Aggressive As Ever - Investment Outlook - June 2003

Having lived in the headlines, the redoubtable Kerzer family is back in the hotel industry's fast lane with plans for Atlantis, a growing 5-star brandand UK gaming.

By Staff -- HOTELS Magazine, 6/1/2003

Only one man regularly goes to work at the Kerzner International office wearing a tie—and that man definitely is not Chairman and CEO Solomon “Sol” Kerzner. Though the legendary South African hotelier has swapped the open shirt, gold chain look that defined him during his headline-grabbing tenure at Sun International for a well-tailored, office casual turnout, the same tough-talking, tough-minded maverick business style still fits like a glove. The trained accountant turned entrepreneur, who summed up his profit forecast for SA Breweries’ (now SABMiller) board nearly 25 years ago by saying simply, “We’re going to make a pot full of dough,” now promises that his One&Only brand’s refurbishment of the legendary Palmilla resort in Cabo San Lucas, Mexico, “will blow you away.”

Kerzner International principals Sol and Butch Kerzner have the cash and moxie necessary to atatck the market and grow their gaming holdings and new One&Only luxury brand.

No Troubles In Paradise
For now, and for the foreseeable future, the US$1 billion Atlantis resort and casino is the heart and soul of the company’s profitability. Revenues in excess of US$470 million account for roughly 80% of EBITDA (before corporate)—good news given a record-breaking performance in 2002, but bad news for those who would like to see speedier diversification of the revenue stream. For KZL’s investor base, the quality of this mixed resort/entertainment asset, which outpolls Disney World in the core New York market as “favorite destination,” largely offsets diversification concerns. With less than 30% of its revenues coming from the casino, Atlantis has an inherently diversified revenue stream that blends income from hotel operations, entertainment venues and retail outletswith condominium sales and a joint venture timeshare operation with Starwood Hotels & Resorts. Analysts such as Marc Falcone, Deutsche Bank Securities’ managing director, hospitality, gaming and leisure, New York City, see another 10 years of built-in expansion potential on Paradise Island.

With occupancy at Atlantis running in excess of 80%, ADR topping US$220 and outlets running at capacity during peak occupancy, Kerzner International is not waiting to tap that potential. “We can leverage the existing investment in the infrastructure for good returns,” says Sol Kerzner. The next step will be the US$40-50 million Phase III project that will add a 1,200-room hotel priced between the Royal Towers and the Coral Tower and Beach Tower. New attractions, a marina village, additional entertainment, food and beverage, and retail venues should further stimulate ncremental visitation. Near the end of the decade, Kerzner envisions a Phase IV that would push Atlantis’ inventory close to 5,000 rooms.

Free cash flow of US$80 million to US$100 million annually from the Mohegan Sun relinquishments, along with revenues from Atlantis, managing fees and other gaming income should fill the financing gap for future construction without upsetting the company’s gearing. Howard “Butch” Kerzner, Sol’s son who learned finance on the other side of the table as an M&A specialist with First Boston Corp. and Lazard Freres before taking on the presidency of Kerzner International, likes to keep financing on a 50-50 footing if possible. “Free cash flow means we can make the necessary investments to grow,” says Butch, frank but more “button down” than his father. “Clearly we are trying to develop our management business, not real estate. But we know we will have to make investments. We can do equity, but we would prefer to provide debt financing as we get a better rate of return.” Generally, 16% return on investment (ROI) is the lowest threshhold.

Falcone expects Atlantis’ Phase III to deliver closer to the 18%-20% range ROI. Cost savings derived from leveraging the infrastructure will help. But so will Kerzner International’s operational savvy and its clout as the largest non-governmental employer in the Bahamas. Joe Greff, gaming and lodging analyst, Fulcrum Global Advisors, New York City, says the primary appeal of Kerzner’s shares lies in the quality of the asset base, particularly Atlantis. But its ability to market to consumers is what will keep the fee income stream flowing smoothly. “Atlantis’ ability to expand its market reach after 9/11 enabled it to far exceed its targets,” says Greff. “Yes, it ashelped along by the fact that travelers perceive the Caribbean as a safe destination. But the way in which Kerzner broadened its market was really impressive.”

