The gaming industry has seen a lot of change from the days when individual casino owners gave way to large publicly traded corporations with responsibilities to their shareholders.

As more corporations took control of resorts, investment houses needed research and analysis to guide them in the study of these leisure-oriented public companies. Before long, most major Wall Street investment groups had analysts who monitored companies in the gaming industry.

Most live on the East Coast and make trips to Las Vegas or talk frequently with company executives, but one Wall Streeter — Deutsche Bank’s Bill Lerner — decided that the best way to monitor Las Vegas companies was to move here.

Lerner formerly was the senior gaming, lodging and leisure analyst for Prudential in New York, but eventually switched to Deutsche Bank where he is now a managing director and senior gaming and lodging analyst with an office in the Howard Hughes Center.

Lerner talked with In Business Las Vegas about issues, technology, growth and expansion and some of the controversies on the horizon for Nevada’s biggest industry.

Question: When you make appearances before groups, you usually have to give a disclosure to your audience. We don’t have to do that, but there are some companies that you can’t talk about. Who are they and why can’t you discuss them?

Answer: We’ve got investment banking relationships with a number of companies in the gaming and lodging industry. There are a handful in particular that Deutsche Bank has restricted us on for various reasons, whether we’re involved in live financing, advising and other banking deals. Those would be Station Casinos, MGM Mirage, Penn National, Hilton on the lodging side and Harrah’s.

You’re the only Wall Street analyst based in Las Vegas. Why did you make the move?

It was a strategic decision. I had originally been with Deutsche Bank about 12 years ago. I left and spent about eight years at Prudential and came back to Deutsche Bank in 2006, and what we agreed on internally was that really the right way, the better way, to cover this sector, gaming in particular, was to be based here. Ultimately, it was in order to capture a better flow of information to just physically be in the middle of where, essentially, all the action is, to be a little clichA~ about it.

Our relationships with corporates that we already knew strengthened tremendously. And it has fostered a significant number of other relationships that most of our competitors don’t have any dialogue with and it’s not just directly in the gaming discipline per se, but it’s everything that’s peripheral to it, whether it’s construction or it’s regulators, for example, or land or other real estate disciplines and it just extends to the gaming supplier side as well, every sort of branch of that business that matters as well. The impetus was to have a strategic advantage with respect to relationships and information flow and we’ve accomplished that so far.

The key seems to be that you’re able to get information that other analysts don’t get by being here.

Ultimately, it’s helping us guide our clients more accurately on investment decisions with respect to gaming in particular. Living here and breathing it everyday is a huge difference from the prior seven-year experience I had flying from New York to Las Vegas every four to six weeks, kind of parachuting in, doing a few meetings and then going back. So it’s been a huge advantage.

The industry has seen a trend toward private equity deals and public companies going private. Why?

A confluence of reasons. The gaming industry is different now than it was five to seven years ago. There is the opportunity for better returns on invested capital. That’s a function of access to new markets. I think that’s a function of a cheaper cost to capital relative to half a decade or a decade ago. The growth profile has changed as well. So there’s new international opportunities. There’s new license opportunities in domestic markets. As gaming liberalization continues — and I think we’re in the early stages — it’s attracted other styles of money.

We’ve seen value investors in this space, we’ve seen growth investors looking at this sector. We’ve seen international investors looking at these domestic casinos and slot-machine manufacturers. Now, for the first time, we’re seeing private equity en masse. Ultimately, I think it’s a function of the space having gone through some consolidation, experiencing better returns on invested capital and generating more free cash flow than before and it’s just on their radar screen. And I think it’s just the beginning.

Is it a good thing or a bad thing for the gaming industry?

Depends who we’re talking about and what market. I think smart investment is always a good thing for this industry, but overinvestment is a bit of a problem. To the extent that private-equity interest in the gaming industry is the impetus to overdevelopment here in the Vegas Valley, the answer would be it’s not a good thing in the short run. The long run, it’s probably good news. That’s ultimately a concern of ours, being overbuilt in a short, compressed period of time. We think the infrastructure issues in that time frame in some of these projects might have some difficulty to function.

How does that affect you as an equity analyst? Is there going to be anything left for you to analyze?

