Palms Place ($600 million), CityCenter ($7 billion), Echelon ($4.8 billion), Encore ($1.4 billion) and the Cosmopolitan ($2 billion), representing approximately $16 billion of new development actually under construction and expected to open over the next three to five years (depending on credit availability).

Other projects in the works but further out include the Fontainebleau ($2.8 billion) and the Plaza on the site of the New Frontier ($5 billion). All told, these add up to approximately $25 billion of capital expected to be deployed over the next several years, almost as much as the existing capital base at the major Strip properties.

Existing operators, some approximately 15 years old, must look to the experience of the past several years to position themselves for this coming onslaught of investment. Lessons learned from Caesars and the Rio indicate that large strategic investments, geared toward untapped market segments, may be required. Caesars was a major part of redefining the Las Vegas experience.

The Forum Shops took retail to another level and expanded the market by increasing spend per customer, but also by reaching out to previously ignored market segments such as non-gamers looking for a resort experience. Rio originally created an upscale product for the locals segment. After Harrah’s purchased the property, EBITDA declined, but it is still a viable property compared to the pre-Mirage era.

Most of the new capital expected to enter the Las Vegas market will be positioned toward the premium segment. Echelon appears to be attempting to win the premium end of the convention segment. Experience from other markets (Atlantic City, see above) indicates that mid-market patrons typically trade up as new inventory enters the market, and higher-end patrons defect if the newer product is superior to the existing product.

Existing operators including several of the mid-tier MGM properties (including the MGM Grand and Mirage) as well as several of the Harrah’s properties, most notably Rio, Bally’s and Caesars Palace, could be in for a tough road over the next several years. The Venetian and Mandalay Bay may be at risk of seeing their premium convention customers defect to a newer and possibly better-positioned Echelon.

Properties such as the Venetian, Bellagio, Mandalay Bay and Wynn may all need an infusion of capital to increase or possibly even maintain cash flow in the face of massive new investment. This in all likelihood will lead to decreasing returns on investment at those properties.

Atlantic City

Atlantic City is an interesting case because there has been only one new casino opened in the past 15 years (the Borgata). Atlantic City is plagued by an old and outdated product.

Most of the casinos in Atlantic City were completed in the early 1980s, before the era of master-planned resorts. These properties are characterized by a substandard room product, extremely large casino floors, meandering layouts and poorly integrated assets (due to real estate limitations). The properties essentially expanded to appeal to an underserved high-frequency gaming customer, living within 120 to 180 miles of Atlantic City.

There was little architectural imagination or product innovation until the Borgata opened in 2003. Since the opening of the Borgata, most of the pre-existing casinos in Atlantic City, despite large infusions of capital, have seen their profits stagnate or fall.

New competition in Pennsylvania and New York has further exacerbated these problems. Chart A depicts the change in profitability of the casino industry in Atlantic City from the opening of the Borgata through the 12 months ending in September 2007.

When we first visited this subject over a year ago, the only properties better off than before the opening of the Borgata were Showboat and Resorts. Since then, Resorts has fallen on hard times while Tropicana and Caesars have improved their operations. This improvement has come at a price. In order to attain these improvements, significant capital was required.

Chart B compares the change in annual EBITDA with the cumulative investment in property and equipment since the opening of the Borgata.

The three casinos (aside from the Borgata) that have realized EBITDA increases are also among the top five casinos (six including Borgata) in terms of investment. Most importantly, the investment at Caesars, Tropicana and Showboat was strategic in nature, appealing to previously underserved markets and broadening the customer base for each of those casinos.

Caesars added the Pier (off balance sheet) and refurbished its public areas and rooms to appeal to the mass market. The Tropicana opened the Quarter retail attraction, and the resort’s product-oriented strategy appealed to a mass market and increased patronage significantly. The Showboat implemented the House of Blues investment, designed to serve a younger, entertainment-oriented customer, albeit at a similar price point to its existing customer base. In all of these cases, however, the investment required to drive increases in EBITDA has resulted in diminishing returns on investment.

Through 2006, gaming and non-gaming revenues in Atlantic City had grown by 4.4 percent and 8.2 percent respectively since 2002 (pre-Borgata era). More interestingly, EBITDA had grown by an annual compounded rate of 6.3 percent in the five years prior to the opening of the Borgata, but has grown by only 3 percent annually in the four years since the Borgata opening (and declined in 2007). This indicates that the entry of the Borgata intensified competition, leading to growing revenue but a compression of margins and a reduction in the growth rate of profitability for the entire industry.