That ability should help fill the expanding number of rooms. When New Yorkers and other East Coast travelers were reluctant to get on planes, Kerzner International took advantage of depressed advertising rates to launch a massive television advertising campaign that attracted frequent individual travelers and retail customers (rather than incentive groups) and made Chicago, Atlanta and Houston Atlantis’ fastest growing new markets. The re-opening of the 174-key Palmilla in Los Cabos, Mexico, scheduled for this December, will open up new cross-selling pportunities in the virgin territory of the U.S. West Coast.

And Kerzner International has time for its markets to build. Not only does it benefit from a gaming monopoly on Paradise Island that runs until 2034, it also showed a necessary nimbleness in slashing operating costs by 8.3% early in 2002 to post EBITDA gains despite a 5.3% decline in revenues. Changing the gaming mix from a focus on high-end table play and its attendant high marketing costs contributed to better margins. “I do not see a lot of investment risk within the company,” says Greff. “The bigger worries are about hurricanes and any continued weakness in travel demand.” Falcone adds concerns about infrastructure to this short list. “Nassau International Airport needs to be upgraded considerably. The roadway infrastructure that winds through Nassau on the way to Paradise Island must be improved as well. These kinds of improvements may be a condition to expansion of Atlantis,” says Falcone. Sol Kerzner acknowledges that Kerzner International “is in negotiations” with the Bahamian government “to rovide some investment.”

And sitting across the table from the Kerzners can be challenging even for a government. “Sol clearly has a distinctive style and a unique way of doing business. In a way, his eccentricities were a harbinger,” says Vincent Vanderpoole Wallace, director general, Bahamas Ministry of Tourism. “There is no question that he got a little testy during the latter stage of what was an enormous investment when no one knew how well it would be received in the marketplace. But, we knew the Kerzners were savvy operators, and we were long tired of the buttoned-down promise meisters who delivered little.”

Initially, the warm welcome for the Kerzners had as much to do with the fact that the Bahamas was mired in the business doldrums as it did with acceptance of KZL’s corporate acumen. “Now at Atlantis has worked spectacularly, most of the naysayers have vanished or become believers,” Vanderpoole Wallace adds. “Paradise Island and the Bahamas have benefitted enormously from the successes of Atlantis and the Ocean Club. The Kerzners were the right tonic at the right time. It is not overstating the case to say they were the primary investment catalyst for the turnaround in the Bahamas’ tourism over the last 10 years.”

Building A Brand
Although the director general speculates that “we are reaching the limits of new investment in Nassau and Paradise Island” with Altantis’ Phase III, he points out that Kerzner International’s ability to innovate and continue to roll out new experiential concepts will drive people to the destination. KZL’s management is aware that, however much potential it has, Atlantis needs omplements on the revenue side. One&Only, Kernzer International’s luxury resort management flag launched in December 2002, represents a means of generating high-margin management fees with low capital risk.

The core of One&Only includes only six of the company’s managed hotels: Ocean Club; Palmilla; Le Saint Géran and Le Touessrok, both in Mauritius; Royal Mirage, Dubai; and the Kanuhura Hotel, the Maldives. Another property in the Maldives, the 124-room Reethi Rah, is scheduled to open next year. That should bring the number of managed rooms, including three unbranded hotels, to 2,100 by the close of 2004. Typically, KZL will have sliver equity of about 20%, though its flexibility is reflected in its 100% ownership of Ocean Club, 50% in Palmilla and, not surprisingly, 0% in the Royal Mirage.Sol Kerzner says Mexico’s proximity to the U.S. market, its political stability and an established market for super-deluxe hotels make it “very interesting” in development terms. “Palmilla will be our flagship, and it is going to create quite a stir. These are the best guestrooms we have ever done. That should help us build our business rapidly,” he says. So should rates, which now average just under US$900 per night with occupancy in the 80s. Business advantages such as the availability of a well-trained work force and little need for expensive imports further rationalize opportunities for at least one or two more One&Only properties in Mexico. The Caribbean is also a clear target, easily leverageable from Kerzner International’s loyal East Coast travel market.

