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Solid trends for US gaming/lodging/leisure sector in 200717/01/2007. Source: Fitch Ratings.
 Despite some concern about the health of the consumer in the slowing US economy, Fitch believes the gaming, lodging, and cruise line industries are poised to continue solid, albeit moderating operating trends in 2007. Fitch does expect consumer spending to slow over the next 6-9 months following the housing market correction, but does not expect a sharp consumer retrenchment and corporate sector trends remain robust, which bodes well for lodging companies.
Significant capital project pipelines are likely to prevent meaningful improvement in credit profiles for gaming operators. However, gaming suppliers should benefit materially from gaming expansion in 2007 and do not carry the same capital burden of the operators. Lodging companies should benefit from a continued robust operating environment, but shareholder friendly capital allocation decisions could prevent further improvements in credit profiles. Strong demand for gaming and lodging assets due to their cash flow generation ability and often significant real estate value should continue to provide an additional source of liquidity/project funding and means for potential balance sheet improvement. Softening Caribbean demand for the cruise lines will continue into early 2007, although that is being offset somewhat by strength in other products and easing fuel costs.
Given increasing private equity involvement in both the gaming and lodging industries in recent years, the announced management buyout offer for Station Casinos and the outstanding private equity bid for Harrah's Entertainment, historically high merger & acquisition activity and continued media speculation, investors in this space are likely concerned about event risk in the form of leveraged buyout (LBO) transactions. While Fitch expects increasing private equity involvement in gaming and lodging industry transactions in 2007 and beyond, Fitch notes the cruise line industry has some structural protection from an LBO transaction due to the industry's tax status.
Gaming Growth Project Pipelines Are Robust
Due to the vast project pipelines for most of the major casino operators, Fitch believes there is not likely to be meaningful balance sheet improvement in 2007 with any debt reduction likely to be temporary as borrowing will increase toward the latter part of the decade. The large-scale Las Vegas projects (MGM MIRAGE's $7 billion CityCenter and Boyd Gaming's $4.5 billion Echelon Place) are scheduled to open in 2009-2010. Therefore, while spending for these projects will start to flow through the capital budgets in 2007, the bulk of the spending will not occur until 2008-2010.
Gaming operator demand trends are likely to remain modestly positive in 2007 with continued strength on the Las Vegas Strip offset by weakness in the Las Vegas locals market. The regional markets are likely to be mixed as new markets ramp up in Florida and Pennsylvania, the latter of which is likely to impact Atlantic City results. New supply will need to be absorbed in St. Louis, Southern Indiana, and Michigan. The robust Gulf Coast recovery will likely slow but casinos should continue to benefit from rebuilding in the region. Macau will continue to be the fastest growing established market as substantial new capacity opens.
Fitch sees significant positive trends in 2007 for the gaming suppliers as it heads toward a new technology cycle, which could spur replacement demand in 2008-2009. Suppliers will benefit in 2007 from new market shipments to Pennsylvania and Florida, the latter of which could also see upgrades to class III machines at the state's tribal casinos. California tribes could get renegotiated compacts approved which may accelerate machine sales in 2007, though Fitch believes 2008 is more likely. Supplier demand will be seen in New York as the racetrack VLT market continues to ramp up and in the Gulf Coast region as facilities continue to recover. Internationally, regulatory changes in Japan and Mexico created near-term demand and the suppliers will partake in the rapid growth in Macau. These positive demand trends will bridge the gap to the next technology-driven replacement cycle, brought about by server-based gaming, which is currently in a test phase but could gain market acceptance in 2008 followed by replacement demand.
Las Vegas Strip to Show Solid Trends
The next wave of casino development in Las Vegas that began with Wynn Las Vegas' opening in April 2005 will continue with Las Vegas Sands' Palazzo opening in Fall 2007. Fueled by the Wynn LV opening, gaming revenue (for Clark County) grew by 11% in 2005 and is up 9% through September 2006. In recent months, Las Vegas has seen strong trends in convention demand as well as international and high-end play, which appears to be continuing in Q4 and into next year. As a result of an expected continuation of those trends into at least early in the year and demand driven by the new resorts, Fitch expects Las Vegas Strip trends to remain healthy in 2007.