The Borgata, however, has been quite successful. For the year ending in 2007 it had generated an industry-leading EBITDA of approximately $245 million and the highest returns on investment in the market (over 20 percent EBITDA return, excluding construction in progress).

The Borgata essentially carved out a space that did not previously exist in Atlantic City. Borgata eschewed the traditional gaming-centric model in Atlantic City and chose not to compete with the pre-existing operators on their worn turf. Rather, the Borgata created a product that was fundamentally different than any of the existing operators, using a combination of amenities, design and hiring practices resulting in an offering that appealed to former Atlantic City rejecters as well as current Atlantic City gamers who were looking for a premium product, but were unable to obtain it. This change in positioning skewed the Borgata’s revenue mix more toward non-gaming.

The Borgata realizes 27 percent of its revenues from non-gaming assets, compared to 19 percent for the rest of Atlantic City. More importantly, the Borgata, while generating 14.8 percent of the net cash gaming revenues in the city, generates 26 percent of cash non-gaming revenue. This basic shift in strategy away from the gaming-centric model to an entertainment destination, coupled with a premium product offering, has created a sustainable competitive advantage for the Borgata. In terms of the competition, only those properties that made large strategic investments were able to maintain or grow their EBITDA.

The recent entry of casinos into Atlantic City’s feeder markets, such as Delaware, Pennsylvania and New York, has combined with certain other events to put further competitive pressure on casino operators in Atlantic City. As several new operators look to enter the market over the next few years, older operators will be hard-pressed to maintain their competitive position and cash flows.

Positioning for the future

In both Las Vegas and Atlantic City, legacy operators were hurt by newer and better-designed competitors entering each market. In the case of Las Vegas, the market had ample room for growth, but the sheer volume of investment eclipsed the older operators, making most of their properties irrelevant and uncompetitive.

Only those that invested on a massive scale (Rio, Caesars) were able to maintain or grow cash flows as competition increased. Similarly, the Mirage was able to grow its cash flows in recent years by investing in destination amenities (entertainment) and by keeping the property fresh enough to leverage its location next to the Forum Shops and across from the Venetian.

In Atlantic City, the Borgata entry did not grow the market enough to save the legacy operators from decline. As in the case of Las Vegas, only large investment in strategic assets such as destination amenities or focus on specific niche markets allowed certain legacy operators to maintain or grow cash flows. Unfortunately, much of this growth was at the cost of declining margins and lower-than-required return on investment.

As operators in Las Vegas, Atlantic City and across the country prepare for increased competitive investment, they must ask themselves which strategies they must employ to stave off decline. Experience from around the country tells us that in competitive markets, new capital, properly positioned, designed and executed, can earn a reasonable return, usually at the expense of legacy operators.

These investments usually enter through a product-oriented strategy, designed to draw patronage based on the quality and breadth of the offering. Some operators take things a step further, designing properties to appeal to specific niches, such as the convention market, Asian or high-end table play, or even multiple niches. The most enlightened operators enter markets with offerings designed to avoid head-on competition with legacy operators. Rather, these entrants focus on previously untapped markets, be they conventioneers or entertainment-seekers.

For legacy operators to avoid the wrecking ball but also earn a reasonable return on future capital investment, they must invest in assets designed for underserved niches. In locals markets, this could include entertainment-seekers currently put off by the gaming experience. In markets such as Atlantic City, this could include underserved convention markets. In some cases, becoming a real estate developer and leveraging the gaming property to a higher and better use might be the best approach.

For some operators, however, painful decisions await. Investing significant capital that is likely to garner returns below those expected by most investors is not a winning strategy. Absent ample real estate holdings and growth options, some operators may opt to sell their properties to the nearest private equity fund.

Cory Morowitz, CPA, MBA, is chairman and managing member of Morowitz Gaming Advisors, LLC, a gaming consulting firm located near Atlantic City, New Jersey. This article was reprinted and updated from June 2007 Morowitz Quarterly. For more information, visit www.morowitzgaming.com.

Cory Morowitz is Chairman and Managing Member of Morowitz Gaming Advisors located in Galloway, New Jersey. Cory has over twenty years of diversified financial, gaming and consulting experience.

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