Negotiations are in “advanced stages of planning” for a One&Only resort in Havana and a hotel/golf complex in Marrakech. A Morrocan destination would offer important entree into the eady tourism markets in the UK and France. Sol Kerzner wants to raise the bar for this offer with a collection of luxury villas to rent. “A residential component helps certain projects because of the liquidity. We can look at all the options in order to keep growing,” he says. Butch Kerzner sees “lots of opportunities” in the Indian Ocean, including the Maldives, where Kerzner International is part owner of the publicly traded Sun Resorts Ltd. The Kerzners say they would be “disappointed” if the group does not reach 20 hotels within five years.

Back Home
The opportunity to create dominance, either through a de facto monopoly or just an early build-up, plays to KZL’s strengths. This is just the situation leading the Kerzners back to South Africa. With their non-competitive clause having expired last year, Butch Kerzner paced through nearly 00 development meetings in a few weeks. “It was not just the volume of opportunities, but the quality of what I was seeing. I thought no one could develop many of those sites,” he says, adding that he was “blown away” by the reception. “It was really about my father and what he did to build South African tourism.”

Sol Kerzner says he, too, was “staggered” by the proposals—especially one from Debswana, a joint venture between the Botswana government and DeBeers, set up not only for diamond mining rights but, more recently, to reduce Botswana’s dependence on mining. Reports in South Africa indicated that Debswana had also been talking with South Africa’s Global Resorts. However, with Global’s recent purchase by Metallon Corp. and Mettallon’s failure to come up with guarantees by the early-April due date, there could be an avenue for a Kerzner base. Sol Kerzner says no one isoffering special incentives for 5-star hideaways in Botswana. “There would be the regular concessions, but nothing beyond what is considered normal,” he says.

If anyone could get the best terms available, it is probably still Sol Kerzner. Though sources in South Africa cite lingering animosity on the part of some former Sun International employees and the bitter battle with former partner and Kersaf Chairman Buddy Hawton, no one refutes the elder Kerzner’s role in putting South Africa on the tourism map nor his capabilities to increase its visibility now. “Sol Kerzner, Otto Stehlick (Protea), Hans Enderle (City Lodge), Bruno Corte (Southern Sun & Legacy) and Chris de Kock (Holiday Inn) all had a major, long-term impact on South Africa’s hotel business. But, in the industry, the media and the general public, Sol is the King Daddy of them all,” says Colin Grimsell, Hotel Performance Consultants, Rivonia, South frica. “Reaction to his return has not been negative at all, though there might be some nervous CEOs. He’s done it once and he can do it again.”

Joseph Aminzadeh, Horwath Tourism & Leisure Consulting, Cape Town, is researching the viability of several One&Only projects for Kerzner International. Still a work in process, Horwath’s data points to interesting trends: 5-star rates (albeit low) rose 33% between 2001 and 2002, while occupancy grew to 62%, the highest of any hotel sector. Average spend per foreign visitor is on the rise—particularly important considering the average stay of the long-haul travelers likely to fill Kerzners’ high-end rooms is 15.3 nights. Aminzadeh estimates break-even at 40%. “The Kerzner name is a household word here, and there is a lot of excitement about the Kerzners’ re-entry. Sol has a reputation as a tough businessman and a visionary. But he is going to have to prove that he success of his past developments can carry through into the luxury resort market,” Aminzadeh says.

Finding The Money
The Kerzners are not alone in understanding the jet set is hungry for new travel alternatives. This is a fickle niche. Regent International, Amanresorts, Rockresorts and dozens of other even more regionalized companies have demonstrated how difficult chain-building is at this level. “We are very different from Amanresorts. Our smallest resort is Ocean Club with just over 100 rooms. Most of our properties will be 100 to 250 rooms,” says Sol Kerzner. “We are also different in scale and economies of scale. Four Seasons operates first-class hotels, but they are not doing what we are doing. People who stay there want a Four Seasons experience. One&Only sells a local xperience. We do not even have development manuals or policy manuals. Each hotel is a start-up.” Development options include both acquisition and green field development.

Nearly three decades of resort operations, beginning with Le Saint Géran in 1975, plus good relations with international and local lenders provide a plausible platform for the quick growth the Kerzners want. Butch Kerzner terms the company revenue driven rather than cost driven. “The product has to be unique in terms of service and design. That can drive rate and business,” says his father. “And, you have to find unique ways to market them.” Kerzner International has a special team responsible for creating the aura of “a hot property” around each new hotel, whether that means attracting celebrities or luring unusual events.

