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MGM Mirage Gains on Upgrade

Shares of MGM Mirage (MGG) rose more than 2% on Monday after Merrill Lynch upgraded the casino operator to buy from neutral, citing increased cash flow from its pending merger with Mandalay Resorts Group (MBG).

According to analyst David Anders, MGM shares have the potential to gain 24% over the next 12 months if the Federal Trade Commission approves the deal. Anders predicts the combined entity would generate $5.16 a share in adjusted free-cash flow during 2005, concluding "even if the company is required to sell off an asset or two, the math still makes enormous sense."

In reaction, shares of MGM -- which have gained 15% since Aug. 24 -- rose another $1.07 to $47.26.

By absorbing Mandalay, MGM will also be able to diversify its portfolio of Vegas properties, seen as important because of the spring 2005 opening of Wynn Las Vegas, which will compete against the Bellagio for the ritziest customers. And with the Las Vegas building boom taking off, the land that MGM will amass in its merger leaves the company with room to grow -- or assets to sell.

"The real estate market in Las Vegas is extremely strong, with acreage on the Las Vegas Strip at times trading hands in excess of $10 million per acre," said Anders in his upgrade. "Furthermore, the residential real estate market {in Vegas} was the strongest in the U.S. in the first half of 2004." (Merrill Lynch does and seeks to do business with the companies covered in its research reports.)

Anders estimates that MGM can increase earnings per share by 15% annually over the next few years, driven by new construction projects on the Strip -- like adding 1,000 rooms and a spa to Bellagio -- and its new venture in Macau.

But one of the most powerful earnings drivers, if the merger is approved, would simply come from deleveraging its debt-laden balance sheet. And with the combined companies expected to generate more free cash than expected, earnings can grow quickly as MGM pays off its debt.

"We estimate that the combined entity would have a somewhat stretched net debt to EBITDA ratio of 5.2 times," said Anders. "Simply by taking roughly $350 million in free cash annually and paying down debt, we estimate that 8 cents in incremental EPS growth would be created."

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