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Harrah's Entertainment

( HET) and

Caesars Entertainment

(CZR) - Get Caesars Entertainment Inc Report

are considering a merger to create the world's largest casino operator, but many on Wall Street took a dim eye of the move on first blush, saying it makes no strategic sense and would likely draw the ire of government regulators.

According to sources close to the deal, Harrah's is looking to buy Caesars, which is said to be open to the offer, and could make an announcement in the coming days. The move comes just one month after

MGM Mirage

( MGG) bought

Mandalay Resorts Group



$4.8 billion and cash and more than $4 billion in debt , creating the largest gaming company in the world.

Terms of the deal, especially with regards to how much Harrah's was willing to pay, were not announced but sources close to the deal termed it "significant." Shares of Caesars skyrocketed on the news, gaining $2.18, or 15.7%, to $16.10. Harrah's shares slid $1.27, or 2.4%, to $50.71.

If combined, Harrah's and Caesars would leapfrog MGM-Mandalay as the largest casino operator in the world, with 54 casinos across an extremely diverse array of markets, from glitzy upscale resorts to decidedly down-market gambling halls. In Las Vegas, the combined companies would control Harrah's, Caesars, Bally's, Horseshoe, Paris, Grand and Showboat, consolidating another chunk of the Strip not owned by the combined MGM-Mandalay.

All told, the duo would have nearly 100,000 employees and $8.8 billion in annual revenue. In comparison, the combined MGM-Mandalay would have 28 casinos and $6.4 billion in annual revenue.

(Neither Caesars and Harrah's were available for comment on Wednesday.)

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Too Big to Fly?

Both deals are expected to draw scrutiny from the Federal Trade Commission as well as regulators in a number of jurisdictions, especially with regards to the Las Vegas Strip, where the two potentially giant-sized companies would form a de facto oligopoly. Already, MGM will have to divest some properties to comply with government regulations in some markets, notably Detroit, and some analysts say a potential merger between Harrah's and Caesars could jeopardize the approval of both deals.

"We believe this could pose a threat to approval for the pending MGM and Mandalay deal as two companies would control more than 80% of Las Vegas Strip and nearly 40% of U.S. commercial casino revenues, excluding Indian gaming," said William Lerner, analyst at Prudential Equity Group, in a research note. (Prudential does not have an investment banking business and Lerner does not have a financial interest in any of the companies mentioned.)

News of the deal, which was first reported by

The Wall Street Journal

caught Wall Street by surprise and engendered a negative initial reaction.

"If this is true, on the surface, we don't like the combination," said Lerner. "This combination would move Harrah's away from its core mid-market slot-focused strategy, providing greater exposure to tables, high-end business and destination jurisdictions."

Indeed, other analysts also questioned the strategic prudence of the deal.

For years, Harrah's has Harrah's has taken a different approach to its business than its rivals, diversifying its portfolio by building casinos in markets like Mississippi and courting low-rollers with preferred customer programs. In comparison, Caesars has been in overdrive for the past year refurbishing its brand by changing its name from Park Place Entertainment and performing a massive overhaul of its flagship property.

But while both companies attract different segments of the markets, they still compete against each other in number of casinos outside of Las Vegas, making the deal less compelling than MGM and Mandalay's, in the eyes of some analysts. In Atlantic City, Caesars owns two casinos while Harrah's owns three, giving the combined entity a nearly 50% share of the market, which is likely to draw anti-trust concerns from regulators.

"We do not clearly understand the strategic reasoning behind the potential acquisition of Caesars by Harrah's," said Steven Kent, analyst at Goldman Sachs, in a note. "While the MGM-Mandalay merger has the strategic underpinning of leveraging growth in the Las Vegas market, we would not say the same opportunity exists in the regional markets, such as Atlantic City and Mississippi." (Goldman Sachs does and seeks to do business with the companies covered in its research reports.)

Over the last six years, Harrah's has expanded through a number of big purchases, buying the Showboat in 1998, the Rio in Las Vegas the following year, Players International in 2000, Harvey's Lake Tahoe in 2001 and Horseshoe Gaming in 2003. But for the constantly-acquisitive Harrah's, Kent said the addition of Caesars could prove to be too much of a distraction.

"The potential acquisition of Caesars would shift management's time from seeking growth opportunities and focusing on current operations to dealing with gaming commissions, antitrust issues and divesting assets," said Kent, who added, "Harrah's would not be acquiring one company, but a hodge-podge of brands that would need TLC, strategic focus and, more importantly, capital."

A Pleasant Surprise?

Not everyone on Wall Street questioned the move. Merrill Lynch analyst David Anders was bullish on the deal because it would enable Harrah's to reach its goal of building a high-end property on the Las Vegas Strip by 2008. Not only would a merger immediately solve that problem, Anders notes that a combined Harrah's and Caesars could see tremendous cost savings, given the overlapping markets.

"Strategically, we believe this deal makes sense owing to similarity in the underlying asset base and Harrah's ability to implement its technology and player-tracking at Caesars' less efficiently run properties," said Anders, in a note. (Merrill Lynch does and seeks to do business with the companies covered in its research reports.)

While Harrah's, which has the best balance sheet and highest credit rating of all of the casino operators, was seen as the most likely candidate to make a move in the wake of the MGM merger, news of a potential deal nonetheless surprised Wall Street and investors alike.

In a number of television interviews over the last month, Harrah's management said it was not looking to bid on Mandalay's assets and struck a decidedly non-acquisitive pose with regards to other casino operators.

But the first signal that Harrah's may have been feeling acquisitive came on June 24, when the company increased $2 billion in existing bank credit facilities to a $2.5 billion revolving-credit facility with an option to boost that to $3 billion. Once Harrah's acquisition of Horseshoe Gaming cleared on July 1, the company's interest in buying Caesars apparently picked up steam.

Gaming investors should be prepared to expect the unexpected. With another mega-merger set to rock the gaming industry and a number of casinos likely to be sold to appease regulators, Harrah's move could trigger a wave of secondary acquisitions as rival operators cherry-pick individual properties.