Glenn Schaeffer
President, Mandalay Resort Group

I want to talk to you today about the Las Vegas phenomenon, which has few or no peers in the rest of the world. I was lucky to have been born in Los Angeles and was able to move over to the fastest-growing suburb of the west coast empire, which is Las Vegas. This is the fastest growing city in the history of the United States, faster than New York City, Chicago or Los Angeles during each of their respective booms. I will give you an overview of how we at the Mandalay Resort Group strategically approach the gaming industry. Along the way, you will get a bit of a tour of the Las Vegas phenomenon.

We think of ourselves as competing in the US entertainment economy, which is one of the vibrant sectors of America's growth story. This was particularly so in the 1990's, and we don't see that changing in the next ten years. "Entertainment" dollars are those spent discretionarily for the purpose of amusement. Within the next few years, entertainment will be closing in on 10% of the gross national product of the richest country in the world - $750B in 2004, up from $285B in 1990.

Casino revenues represent one measure of our industry, but it is no longer the only measure. During the 1990's, it became ok to gamble in the United States, culturally speaking. Over a ten-year period, there was an unprecedented expansion of opportunities to place a bet somewhere in this great country. Total casino revenues in 1990 were about $8B. This grew to over $39B in 2002. Of this $40B industry, 11% goes to Atlantic City, 12% to Las Vegas, 6% to the rest of Nevada, 31% to Indian Reservations and 40% to riverboat casinos. The biggest and most important market in this industry is Las Vegas, principally the Las Vegas Strip.

This is not going to change, but there have been a lot of new competitors appearing over the last decade. Eight new jurisdictions were legalized for gaming companies principally in the Mississippi River basin during the first half of the 1990's. Most of those are gaming vessels. In the second half of the decade and continuing today, we are seeing a striking expansion of Native American gaming, particularly in the state of California. The Native American gaming industry in California today is over $5B in annual casino revenue, and they pay virtually no taxes. Las Vegas has continued to grow, but our model for growth has changed away from unit growth. Atlantic City is the other gaming hub, and they helped launch the gaming boom when they legalized gaming in 1977.

Let me give you a sense of the scale of the Las Vegas Strip. The Las Vegas Strip is just over three miles long. The total annual revenue generated on the Las Vegas Strip is over $11B. This is larger than most other forms of entertainment. Movie box office revenues are about $9.1B. All professional sports teams generate about $8.7B. And theme parks generate $8.1B in revenue. Our three miles of Strip here in Las Vegas is bigger business than all of Hollywood.

Mandalay Resort Group is a Las Vegas-centric company. Our destiny is tied to the Las Vegas strip, even though we own fourteen buildings around the country. We generate about 70% of our profits out of our few big stores on the Las Vegas Strip. The "Big Box strategy", to borrow a term from the retail industry, has been the defining characteristic of the major operators in this industry for the past ten years.

Our prime consumer is the Baby Boomer. The one thing that America will not run out of any time soon is 50-year-olds. We create one every seven seconds in the US until the year 2013. On the Las Vegas Strip, our prime customer is 49 years old - that's about the age at which their discretionary spending is just beginning to peak. They have already bought their houses and cars, and they have mostly paid the college tuitions for their kids. If you look at household budgets in the US, the fastest growing category for Baby Boomers is entertainment, especially destination entertainment which is the business we are in.

The growth of the next ten years will come from the fact that we are in an up-cycle in our prime demographic - the 49-year-olds who wants to act younger than they actually are. We are also in a period of historically low supply on the Las Vegas Strip. Between 1996-2000, $7B of new product was added to this three-mile Strip. That will not happen again. We cannot convince the people on Wall Street that this is true because they always believe that whatever happened last year will happen again this year. I have been in this business for 25 years, and I am now working with the sixth or seventh generation of sell-side analyst. They believe that there will be another $7-$10B added to the Las Vegas Strip in the next few years.

This will not happen for several reasons. First, we are out of land. Second, all of the freeway exits and street corners have billion-dollar buildings on them already. These will not be torn down. The compound annual growth rate of new room supply to the Strip will be about 1.5% per annum over the next three or four years. This will be the lowest growth rate in over twenty years. I think it will be a permanent condition.

So, we have more well-off consumers in our target market than we've ever had. We will also not generate new supply nearly as fast as we have over the last twenty years. That's the formula for prices to go up.