Actually, we get that question a lot. In fact, I think it’s going to be quite the opposite and we’ll get a lot of public companies as a result. The private-equity folks — not all of them, I don’t mean to make a blanket statement here — want some kind of liquidity event or exit strategy. While a number of these companies will be private for some period of time, they’ll want to exit and I would suspect one way might be new IPOs (initial public offerings). I think the assets that we’ll see, of course, will have been familiar to a lot of us. As part of those public companies, they might be a different mix of assets, they might be in different hands.

We’ll see what happens after these guys go private with respect to asset sales and so forth. But I think a number of these things will be back. With new markets as well, if you think of Macau’s expansion and you think of Singapore, if you think of expansion in other parts of the world, they need capital. Of course, the equity market is one attractive way of accessing it. The other can come from the $30-plus billion in development in the pipeline here in the Vegas Valley, particularly in the resort corridor. So I think you’ll see some of these entities look to the equity markets in order to raise capital as well. So I think it’s quite the opposite and we look at it as very good news from the bank perspective.

What do you think will happen next with this trend? Will we see manufacturing companies taking this same route?

I think that suitors such as private equity shops should be looking at the gaming suppliers. I don’t think they’ve been at the front of the radar screen for most of the usual suspects looking into the gaming industry. The most obvious initially is the casino sector and trying to roll that up and trying to take advantage of new licensing opportunities domestically and internationally, but I think there’s been some early work done, but I wouldn’t expect to see anything imminently.

It’s as part of the sector that needs to roll up. There certainly is duplicative R&D at the very least and a lot of fragmentation beyond the top four players, IGT, WMS, Bally and Aristocrat. If I were involved with private equity on that side of the business, certainly I’d be looking at these companies. It’s good timing to be looking as well. We’re about to step into what I would think is a dual cycle for the gaming suppliers. That’s global gaming expansion — which isn’t speculated, it’s bagged and tagged; we’re now waiting for properties to be built so there’s a huge pipeline of new expansion globally — and for the first time in memorable history, we’ll get a new replacement cycle domestically that will overlay with the expansion story. That’s a pretty exciting time. This is when you want to be buying the stocks of these gaming suppliers.

You recently returned from a couple of trips to Macau. Give us some impressions about the market and how the Las Vegas companies in that market are faring.

Massive. And early. How’s that? I spent a lot of time in Macau over the last four years or so and I’ve probably been to Macau three or four times a year over that time frame. I took my first trip there in 2003 for the opening of the Sands Macau. It was just eye-opening. It had already been a 40-year-old market which most people from the U.S. hadn’t spent any time in.

Parachuting into that market in that first trip made it obvious immediately why it would be a big opportunity for the U.S. casino operators to capitalize on. It’s just a very deep market in terms of volume with, at the time, generally speaking, some poor gaming assets capturing a disproportionately huge part of the consumer’s wallet there who have a great propensity to gamble there.

As I spent time over these last four years revisiting that market, we’ve seen an amazing evolution in a short period of time, whether it’s the type of customer that’s coming or the type of hardware, if you will, that’s now being offered to these folks. From my perspective going forward, there’s still a huge opportunity. Yes, there’s a big pipeline of casino resorts coming over the next three or four years. Perhaps there’s another 8,000-plus tables — because it’s essentially a gaming table market — in the pipeline.

However, there’s two interesting things that will probably justify that amount of supply over the medium term. It’ll be lumpy; it won’t be linear. But over the medium term, I’d say the individual visitation scheme, which is a government-driven program to allow more than 320 million Chinese into Macau, most of whom weren’t able to come in the past without restrictions. So you have a growing visitation scheme that will really develop once the transport infrastructure is built out in that market. That, of course, is a multiyear story and we’re just in the early innings of it.

Will some Macau casinos be unable to compete? Why?

The older properties for sure are going to have a tough time. Most of those are run by SJM (Sociedade de Jogos de Macau) which is Stanley Ho, who had a monopoly for 40-plus years in that market. Mr. Ho has realized what it is that you just asked and has started to redevelop. So he’s got a significant amount of land and a significant amount of casinos in the market already, but he’ll redevelop, I would suspect, much of it and expand his platform to compete.

What has been the biggest surprise as development unfolds in Macau?