Room Supply Growth Outlook Could Improve
Historically, new mega-resorts in Las Vegas have driven demand and revenue growth, but a significant increase in room supply over the next few years could cause investors some concern. However, Fitch believes there are some mitigating factors:
There has been very little room supply growth so far this decade, as Wynn Las Vegas was the first major new Strip resort to open since 2000. Specifically, Las Vegas hotel room supply has only grown roughly 1% annually from 2000-2006, well below the 5% historic average. Therefore, Fitch believes Las Vegas will be able to absorb a somewhat higher than average growth rate over the next few years as current year-to-date citywide hotel occupancies are 94.0%, which is an historical peak.
Due to the sheer size of CityCenter and Echelon, it is possible that some of the other projects scheduled for completion toward the end of the decade may be delayed due to those two projects impacting construction costs and depleting the labor force. Some projects from less well-capitalized developers may be scaled down or cancelled.
Some older properties could shut down to make way for new development, which could offset some of the near-term projected growth. Stardust recently closed to prepare for Boyd's Echelon development, which should help the lower-end properties on the Strip in 2007, and other older properties could follow the same path. Harrah's could be the biggest beneficiary of this dynamic.
Fitch is concerned that much of the increase in supply is concentrated on high-end room product. However, the high-end concentration could be mitigated as older properties, such as MGM Grand and The Mirage, could migrate down-market as new supply comes on line.
LV Locals Market to Continue to Digest Capacity Growth
Fitch expects the Las Vegas locals market to continue to digest the capacity growth from the recent openings of Station Casinos' Red Rock in April 2006 and South Point (formerly Boyd's South Coast) in December 2005. While the recent weakness from the capacity growth and promotional environment could continue for the next few quarters as Red Rock continues to ramp up with its phase II and phase III expansions in early-mid 2007, Fitch expects the recent weakness to be temporary and that the capacity will be absorbed. As a result, the credit profiles of Boyd and Station will not likely be affected materially because Fitch believes the longer-term fundamentals of the Las Vegas locals market remain in tact. Constrained supply growth and a solid demand picture should be driven by a fast-growing local economy with strong population and job growth stimulated by the large projects noted above.
Las Vegas Sands, Wynn, and MGM MIRAGE Best Positioned for International Growth
In 2007 and for the next few years, Macau will continue to be the fastest growing established market as it has been in recent years. Las Vegas Sands' Sands Macau, which opened in 2004, has been a tremendous success as that property proved there was a significant, under penetrated mass market in the region. In 2007, U.S. operators will make a greater push into the more established VIP market as Macau Sands has recently ramped up its VIP business, Wynn Macau opened in September 2006, Venetian Macau on the Cotai Strip opens in mid-2007 and MGM Grand Macau opens in late 2007. As these developments come on line and the Cotai Strip is further developed, the market appetite for non-gaming amenities similar to the Las Vegas Strip will begin to be determined. Historically, Macau has been largely a gaming-centric market, while the U.S. operators plan to capitalize on broadening the product offering.
In other international markets, Singapore is likely to announce the winner of the Sentosa license at some point before the end of this month. The first (Marina Bay) went to Las Vegas Sands and Sentosa is the second of two gaming licenses it is issuing. After Harrah's dropped out, Isle of Capri is the only U.S. operator with an interest in one of the three bids. Japan has reportedly been discussing legalization with U.S. operators and could consider legislation as early as 2007.
New Market Growth Highlight Mixed 2007 Regional Outlook
Fitch is somewhat concerned that the newest gaming markets decided on high tax rates of 50% in Florida and 55% in Pennsylvania. The high tax rates may limit investment and profitability for the gaming operators. Longer-term, Fitch is concerned that other potential jurisdictions could look to Florida and Pennsylvania as a barometer when considering tax structure, which could dampen the industry's expansion outlook.
Gaming operations in Pennsylvania commenced in November and additional licenses are expected to be awarded on December 20. The additional supply in Pennsylvania in 2007 is likely to impact casinos in Atlantic City. The competitive impact should be somewhat mitigated by the closure of the Atlantic City Sands, which was recently acquired by Pinnacle and shut down on November 11 for its future new development.
Also, Fitch expects the AC market to be ripe for the announcement of events in 2007, which could include: announcement of Harrah's master-planned expansion of the Center Boardwalk (depending on the outcome of its outstanding bid), the debate of casino development on Bader Field, a potential development announcement of Morgan Stanley's site, Wynn potentially entering the market (talks with Trump have been reported), and a possible sale of one of Colony's properties.
