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Regional consolidation has accelerated and become more palatable because of the REIT phenomenon

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The story of the casino industry is a story of big companies buying other big companies, big companies buying not-so-big companies and smaller companies buying other smaller companies and becoming bigger companies. The last 20 years have seen more than a dozen operators disappear in this way, their names surviving only in the lights on the marquees, on chip faces and on the logos on table felts.

The experts will tell you this had to happen. It’s the Dao of capitalism.

“I can’t think of an industry where that doesn’t occur,” says Steve Gallaway of Global Market Advisors, a research and advisory firm specializing in gaming and hospitality. “That’s a natural business cycle—consolidation.”

The bottom line is that casinos are like shopping malls now; they’re pretty much everywhere. Looking across the Northeast, the Midwest and the South, there are few new jurisdictions to grow afresh, few opportunities, save for the very largest operators, for greenfield projects worth the enormous cost of building them.

There is the fact, too, that the ground beneath the industry has shifted irrevocably.

“The customer base is aging. Tastes are changing,” says Cory Morowitz, a gaming consultant and educator based outside of Atlantic City. “Consumers today want emotional engagement with their products, and I don’t know, with the regulatory constraints, that we’re seeing the innovation keep pace. Millennials don’t really spend at high levels. And consumers, even though the economy is fairly strong, are challenged in some respects. There is a lot of competition for their spending dollar. And the gaming industry is a victim of all these trends.”


Revenue Revival

Commercial casinos generated $41.2 billion in gambling revenue last year, according to figures compiled by Ken Adams, a strategic analyst with CDC Consulting in Las Vegas who writes frequently on industry issues. Backing out Nevada, the take was roughly $29.5 billion, which translates into year-on-year growth, with notable exceptions in some markets, of between 1 percent and 2 percent.

It’s a battleground, in other words.

One impact has been “an increasing and heightened focus on the cost side of regional gaming, particularly around promotional expenditures,” according to investment analyst David Katz, a managing director with Jefferies covering gaming, lodging and leisure. “There’s been an increasing focus on leveraging and infrastructure from a loyalty and marketing perspective. And all of those things point to consolidation. It’s much easier to drive synergies when you’re bigger and cut the cost side of the business.”

There is finally the REIT factor.

Since 2013, when Penn National Gaming spun off ownership of 20 of its 23 gaming properties into Gaming & Leisure Properties, a Nasdaq-listed real estate investment trust—MGM Resorts International followed in 2016 with the creation of MGM Growth Properties, Caesars Entertainment in 2017 with VICI Properties—the casino REITs have amassed $30 billion of assets, transforming vast, financially fallow tracts of resort real estate into bankable equity in the process. The effect has been to shower the deal market with liquidity, and with interest rates as low as they’ve been it’s not surprising that public companies with investments tied up in low-growth regional markets and hungry shareholders to satisfy have concluded there may never be a better time to buy.

As Katz explains it, “If a property is for sale, an owner-operator that trades at around 8.5 times EBITDA is not going to be able to pay much more than that; whereas, if you split the property into real estate and an operating company, those two entities combined can pay a considerably higher multiple. So the seller wins, the opco is buying an operating stream at probably 6.5 times, and the REIT is buying a string of leases at 12 times. Everyone comes out a winner.”


‘Cheaper’ Money

Real estate investment trusts are nothing new, of course. The outgrowth of a decades-old federal government initiative to promote outside investment in real estate, today there are more than 1,000 recognized by the Internal Revenue Service. Some are engaged in purchasing or originating mortgages and mortgage-backed securities (mREITs, as they’re known), but most are classified as equity REITs.

These function much like mutual funds except they don’t trade in stocks and bonds; they make money for their investors by buying income-producing real estate which they lease to tenants that range across all sectors of the economy: retail (the largest segment), residential, office and industrial space, lodging and leisure, health care, data centers and other infrastructure facilities, even prisons. Equity REITs control around $2 trillion of assets in the U.S., according to the National Association of Real Estate Investment Trusts (NAREIT), an industry trade group. Most are traded on the major stock exchanges, where they command a combined market cap of more than $1 trillion.

The key to what defines a company as a REIT is the unique status it enjoys under federal law: it pays no corporate income tax on the profits it distributes to its shareholders as dividends, and by law it must return at least 90 percent of profits in this way. In recent years, this has amounted to more than $60 billion annually, according to NAREIT.

The three gaming REITs exemplify the best characteristics of the model: 1) solid, stable cash flows derived from the rents paid by their operating companies, the gaming licensees; 2) handsome dividend yields; and 3) robust growth opportunities in a mature industry that is consolidating at an increasing pace.

Investors, in turn, have rewarded them with trading multiples (currently around 13 times estimated 2018 EV/EBITDA) that are the envy of the industry. When VICI, the landlord of 20 Caesars Entertainment casinos, went public in February for $1.4 billion it was the fourth-largest IPO in REIT history and the largest-ever among hotel REITs (a crown it snatched from MGM Growth Properties).

The higher multiples stem from their perceived stability. Leases are fixed for periods generally lasting 10-15 years, with increases built in based on certain revenue or EBITDA thresholds over that time and optional extensions that can spread them out over another 20 or 25 years.