How you can grow 40-50-plus percent off of that space is a pleasant surprise. That’s in terms of gaming revenue. How you can grow visitation off a 20-million-annual visitor base at 20-plus percent is a big yet pleasant surprise. Also, the depth of demand for nongaming, which the folks at Las Vegas Sands have really started to mine more than most of their peers with lots of retail square footage at the Venetian Macau. Lots of spend from folks who were thought not to be interested in nongaming, so retail, entertainment and hotel. Those have been surprises, pleasant ones.

Singapore is the one of the next international markets on the horizon. What’s happening there?

Singapore is interesting. It will start to see those properties open at the end of the decade. For the time being, there are two gaming licenses which were awarded. One went to Las Vegas Sands on Marina Bay, which is basically downtown Singapore, and the other went to Genting, which is a Malaysian company in an area called Sentosa, which is a bit more of a resort area.

My sense is after understanding the power of Genting’s property in Malaysia called Genting Highlands, it’s perhaps the largest cash flow-generating property in the world for now, that this is a very deep, wealthy market and a big opportunity. So I’d look for Singapore to feed off, of course, the city-state itself, but also Malaysia and also India, which is another opportunity, I think, as for new markets going forward. But as far as the end of the decade goes, the big feeders will be those markets.

Are there any other international markets you expect to blossom in the years ahead?

I think we’re just getting started. The Macau model will have been the impetus to all this international gaming expansion. One that is talked about and probably is closer than most give it credit for is Japan. It’s worth spending a second on Japan. Japan, in a way, is one of the largest gaming markets in the world with pachinko and pachislo slot parlors. So there’s no social hurdle or moral or otherwise hurdle to gaming in that market. We already have it there.

But we haven’t had any traditional U.S.-style casino gambling. Japan’s issue is that its population is aging. In addition, there really is no external tourism into Japan. You have Okinawa, which has a U.S. military base that is actually moving. So you’ve got an economic gap in the pipeline that needs to be resolved.

Looking at the success of Macau and the early success of the licensing process in Singapore, I think has given hope to the Liberal Democratic Party in Japan that they can help resolve some of that with gaming expansion. So I think we’ll ultimately see a licensing process start perhaps start next summer, in 2008, with perhaps three, four or five casino licenses being given out at first and perhaps more down the road.

Japan is one that’s a glaring opportunity, of course, a wealthy economy for the time being. Beyond that, I think India’s one to look at. Also, no moral hurdle to gaming despite what is probably perceived. A very young, fast-growing sort of cash economy. In addition, Taiwan, although not talked about a lot, I think is a possibility. Generally speaking, it’s Asian expansion here. But Asia is a particularly deep market and I don’t see why it can’t be mined much further.

How about Eastern Europe?

Hungary’s looking to do something. There’s a project called Euro-Vegas that some folks in Vegas here have passed on. But Hungary is looking to expand on the border. Croatia you might see some gaming expansion in that part of the world. You will see some expansion in Russia after retraction there. In Slovenia, there’s some expansion going on. So, yeah, Eastern Europe there will be some expansion, more so than in Western Europe.

How about some of the domestic markets? What’s happening in Pennsylvania?

Lots of expansion here in the U.S. which is one of the reasons we’re big fans of the slot-machine manufacturers. Yes, it’s a fragmented industry but it’s the Pareto Rule, 80 percent of the revenue and cash flow is generated by 20 percent of the operators. I guess in this case, it’s probably even a little more extreme.

But you have a number of jurisdictions that have recently expanded or continue to expand. It’s always a lagging effect of budgetary issues in some way, shape or form. And it’s usually contiguous geography that expands because it becomes an opportunity cost. After the Religious Right realizes that the state next door is doing it, we better try to capture some of that tax revenue.

So Pennsylvania, of course, made the leap. Ultimately, we’ll have 14 slot-based casinos or racinos in that market. That’s still physically building out. Maybe you’ll see table games in that market over some period of time. But there are a number of other markets, too. Of course, New York has video lottery terminals at a number of racetracks. West Virginia is expanding with traditional table games in some of their properties.

You’ve got California which has seen new compacts signed for additional games and then ratified. We’ll see if that moves forward. Oklahoma is upgrading the types of games that they have traditionally had at tribal casinos there. Alabama is moving forward with charitable gaming. Maryland is proposing some kind of slot story in that market. Chicago is looking for expansion. The list goes on and on.

