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Converging Forces

The first six months of 2014 could signal the industry's next era.

Converging Forces

We have commented in recent years on the accelerating pace of globalization and technology convergence in the gaming industry.

This has become evident in events such as the alliance between 888 and Caesars, deals between and MGM Resorts and Boyd, and with Amaya acquiring Cadillac Jack and Rational Group.

Much of this has been predictable. Some of the transformation has surprised, such as the explosive emergence of social gaming.

And some of it has been the empowering nature of the internet, such as exchange wagering pioneered by Betfair, now starting its integration into more conventional forms of online gambling, such as account wagering in the U.S.

Now, we have reached a new stage in which the convergence is extending to mergers resulting in international giants reaching into every distribution channel and technology.

Clearly, the merger of the world’s biggest lottery company with the world’s biggest gaming supplier is the ultimate example. But the Amaya acquisitions, and Bally-SHFL and Scientific Games-WMS mergers, also fit into the new and broader strategic structures.

The questions now are: Who’s next? What’s next? What does this mean for investors?

• Who’s next? With GTECH and Scientific Games merging with slot-dominant companies, Athens-listed Intralot could be the next candidate to seek a similar acquisition.

The world’s second-largest lottery company has been expanding assertively in the U.S. in recent years, but not on the slot front like GTECH.

Whether Intralot wants to follow we don’t know. But if it does, there are only so many significant candidates left. One of the most attractive might be Multimedia Games.

MGAM is small, to be sure. But it has popular products, an increasing number of jurisdictional licenses, and a central server system that a lottery company can appreciate.

Aristocrat also might be attractive given its relatively low valuation, systems business, and strength in Australasia, though the guys Down Under have a lot of Aussie pride, and might resist being absorbed into a foreign company.

• What’s next? Merging companies will talk about synergies, compatible cultures, complementary business lines, economies of scale, internationalizing their opportunities.

But combining companies from entirely different industries with sprawling global operations and scattered headquarters for different business segments also brings the risks of being too big and diverse to manage, and of being unresponsive to shareholders and too administratively burdened to innovate.

If they succeed, a whole new era opens and gambling has truly matured into a global industry.

• What does it mean for investors? Given the valuations awarded in the recent acquisitions, we might see permanently higher stock prices, free cash flow generation that drives further growth and returns capital to shareholders, and the attraction of more mainstream investors.

If things don’t work out, today’s consolidations might lead to tomorrow’s restructurings and right-sizings.

Consolidation is also happening on the casino side, and the price of casinos is going up. High-yield analyst Dennis Farrell of Wells Fargo published a report in May that found deals this year have averaged 9.9 times forward EBITDA.

That is up from 7.5 times last year and 7.1 times historically. One deal alone, however, pushed up the average—Blackstone buying Cosmopolitan Las Vegas for an estimated 15.7 times forward EBITDA.

At the time, there was a lot of cheering with many observers noting that Blackstone is a shrewd and experienced real estate investor.

We’d caution, however, against too much enthusiasm. The top of a market often is near when companies from outside start moving in. Remember El Al, George Clooney, Ivana Trump, the Fontainebleau’s Jeffrey Soffer and all their dreams of Las Vegas gold during the era when lenders were throwing money at people? And whatever happened to Robert Sillerman’s Elvis casino-resort, anyway?

That era topped out in 2008 with casinos selling at 11.9 times forward EBITDA. It crashed the next year when the average price fell to 5.6.

Indeed, Cosmo itself was part of that trend when New York City condo developer Bruce Eichner decided he could build a $4 billion property on a Manhattan-sized slice of Las Vegas.

The result was Deutsche Bank having to take over, and Blackstone now having bought Cosmo for $1.73 billion.

Of course, the bulls say, Blackstone isn’t just buying a casino, it’s buying a lifestyle property it can understand. Is that almost the exact same rationale that convinced Eichner to build, and Deutsche Bank to finance, the $4 billion in the first place?

The other extreme, of course, is Atlantic City, where visions of multibillion-dollar resorts are now just sand by the sea, and where casinos worth many hundreds of millions now fetch $20 million, or $30 million, or simply are closed down for nothing.

Everyone knows about the $2.4 billion Revel. Or about Carl Icahn buying Tropicana for less than it cost to build that property’s Quarter retail-restaurant addition.

A more sobering message, however, might come from Tilman Fertitta’s Golden Nugget experiment.

A hard-nosed, value-oriented businessman, Fertitta paid just $38 million for the then Trump Marina and then invested $150 million in a makeover that everyone agreed refreshed the property wonderfully.

The result? Golden Nugget continues to report operating losses and some speculate it might close.

So where is the sweet spot for casino purchases? Obviously, the answer varies by geographic location and property. However, the historic range of 7 to 7.5 times isn’t a bad place to start.

Or to look at Icahn, who hasn’t stumbled yet.

His Tropicana Entertainment paid $260 million, or 7.5 times forward EBITDA, for Lumiere Place last year. For that, Icahn got a nearly new casino, a Four Seasons-branded hotel, and a location in the heart of St. Louis near pro sports stadiums, the financial center and the Gateway Arch.

And, while other regional casinos have been in decline, Lumiere grew gaming revenues 4.6 percent in May, which might say something about paying the right price.

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