“You can borrow money for a lot less because you have solid assets,” explains Gallaway. “Borrowing rates are much lower for a REIT than for the operating casinos. Their money is cheaper. It’s a huge factor.”

Speaking on VICI’s first-quarter earnings call back in May, Chief Executive Edward Pitoniak, who previously headed InnVest, Canada’s largest hotel REIT, said, “The announced trades in the sector by us and our peers over the last six months are a testament to the growing confidence in the gaming REIT model. Market participants, both buyers and sellers, are gaining more confidence that the liquid market is truly developing. We believe this confidence will be key to generating further deal flow.”


Done Deals

“If you’re an entity that owns one to five properties, it becomes harder and harder to compete,” says Katz, “and in that regard, those entities capitulate and sell, particularly if they can get a good multiple.”

They’re getting them, too. The industry has seen more than $12 billion of M&A activity the last couple of years. Penn National (Nasdaq: PENN), Boyd Gaming (NYSE: BYD) and Eldorado Resorts (Nasdaq: ERI) have accounted for more than $10 billion of it.

The REITs figure prominently in most of these deals.

The current wave was launched in December with the announcement that PENN had concluded a $2.8 billion deal to acquire regional rival Pinnacle Entertainment (NASDAQ: PNK), whose 15 casinos and racinos in nine states had been acquired by Gaming & Leisure Properties the year before for $4.8 billion in cash and GLPI stock, essentially making Penn and Pinnacle sister companies.

Penn National gets 11 of these properties, comprising 17,700 machine games, 525 table games and 3,570 hotel rooms in seven states, and access to an array of new markets: New Orleans, Baton Rouge, Lake Charles, Black Hawk, Vicksburg and Chicagoland.

Pinnacle shareholders get $20 in cash and 0.42 shares of PENN for each of their Pinnacle shares, an implied value of $32.47 per share, by Penn’s reckoning, representing a hefty 36 percent premium to where PNK was trading at the time word of the merger talks leaked to the media back in October.

Concurrent with the deal’s closing in the second half, Penn will sell its Plainridge Park racino in Massachusetts to GLPI for $315 million.

GLPI also gains a new tenant in Las Vegas-based Boyd Gaming, which is paying $575 million to expand into the St. Louis, Kansas City and Cincinnati markets with the purchase of four Pinnacle casinos.

Factoring in these sale-leasebacks, adjustments to its master lease with GLPI and a projected $100 million in synergies over the next two years, Penn figures it effectively paid $1.71 billion for Pinnacle, a relatively modest 6.6 times EBITDA for the previous 12 months. It emerges a 40-property behemoth with casinos and racinos in 20 jurisdictions in 16 states and Ontario, Canada—53,000-plus slots, 1,300 table games and some 8,000 hotel rooms—and a VGT operation spread across more than 300 locations in Illinois.

At the same time that details of the Penn-Pinnacle merger were unfolding, Boyd announced it was entering the Philadelphia market with the acquisition of Valley Forge Casino Resort for $280.5 million in cash. In May, the company snapped up an Illinois VGT operator called Lattner Entertainment Group.

Between the Pinnacle and Valley Forge deals, Boyd has added 369,000 square feet of casino space to a nationwide portfolio now comprised of 29 casinos in 10 states—an additional 6,600 slots, 240 tables and more than 1,700 rooms.

The Lattner deal in Illinois adds another 1,000 or so machine games in 220 locations. Why get involved in VGTs? According to Keith Smith, president of Boyd Gaming, it was all about research.

“The studies we saw told us our players were spending significant time at their local bars or restaurants playing VGTs,” he told the audience at the Southern Gaming Summit in May. “If that’s the case, we want to be where our customers are.”


A Bigger Bang

The other REITs have been busy as well, shelling out big money for their piece of the action.

MGM Growth Properties (NYSE: MGP), formed in 2016 with the transfer of six MGM resorts on the Las Vegas Strip, MGM Grand Detroit and MGM’s Beau Rivage and Gold Strike casino hotels in Mississippi, has grown its asset base to $12 billion and its 2017 rental income to $756 million with the acquisitions of Atlantic City’s Borgata Hotel Casino and Maryland’s market-leading MGM National Harbor. MGP paid for the deals with a mix of limited partnership interests and the assumption of $970 million of debt and $462.5 million in cash.

This spring, MGP announcing it was paying a cool $1 billion to acquire a racino near Cleveland, the Hard Rock Rocksino in Northfield Park, Ohio, with 2,300 VLTs, a 1,900-seat concert venue and gaming revenue last year of $232.5 million. The plan is to spin off the operation by leasing it to an outside company.

It also has an option on the $950 million MGM Springfield, a category-killer scheduled to open in Massachusetts this summer.

Earlier this year, according to press reports, MGP even tried to buy VICI, the Caesars REIT, then all of about three months old. The $5.85 billion bid, representing a per-share offer of $19.50 (VICI was trading at $20 and change at the time) was rejected.