Butch Kerzner remains cautious about finance. Less than US$50 million has been drawn down rom credit facilities and most major maturities are 10 years away. On the equity side, he prefers matching the investor to the project. “We have long-standing relationships with a number of international lead banks. However, sometimes you need local capital and local expertise,” says Butch Kerzner. “An international bank’s (risk-related) premium for a project in the Maldives probably would be higher than a local bank that understands the market and sees that it does not warrant a risk premium.”

A Sure Bet
The Kerzners are no strangers to calculated risk, especially in the gaming industry. Casinos have long been an integral part of the family’s expanding business empire, before and after South Africa. The success of Mohegan Sun, a project of the Mohegan Tribe in Uncasville, Connecticut, aised the bar for gaming on the U.S. East Coast. Opened as a US$400 million casino/entertainment complex in 1996, the facility underwent a US$1 billion expansion in 2002, which included a 1,200-room luxury hotel and spa, convention space, arena, more gaming space and a retail mall. As in Atlantis, Sol Kerzner sees Mohegan Sun’s business moving away from high-end table play. Few could disagree. Falcone estimates that Mohegan Sun and its closest competitor, Foxwoods, generated a year-over-year 8% increase in slot wins for a total of around US$1.5 billion.

Although several surrounding states have mooted enabling legislation for casino or “racino” gaming, none has yet made a move. If New York is first, it could be good news for KZL. Trading Cove Associates, the entity through which Kerzner provided management for Mohegan Sun, has development and services agreement with the Stockbridge-Munsee Band of Mohican Indians. The tribe has filed an application to build a casino in New York state.

For the moment, Sol Kerzner’s attention on the gaming side is turned to the other side of the Atlantic. He says the July 2002 purchase of a US$15 million stake in London Clubs International (LCI) “bought us a seat at the table.” “We wanted to be the first company to enter the UK market in 20 years,” he adds. A liberalizing of UK gaming laws is all but certain; the only remaining question is whether the legislation will get through Parliament sooner (which is likely) or later (more like three or four years from now). Sol Kerzner makes it clear he was not after LCI; only a license for greenfield casino development. “I did not want to get saddled with old parts and an old plant. That would be highly disadvantageous,” he says.His vision is nothing less than revolutionizing a gaming market that has private clubs with tuxedoed players on one end and neighborhood players in flocked wallpaper premises on the other. Prior to steps toward deregulation last year, entertainment and liquor services could not be mixed with gaming. The number of slots permitted per square foot was dismally low. Kerzner International plans to introduce a dramatic destination resort. Like Mohegan Sun, any UK project most likely will be phased from an initial casino to include a hotel and entertainment complex.

In the meantime, analysts would like to see LCI enact a financial recovery to generate some solid returns. Long term, “Kerzner’s experience and reputation in gaming could be a good fit for the UK market,” says Falcone. Jeff Klatzkin, managing director, Jeffries & Co., New York City, agrees that LCI has to make up ground lost on its US$200 million investment in the now-bankrupt Aladdin, Las Vegas. “But you have to remember that LCI has a good reputation and a great customer list,” he says.

The UK is the most obvious opportunity but not the one and only. “We see big casino potential internationally,” says Sol Kerzner. Sources say the company has been “kicking the tires” in Cuba, Hawaii and Southeast Asia, as well as New York. “We would love to see more projects like Atlantis,” says Klatzkin. “But monopolies are rare. I don’t think we’ll see the Kerzners going into a market where they are one of 15 or the last company in.”

Klatzkin and others says the Kerzners have become more conservative over time. “They have grown as they became a major corporation,” he says. But Vanderpoole Wallace sees little difference and Sol Kerzner probably sides more with Vanderpoole Wallace. He is clearly proud of his lifetime achievement award from FEDHASA, South Africa’s major tourism agency, and his place as the only non-American in the U.S. Gaming Hall of Fame. The calls from Nelson Mandela, offering to explain how Kerzner’s South African business activities countered the drag of apartheid, mean a lot to a man who refuses to discuss his reportedly generous charitable endeavors. “I am focused on conceptualization, planning and construction. That is what I love so that is what I do,” he says.