Following the strong recovery of the Gulf Coast gaming markets in 2006, growth should begin to slow in 2007 but the casinos should continue to benefit from rebuilding in the region. Pinnacle will open Lumiere Place in St. Louis in Fall 2007 followed by the St. Louis County project roughly one year later at a total combined project cost of $805 million. Much of the spending for those projects will run through PNK's capital budget over the next 24-30 months. In early November, French Lick Casino in Indiana became the first casino to open in the state in six years and could impact results in 2007 at other Southern Indiana casinos, just as new competition impacted Iowa casinos in 2006. The Pokagon tribal casino in Michigan is scheduled to open in mid-2007 and will likely have a significant impact on results at Boyd's Blue Chip.
Private Equity Investment Likely to Continue
Fitch expects private equity to be increasingly involved in gaming transactions in 2007 and beyond. Station Casinos announced yesterday a $4.7 billion buyout offer from an entity including its management team and private equity firm Colony Capital, roughly two months after a bid for Harrah's Entertainment. On October 2, Apollo and Texas Pacific Group announced a $15 billion (excluding debt) offer for Harrah's. Harrah's has not yet responded to the offer while the bid has reportedly since been raised to roughly $15.5 billion. If completed, that would be the largest and most high profile private equity investment in the gaming industry. However, on November 28 there were media reports that a potential competing bid from Penn National backed by Lehman, Wachovia, and hedge fund D.E. Shaw could be on the horizon. Therefore, this story is likely to lead the gaming news in the coming weeks and months.
Private equity firms have been involved in the industry at least as far back as the late 1990s. For example, Colony Capital, which has been one of the most active private equity firms in the gaming industry, closed the purchase of Harveys Casino Resorts back in February 1999 and has made a number of investments since then. In summer 2006, the Nevada Gaming Commission approved a licensing change for the financing structure of the Las Vegas Hilton, which is controlled by Colony. Under the structure, three executives of the Whitehall Fund, which is a Goldman Sachs private equity arm, will share one seat on the board of the Colony entity that controls the LV Hilton. Licensing was required for the three executives, but without the policy change licensing could have been much more onerous. Therefore, this approval likely makes it easier for private equity investment in the Nevada gaming industry going forward.
The ability to tap additional sources of financing should increase the financial flexibility of gaming operators and could give them access to capital at a lower cost. Fitch views that positively given the significant capital requirements of the industry. However, to the extent that private equity involvement stimulates highly leveraged transactions, bondholders of issues with weak change of control protection could bear additional risk.
Lodging Should Enjoy Another Strong Year
The lodging industry is poised to benefit in 2007 from continued positive fundamentals with strong demand and limited supply growth. While Fitch expects the overall economy to continue to slow in 2007 (Fitch forecasts 2.4% U.S. GDP growth, down from 3.2% in 2006), the outlook for the business sector remains healthier than the consumer, which bodes well for the lodging companies since their operating environment is more sensitive to the business economy. The healthy business economy, strong demand for Upper Upscale and Urban segment properties (segments where the Fitch-rated lodging companies are most exposed), and tame low-single digit supply growth should support continued strong RevPAR gains in 2007. Initial company forecasts indicate lodging RevPAR should grow in the mid-to-high single digits in 2007, below the low double-digit gains in 2006 but very solid nonetheless.
Continued Business Model Transformation
The positive operating environment has continued to fuel asset sale programs and a continued transformation to a more fee-based, less capital intensive model across the industry. This year, Starwood's credit profile was the biggest beneficiary of the trend, as it sold 33 properties to Host Hotels for $4.1 billion in April 2006. Fitch believes that Starwood will continue to selectively sell owned hotel assets in the next 12 months and in many cases retain long-term management contracts. In 2007, Fitch expects Hilton to be the biggest beneficiary of that dynamic as it continues to digest the Hilton International acquisition, which closed in February 2006. Hilton announced it is marketing or planning to market for sale 11 hotels in continental Europe and six hotels in the United States, and it is exploring strategic alternatives (including the possible sale of all or part of the business) for the Scandic brand, which has 129 hotels and 22,800 rooms in its system.
