MGM MIRAGE (MGM)

The upsurge of gaming and lodging capacity in Las Vegas and Macau may dilute MGM’s customer base. By the year 2010, $20 billion worth of new hotels will have risen in Las Vegas.

Because of recent acquisitions and long-term investments, MGM is now $13 billion in debt. This high leverage will exacerbate any downturn in company performance.

After a few years of limited new development in Las Vegas, MGM is looking to kick things up a notch or two. Capital expenditures more than quadrupled from $719 million in 2005 to $2.9 billion in 2007. The total capital costs for two Las Vegas strip development projects are expected to approach $13 billion. Another $1 billion is expected to be spent on upgrading non-casino areas at the Strip resorts and $5 billion more for the MGM Grand Atlantic City.

The situation reminds me of late 1998, when the Asian financial crisis and a slew of new Las Vegas developments (many of which are now owned by MGM Mirage) depressed share prices for the gaming stocks and proved to be an ideal buying opportunity. As happened then, majority owner Kirk Kerkorian has been buying shares recently at prices well above the current levels. Last time, he cashed in handsomely on those bets. Will 2008 be a repeat?

According to the latest 10K, the investments are paying off. “For instance, between 2003 and 2006 we invested a significant amount of capital at MGM Grand Las Vegas…. That resort earned $290 million of operating income in 2007, a dramatic increase from the $127 million earned in 2002. Similarly, we transformed The Mirage…. The Mirage earned $108 million of operating income in 2003; in 2007, The Mirage earned $173 million of operating income.”

Perhaps it is because I just read Warren Buffett’s letter to Berkshire Hathaway (BRK) shareholders, but I thought I should check whether this improvement in operating income was actually a good return on the investments being made. Buffett evaluated two of his business on the basis of pre-tax operating income divided by the total capital required to run the business.

Unfortunately, MGM has a bunch of non-operating items to contend with, and I didn’t like the way the database I use broke out the data. So I decided to use cash flow from operating activities as a proxy for operating income (in this case, after-tax.)

I don’t think Buffett would be impressed. In 1997, average net operating assets (NOA) for the year were $1,055 million, while cash flow from operations was $184 – a cash return on NOA approaching 18%. By 2007, average NOA were $16.6 billion and cash flow from operations was $994 million – a cash return on NOA of just 6%.

While it’s true that the current NOA includes substantial investments in long-term projects that aren’t yet contributing to operating cash flow, the trend was heading down even before these got underway. Even if the projects do boost returns on invested capital to prior levels, it will be some time before that happens. CityCenter is not expected to open until November 2009, the other Las Vegas strip development is expected to finish in 2011, and MGM Grand Atlantic City in 2012.

At an enterprise value of 3.8 times 2007 revenue and 21 times 2007 income from continuing operations, MGM looks about as fully valued as one can imagine. The acquisition of Harrah’s, which recently closed after a year-long process, valued that company at 2.6 times 2007 revenue, and 17 times 2007 operating income. And that deal was launched at the height of the private equity boom. It seems wishful thinking to expect a similar valuation in today’s environment[1].

With the economy going down the tubes, Casino properties are being badly squeezed. They are getting squeezed big time and this thing could go under. Publicly traded casino operators MGM Grand (MGM) and Las Vegas Sands (LVS) are down 90% and 96% from their highs just 1 year ago! These things also look like they are already pricing in a severe recession - or even a depression. It suggests investors are worried they will even be able to survive.

Privately held Harrah’s only had about $12 billion in debt at the end of 2007 and $800 million in interest expense that year. Interest expense for the first half of 2008 was more than $900 million. That extra interest expense is going to eat up most of their operating cash flow and the slowing economy will likely eat up the rest.

The rise of casinos in other geographical locations has already begun to impact MGM’s operations. Specifically, Native American gaming has already taken some visitors away from MGM casinos.