But what we think is really, at this point, bagged and tagged in the U.S. represents close to 200,000 incremental slot machines on a base of 800,000 to 850,000. So 25 percent more, roughly, growth in the domestic installed base slot machine over the next three to four years, that’s pretty compelling. That’s relative to say 5 to 6 percent organic growth.

We’ve even heard about plans in Kansas now.

Kansas is another one I didn’t even mention. Kansas is going to have a number of slot-based casinos in that market. There are a number of states that will try to capitalize on this sort of mechanism to resolve tax revenues. I think what these states have discovered is that there hasn’t been material or any change to the amount of crime in the state. There hasn’t been material social issues that have arisen as a result of this industry. So it’s essentially become a new refreshing form of entertainment for these states.

What technological advances do you expect to have the greatest impact on the gaming industry?

The glaring one is server-based gaming. It’s the next product cycle for the slot-machine manufacturers. I think the commercialization of it, to be fair, will be early 2009, maybe a little earlier at the end of 2008. These product cycles in the slot-machine industry are always a function of technological disruption. What happens is it creates an accelerated replacement. Since slot machines generate 80 percent of a casino’s revenue — just the casino portion of the resort — it’s not a particularly price-sensitive product and that’s relatively speaking.

So the installed base of games domestically are ripe for a new product. The product’s getting stale. The last cycle, which was ticket in-ticket out games or cashless games, began in early 2002, so by the time we get this new product, it will have been roughly seven years later. So the slots are getting stale. The casinos made their money back, on average, on those games that they started to replace in early 2002 in 57 or 58 days. So it’s time.

The reason I think it will have an impact is that the product itself should enable slot floors to be more efficient. Essentially what you get is the ability to yield the floors more efficiently, so pricing, content, pay tables, things like that can change depending on day park, depending on which customers are there, something you haven’t been able to do before. At any given time on a slot floor, you’ve had, in theory, the optimal number of games, the optimal content, the optimal denomination and pay tables and so forth, but it hasn’t been real time. It’s been static. So this is going to be pretty exciting and, ultimately, drive more time on device for consumers.

In a recent report to investors, you said the Las Vegas gaming industry is going to have to develop a new mindset about transportation with worsening gridlock on the Strip. Please elaborate.

We spent quite a bit of time contemplating all the variables that will relate to this enormous gaming development pipeline in this market. There’s more than 50,000 rooms in the pipeline, there’s over $30 billion in development of casino resorts coming and most of it really comes to a head in 2011 or 2012. There’s just tremendous supply to think about. What we’ve done is some work on transport infrastructure and other structural things that will have to support that sort of pipeline that’s never been seen before in absolute or relative terms. It’s transport in, the road system, it’s airlift. It’s also employment.

Let’s pick on airlift. Despite, for example, the success of McCarran and despite the expansion in the pipeline at McCarran, we think we’re going to run into capacity issues in short order. If you go backwards in the analysis and try to determine the amount of visitation needed to justify $30 billion and 50,000 rooms, the visitation we arrive at would have trouble getting here. So whether it’s via air or, once they get here, via auto on the Strip corridor, it’s going to be a problematic story for consumers’ experience here. Something we want to protect and hold dear is the experience of consumers in this market. Of course, in many cases, this starts at the airport and for many folks, it continues in and around the road system. There’s two issues that are going to have to be addressed.

Perhaps a rail system from California connecting to an expanded monorail here is the answer to some degree. The other concern is just labor. We, of course, have more than 6,000 folks migrating here net per month and that’s been a phenomenal opportunity for this industry and for the housing industry until recently. The amount of labor we think we’re going to need is at least 125,000 short, if you will, of direct and indirect requirements also backed off the number of rooms that are in the pipeline. My concern is that the migration story won’t fully support the amount of labor needed to support all this development in the pipeline and these casino resorts will have to import labor and therefore, buy it, and that’s going to impact margins. So we’re concerned about it.

Is room oversupply going to be a problem?

I think so. I think some of the projects in the pipeline won’t move forward. That might be helpful for the time being. Some of the projects in the pipeline may push back timing and that might be helpful too. But I’m just trying to be realistic about something that this market has always shrugged off in the past saying it will resolve itself or we’ll figure it out. To be clichA~ about it, this time is different.

What other big problems do you see for the gaming industry in Las Vegas?