Due to the continued transformation to a more fee-based model and that the expected RevPAR gains in 2007 should be mostly rate driven, lodging margins should continue to expand significantly in 2007. When RevPAR gains are primarily driven by rate rather than occupancy, the revenue gains don't carry additional operating costs, which make rate-driven revenue gains more profitable than occupancy-driven gains. Accordingly, the three major lodging companies have indicated margin improvement of 100-200 basis points in 2007.
While Fitch expects Hilton to use asset sale proceeds to improve its balance sheet, Marriott and Starwood are expected to be more shareholder friendly in their capital allocation decisions. As a result, it is more likely that Hilton will see positive rating actions in 2007 compared to Starwood and Marriott.
Cruise Line Demand Moderating to More Normalized Level
Higher gas prices, higher interest rates, and a weakening housing sector weighed on the low-end consumer in 2006 and had an impact on the cruise lines. The demand environment in 2006 was characterized by softening Caribbean demand offset by strength in more premium destinations such as Alaska and Europe. Much of the Caribbean weakness was felt in the shorter 3-5 day product, which sells at a lower price point, is targeted at the mass market, and attracts a high level of first-time cruisers. Notably, despite the challenges, cruise lines should still realize a net yield increase of 1-4% in 2006. While this is below the increases of 9-10% in 2004 and 6-7% in 2005, Fitch notes that net yields in 2004-2005 were above normal due to recovery from travel disruption. The net yield growth experienced in 2006 is more akin to the longer-term historic growth in net yield of roughly 2% annually.
Some of that Caribbean weakness seen in 2006 is continuing into the early part of 2007, though Europe continues to perform better. However, the most significant booking period of the year occurs during January-March (known as wave season), so a better picture of the 2007 yield environment will be seen at that time. At this point, Fitch anticipates 2007 net yield growth to be similar to slightly weaker than 2006, but remain positive. Fitch believes the industry remains very well positioned as many of the attractive investment characteristics remain in tact-strong cash flow generation, high barriers to entry, attractive demographics, oligopoly industry structure, mobile assets, and high visibility on new supply.
Cruise Lines Could Benefit from Easing Fuel Costs
Fuel cost per unit has pulled back recently, but will continue to be a factor to watch in 2007. Fuel cost per unit is up roughly 30-40% for the industry YTD 2006 and if it remains at current levels in 2007, fuel cost per unit could decline next year. However, energy prices remain volatile, and Fitch remains cautious regarding the near-term fuel cost outlook.
Stable Capacity Outlook
Industrywide capacity growth in North America should remain at roughly 5% annually through 2009, which is below long-term historic averages of 7-8% and well below recent highs of 11-12% annually in 2003-2004. So that bodes well for a rational price environment in 2007.
The three largest cruise operators -- Carnival, Royal Caribbean and Norwegian Cruise Line -- will take delivery of seven ships in 2007 with more than 19,000 berths for a total cost of roughly $3.8 billion, or nearly $200,000 per berth. Therefore, due to substantial capital expenditures and capital allocated to shareholders, it is unlikely there will be any meaningful improvement in balance sheets through debt reduction for the cruise lines in 2007. For most of its ship deliveries in 2007, Carnival is likely to use unsecured export credit financing, for which it has obtained very attractive financing terms.
Fitch does not expect much in the way of mergers & acquisitions since the industry is already highly concentrated and Royal Caribbean just closed on its $900 million purchase of Pullmantur, a Spanish cruise line, on November 14. While this could be a short-term leveraging transaction, Fitch recognizes the longer-term benefits of acquiring a leading brand in the fastest growing market in Europe where it did not have a wholly-owned local brand. It will allow RCL to diversify its cash flow, make more efficient use of its assets, and more effectively manage capital and asset allocation. Royal has already reallocated some assets among its brands following the transaction.
LBO Risk Could be Mitigated by Industry Tax Structure
The cruise lines pay minimal U.S. tax under Section 883 of the Internal Revenue Code and in order to qualify, the level of closely-held ownership can not be above a certain threshold. Therefore, Fitch believes the tax status offers some protection from an LBO because any entity attempting to take a cruise line private would jeopardize qualifying for that tax treatment and potentially create a very large tax bill. Furthermore, there would be very little benefit from an interest tax shield in a leveraged transaction.
Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.
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