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Judging by Wall Street's initial reaction to

Harrah's Entertainment's

( HET) plan to buy

Caesars Entertainment

(CZR) - Get Caesars Entertainment Inc Report

in a cash-and-stock deal valued at $5.2 billion, the move is a gamble -- with Harrah's standing to lose as much as it has to gain.

The transaction would create the world's largest casino operator with 56 casinos in nearly every gaming market in the U.S. Under the terms of the deal, released on Thursday, Caesars will receive $1.8 billion in cash and 66.3 million shares of Harrah's common stock, while Harrah's will assume $4.2 billion in Caesars' debt. Based on the closing price of Harrah's shares Wednesday, the transaction values Caesars common shares at $16.96, a 23% premium from where shares closed Tuesday.

"This acquisition will solidify Harrah's position as the pre-eminent distributor of casino entertainment," said Gary Loveman, Harrah's president and CEO. "We are adding attractive assets in stable markets with outstanding long-term growth prospects where we have a demonstrated record of success. Our network will also be enhanced as Caesars provides us access to new markets and new customers."

But since news of the deal first surfaced Wednesday, analysts questioned its rationale, unsure that bigger is necessarily better. In research notes, Prudential Equity Group said "we don't like the combination," while Goldman Sachs questioned "the strategic reasoning behind the potential acquisition." (Prudential has no equity banking business, while Goldman Sachs does and seeks to do business with the companies covered in research reports.)

Shares of both companies were off more than 4% on Thursday, once the deal became official. Harrah's fell $2.23, or 4.4%, to $48.75, while Caesars dropped 64 cents, or 4%, to $15.36 after Fulcrum Global Partners and Prudential Equity Group downgraded the company, saying it was fully valued after rising 15% on Wednesday. (Fulcrum does and seeks to do business with the companies covered in its research reports.)

Not every firm questioned the merger -- Morgan Stanley called it "modestly favorable" while Citigroup Smith Barney said the "strategic rationale is sound" -- but the initial reaction has been far different than the overwhelmingly positive one seen by

MGM Mirage

( MGG), which made a $7.9 billion cash-and-debt offer for

Mandalay Resort Group


a month ago. (Both Morgan Stanley and Citigroup do and seek to do business with companies covered in research reports.)

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Despite the negative reaction, however, Harrah's stands to win as much as it seems likely to lose if the deal passes muster with government regulators and closes in a year, as Harrah's expects.

What Harrah's Wins

First and foremost, Harrah's latest acquisition allows it to keep up with the Joneses -- or rather, MGM Mirage. And given Harrah's track record of making acquisitions work, the company could see tremendous upside to the $80 million in cost savings expected to be generated in the first year by simply cutting overhead.

Harrah's not only wins the title of world's largest gaming operator, it also becomes the industry pure play on the spread of gaming in the U.S. and abroad. Combined, Citigroup said the companies would have 56 casinos in nearly every gaming market in the U.S., with $8.8 billion in revenue and EBITDA of $2.5 billion. In comparison, MGM-Mandalay would have 28 casinos, $6.5 billion in revenue and EBITDA of $2.2 billion.

"A combination of Harrah's and Caesars would create an industry leader by any measure," said Jake Fuller, analyst at Thomas Weisel Partners. "On slot count, the company would have 78,674 slot machines vs. a combined 48,210 for a combined MGM Mirage/Mandalay." (The brokerage does and seeks to do business with the companies covered in research reports.)

Indeed, with so much overlap in their businesses, Harrah's-Caesars would immediately become the No. 1 slot machine operator in at least six U.S. markets, according to Fuller's research. Before selling any properties, Harrah's-Caesars would have 47% of the slot revenue in Atlantic City, with better-than-30% of the slot take in Mississippi, Louisiana, Indiana and Delaware.

The Upside For Harrah's
With its $9.4 billion cash-and-stock offer for Caesars Harrah's stands to:

* become the largest gaming operator and a pure play on the spread of gaming in the U.S.

*boost its presence in Las Vegas, the hottest market in the U.S., and counter MGM's bid for Mandalay.

*dominate a number of markets, with a 50% share of Atlantic City and big concentrations in Mississippi, Louisiana, Indiana and Delaware.

*create a loyalty rewards program without rival.

*keep its status as the lone gaming company with an investment-grade credit rating.

*use its proven management team to turn around Caesars' chronically underperforming assets.

The move finally allows Harrah's to accomplish its long-term goal of boosting its presence on the Las Vegas Strip. Harrah's down-market Las Vegas properties, which include Harrah's and the Rio, will be added to Caesars more upscale offerings, which include Caesars Palace and Paris. The combination only makes Harrah's industry-leading rewards program more attractive to members, with Harrah's-Caesars controlling 25% of the hotel rooms in Las Vegas and 20.5% of the slot machines.