VICI (NYSE: VICI) has mapped a growth trajectory of its own. Launched last fall, VICI was one of the keys to getting creditors to buy in to a court-supervised restructuring of the largest and most heavily indebted company in the Caesars stable, Caesars Entertainment Operating Co., which had been in Chapter 11 protection since early 2015.

Originally a portfolio of 19 CEOC casinos (and four golf courses), VICI acquired Harrah’s Las Vegas in December for $1.14 billion and now owns a $10.5 billion, nine-state portfolio that includes the iconic Caesars Palace, 10 Harrah’s casinos and the Bally’s, Horseshoe and Harvey’s brands. The company also has options on Harrah’s Atlantic City, Harrah’s New Orleans and Harrah’s Laughlin and a right of first refusal on the Indianapolis-area racetracks casinos—Hoosier Park and Indiana Grand—Caesars purchased in November from Centaur Gaming for $1.7 billion. VICI also is in line to own a 300,000-square-foot convention center Caesars is developing on the Las Vegas Strip.

Then there’s the Tropicana Entertainment deal announced this spring, perhaps the best example yet of the force the REITs are exerting on acquisitions. Gaming & Leisure Partners is partnering with Eldorado Resorts on the $1.85 billion deal and will pick up most of the cost ($1.21 billion) in exchange for the real estate under six Tropicana casinos in six states, including the company’s Atlantic City flagship. For $640 million, Eldorado gets those six quality operations, plus MontBleu Casino Resort in South Lake Tahoe—in all, 7,900 slot machines, 265 table games and 5,400 hotel rooms.

For Eldorado, fresh off last year’s $1.9 billion Isle of Capri purchase, it works out to a very affordable 6.6 times EBITDA on a trailing 12-month basis after giving effect to Tropicana’s cash on hand and cash flow from operations through the deal’s expected closing in the second half. Eldorado has identified a further $40 million in cost synergies, which it calculates down to a purchase price multiple of less than 5 times.

Put this together with an agreement Eldorado reached around the same time to acquire the Grand Victoria Casino in Elgin, Illinois, for $327.5 million in cash and you’ve got a very savvy operator that has bought into a fresh $900 million-plus revenue stream and two significant new markets—Atlantic City and Chicagoland—for a blended multiple of 5.5 times earnings, roughly speaking, after synergies and other cost savings.


Who’s Next?

For investors in all these concerns, it’s shaping up as one heck of a run, that’s for certain. But is it good for the gaming consumer?

“Is it a good thing that Walmart dominates, that Amazon dominates? You get to a point in a capitalist economy, in the end, where that’s going to happen,” Adams says.

“For the consumer, what do you get? Well, you get the operators with the most money. Does that always result in the best product? Probably not.”

But then, in his view, the statutory limitations on licenses that prevail in most jurisdictions more or less decree oligopolies anyway.

“The slot machine product in Downtown Las Vegas is much more competitive and much friendlier to the customer than downtown Detroit or Atlantic City or New Orleans. They don’t have the same kind of open competition that exists in Nevada.”

But that’s only part of the story, and not the most important part either, because, as he puts it, “The current model is not to make it cheaper, it’s to make it better, so you appreciate what you’re getting and you’re willing to pay full price for it.”

Morowitz says, “On the marketing side, consolidation certainly helps because they should be spending less on marketing and promotional allowances. It’s interesting as you look across the landscape: Atlantic City went through a period with less casinos; marketing costs came down significantly. And now they’re starting to inch their way back up again. We expect with the opening of two new casinos that those marketing costs will continue to go up.

“And we’re seeing everybody improving their properties. So, having a wider distribution obviously helps the consumer. I think on the positive of this consolidation, with it usually comes some investment. As these companies invest in these products and make them better, it’s good for the consumer.”

Machines might get tighter, he says. “But there’s so much competition for that discretionary dollar, casinos will still have to treat their customers well in order to keep them.”

And no matter who buys up who, the 80-20 rule will always be there to assert itself when the dust settles.

“For those small number of customers that generate the lion’s share of revenue, I don’t think it’s an issue,” he says. “They’ll continue to get treated extremely well, and even fought over.”

Ultimately, there is a ceiling to how much efficiencies can be wrung from a property without damaging the player experience, he says. “I think that future margin improvements have to come from top-line growth. That’s part of the consolidation wave.”

He doesn’t see it subsiding either, not with the “financially engineered value” the REITs have brought to the equation.

“As with a lot of other industries, there’s a lot of copycat stuff out there, a lot of operators who are seeing opportunities to cash out and get full value. So as long as those multiples stay where they are, you’ll continue to see consolidation.”

It’s not as though there’s a lack of targets.

“There is still room for growth for medium- and small-size acquisitions and mergers, and certainly plenty of room to buy casinos that are freestanding,” notes Adams.

“Don’t forget, Caesars Entertainment is a meaningful player in regional markets,” says Jefferies’ David Katz. “Boyd, Eldorado. Monarch (Casino & Resort) may have a future in additional markets. Churchill Downs has been an acquirer. Golden Entertainment has been an acquirer. That’s not a bad list. Not as big as it used to be, but it’s not nothing either.”

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