The one that comes to mind is this proposal to raise gaming taxes. I think what we’re seeing is some locals take a look at the gaming tax rate which is a gross revenue tax, which many other industries certainly don’t pay. This industry pays a relatively low tax rate — 6.75 percent on revenues — but it’s the reason why we don’t have state and city taxes and why our property taxes are relatively low. The proposal here is, after looking at a number of other gaming jurisdictions around the U.S., is to take that nearly 7 percent gaming tax on the casinos to a 20 percent level in order to get property tax relief. My comment on that it doesn’t make any sense. It’s not been well thought out.

First of all, we pay awfully low property taxes here to begin with. The other is that the almost immediate reaction to that sort of tax rate or anything close to it would be the cessation of gaming expansion, so you lose construction jobs. You lose capital investment in the state and you lose a tremendous amount of employment. That story for us which is there’s too much supply in the pipeline and not enough labor turns into there’s not enough supply in the pipeline and too much labor. That becomes a problem, so from my perspective, it’s not been well thought out. Casino resorts in and around the Strip corridor are generating relatively low returns on invested capital — better than they were in the past, but relative to the cost of capital, the returns are only a few hundred basis points. That goes negative if we take the tax rate to 20 percent.

Because there are other jurisdictions with tax rates of 20, 30, 40, even 50 percent, is there room for some compromise?

The reason why those relatively high tax rates work in other jurisdictions is because they’re limited-license jurisdictions, so they’re not particularly competitive. This is essentially a place where if you’ve got land and you’ve got capital and don’t have any skeletons in your closet, you can build a casino and get a gaming license here. You can build it in or around the Strip corridor and then be competitive with everyone. In most other markets, there’s a handful of licenses — gosh, in Connecticut, there’s two casinos.

Yeah, a 25 percent gaming tax rate makes sense when there’s two casinos feeding off an extremely deep market. The structure of this market doesn’t lend to that sort of tax rate. And, you know, in the past we saw a gaming tax increase here several years back from 6.25 percent to 6.75 percent and the industry was compliant. The industry was willing to do its part as long as other industries were subject to that tax increase and I would suspect that the industry wants to continue to be treated fairly in that respect, but the structure of gaming here does not lend to a tax rate that is typical of other jurisdictions around the country.

What are your thoughts on the proposal from Nevada educators to raise the gaming tax by 3 percentage points to 9.75 percent to increase teacher pay and finance other education programs?

I do think we need to find ways to improve the public education system here in Nevada, however, 3 percentage points is a huge increase in gaming taxes, approximately 44 percent when levying off of a 6.75 percent base. We think the direct impact would be severe, resulting in a nearly 12 percent reduction in profits for Nevada casino assets collectively. Indirectly the tax initiative could damage the $30 billion development pipeline, wreak havoc on consumers’ experience, visitation and perhaps even labor as operators would need to modify operations to handle this proposed hit to the engine room. I’d suspect that as always the casino industry would be willing to play a part in improving the education system, but absorbing the entire burden is simply unreasonable to ask — especially as the gaming industry is already the largest employer and taxpayer in the state by far.

A much smaller increase in conjunction with shared burden by all of Nevada’s industries should be alternatively considered.

Originally posted 2007-10-29 04:36:22. Republished by Blog Post Promoter

Related Posts

• Macau News August 2007 Macau imports rise 16 percent During the first five months of 2007, the value of Macau's imports grew 16.9 percent to MOP 16.45 billion, according to the Statistics and Census...
• Looking Ahead, the Cotai Strip in 2014 From the terrace of my apartment on the 25th floor of One Grantai the whole of the Cotai Strip glitters below, from the subtle ochre shades of the Venetian Macao...
• Wynn Plans Listing in Hong Kong to Raise Cash for New Macau Casino Casino magnate Steve Wynn's flagship Wynn Resorts is reportedly planning a secondary listing in Hong Kong, aiming to raise $3 billion to finance the construction of a mega-resort complex in...

Related Websites

• The Problems with Small Business Tax Credits President Obama has recently proposed tax credits for small business that he thinks will create jobs. I think he's either fooling himself on the merits of the proposal or is...
• Starting a Baseball Card Collection There are more collectors of baseball cards than there are of any other type of sports card. It makes sense, when you think about the fact that baseball cards have...
• VoIP Providers In the legacy system, the cost of maintaining the infrastructure is high, forcing call costs, such as longdistance calls, to be high. Hence, the services are dominated by large telecommunications...