For Harrah's, the deal is pinned to its ability to reap huge benefits by streamlining Caesars operations, which have historically underperformed financially, while capitalizing on the strength of its brands. Analysts say the combined companies could see a tremendous amount of earnings leverage and pricing power, if Harrah's can pull it off.

"The opportunity for Harrah's is in both cost savings and revenue enhancement, particularly in Las Vegas, as well as with promotional costs in Atlantic City," said Harry Curtis, analyst at J.P. Morgan. "We estimate 2 points of margin expansion at Caesars' earnings in Atlantic City and Las Vegas would generate $60 million to $65 million in additional EBITDA." (The brokerage does and seeks to do business with the companies covered in its research reports.)

There's a lot of execution risk in the merger, but Harrah's didn't overpay. The company said its offer for Caesars valued the company at 8 times 2005 EBITDA, a multiple that stacks up well vs. the industry's historical M&A multiple of 7.5 times EBITDA, according to Thomas Weisel research. Recently, MGM paid 9.6 times EBITDA for Mandalay after paying 10.1 times EBITDA for Mirage in May 2000.

Ultimately, by using so much equity as part of the deal, Harrah's will dilute current shareholders, it won't lose its status as the only gaming operator with an investment-grade credit rating. On Thursday, Moody's Investors Service reaffirmed the company's long-term credit rating.

"This seems like a deal that makes sense and has strategic value to it," said Steven Cohen, chief investment officer at Kellner DiLeo Cohen & Co., a New York-based M&A arbitrage firm with $550 million in assets. "After the short term effects have worn off, these kinds of mergers are usually positively greeted by analysts. I think perception will be that Harrah's is creating value for shareholders through this deal."

What Harrah's Loses

Given the size and scope of the merger, Harrah's-Caesars isn't a slam dunk. Many doubt that so many different assets can be wrangled into a cohesive business model that can outperform peers. Ultimately, the big fear is that Harrah's has finally bitten off more than it can chew.

"It would be the largest gaming company, providing it with scale and distribution, but it would also be somewhat unwieldy with more than 50 different properties," said Eric Hausler, analyst at Susquehanna Financial Group, adding later. "Harrah's would have to put more capital into the properties to make them competitive." (The brokerage does and seeks to do business with the companies covered in its research reports.)

Expending large amounts of capital after plunking down $1.8 billion in cash for Caesars could eventually weaken Harrah's balance sheet. Furthermore, taking on the largest merger in the history of the gaming industry could distract Harrah's management from other parts of its business, making it harder for all of its properties to stay competitive.

Since 1998, Harrah's has expanded through a number of big purchases, buying the Showboat, the Rio in Las Vegas, Players International, Harvey's Lake Tahoe and Horseshoe Gaming. But for the constantly-acquisitive Harrah's, such tactics are a blessing and a curse. On one hand, the company has a solid track record of returning value to shareholders, but on the other, the addition of Caesars could simply be too much at once.

The Downside For Harrah's
But while there are clear strategic benefits, Harrah's could also:

*dilute current shareholder value.

*be forced to sell a number of properties to comply with regulators, reducing some of the potential benefit from the deal.

*lose focus as integrating Caesars could distract management from current operations.

* limit its competitive response, especially in emerging markets like Philadelphia where operators are not allowed to own two casinos.

*fail to get the value it deserves when selling properties, since MGM will likely be selling ones as well.

"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 Steven Kent, analyst at Goldman Sachs, 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."

It may be large, but Harrah's strategic response will be limited in certain markets. In Pennsylvania, where gaming is newly legal, the casino operator would only be allowed to own one casino and a part of another, limiting its ability to diversify to offset the expected drop in Atlantic City gaming revenue once casinos open near Philadelphia.

Strategic planning will also be complicated because there's no way of knowing what the combined Harrah's and Caesars will have to look like in order to win the approval of the Federal Trade Commission and local regulatory agencies.

Even before the FTC casts its eye on the deal, Harrah's will have to play triage. In Atlantic City, the company would have to sell at least one, if not two, of the five casinos it has in that market, in order to comply with local regulations. Harrah's would also have to sell one of its three casinos in Indiana. And the company could be asked to divest some properties on the Las Vegas Strip where MGM and Harrah's would control 80% of the hotel rooms if allowed to keep all of their Strip properties.

With two mega-mergers on the docket and so many different properties potentially available for sale, finding buyers for the divested casinos might become a problem. While interest in casino investments has been strong, the glut of for-sale properties could create a buyer's market, sapping the value of the deal.

"While there may be buyers, price is the question," said Hausler. "Several of these properties are in declining markets with tough competition and cash flow that has either been flat or declining as well ... Who would want to buy them and what kind of fire sale price would they have to go for?"