The best thing about Baby Boomers is that they out-spend every other demographic group. Baby Boomers spend more than they make. That's great news if you're in the casino business. Not only do we have a lot of these Boomers, but they also are not going to suddenly turn into savers beyond what they've done in the past. They are going to enjoy themselves, and we are going to help facilitate that behavior.

Like I said, Mandalay Resort Group is a Las Vegas-centric company. 70% of our EBITDA cash flow is generated in our big boxes on the Las Vegas Strip. We own Mandalay Bay. We own the Four Seasons. We will open a property called The Hotel at Mandalay Bay, which will be a destination resort in its own right. This tower is under construction next door to our existing facility. We own Luxor, Excalibur, Monte Carlo and Circus Circus Las Vegas.

The Las Vegas Strip is pretty well consolidated. There are 80,000 hotel rooms on the Strip. There are 43,000 slot machines. There are about forty casino licenses, but there are three companies that own over 80% of the operations on the Strip - Mandalay Resort Group, MGM Mirage, and Caesar's. It is not a bad game for these three big competitors. No one is going to knock any of these companies out of the top three. We have advantages of scale that could not be replicated by a newcomer or an upstart. The three of us are about equal in size, which is good for competition, whether you measure us by room count or by casino square footage. Mandalay Bay, with the build-out of our new Hotel and "Project Z" which will be built to the south of us, will have the most hotel rooms on the Strip. We will also have the most new hotel rooms - rooms built in the last five years.

Over the course of my career, Las Vegas has undergone some transformations. In 1980, the gaming industry drove this economy. Before 1989, when the building boom began with the construction of the Mirage, a new resort had not opened in Las Vegas for over seventeen years. Then we saw an explosive expansion in Las Vegas. We measured ourselves by unit growth. There were 40,000 hotel rooms on the Las Vegas Strip in 1990, and in 2000, there were 80,000 rooms. We doubled the number of rooms during the 1990's. It is interesting to note that room rates went up every year during the 1990's, even with an unprecedented growth in supply. Keep this in mind as we enter a period in which there will not be much growth in new room supply. Room rates should grow all the faster.

Today we are in the destination entertainment business. Thirty-seven million people come to Las Vegas in a year, yet fewer than half of adult Americans have ever been to Las Vegas. All of the gamblers knew about Las Vegas by 1990 so our industry did not build the next 40,000 rooms merely to serve the gamblers. People do not come to Las Vegas if they don't have some interest in gaming, but they also come to Las Vegas because they have interests in lots of other things. They are interested most in the entertainment value, the most selection of things to see and do and experience, for the best price. There is nothing comparable to Las Vegas (as a brand) anywhere else. The new NBC TV show is called "Las Vegas". It is not called "Indian Casino". It is not called "Slot Machine". It is called "Las Vegas" and it is based on this property - Mandalay Bay. This is arguably the most famous single hotel in the world today. The numbers that come through this hotel matches the number of people who go to Disneyland in Anaheim. These are highly populated, highly identifiable buildings, and we have a huge share of mind among consumers who are seeking an entertainment experience and who will travel to get it.

What I will talk about next is how we have transformed our company strategically. It became clear to us in the 1990's that in the future, people would have to drive past or fly over a box that has slot machines in it in order to get here. Slot machines are closer to where most people live than Las Vegas is. What can we offer the consumer that will make them travel past the closest slot machines to their home and come to our store?

We own one third of the Las Vegas Strip, and we are the only company to own a contiguous mile on the Strip. When we complete our next project in two years, we will own about 17,000 hotel rooms in an interconnected entertainment complex that run at 92% occupancy year around. These rooms cover every level of the market coming to Las Vegas, from Excalibur all the way up to the Four Seasons or The Hotel.

We want to be a Las Vegas Strip within a Strip. Once you get into our clustered resorts, you don't need to leave to find something that you could not get here. It is all here. This will be the super-city of entertainment experience. You could not duplicate this. This is one of those businesses that Warren Buffet claims to like. It is a consumer franchise. It is known around the world. You cannot make another one. And we can raise prices every year.

The Beach was our idea to cut off tourism to Hawaii. With this invention, we did better than we knew. The next project will certainly have a tropical theme. The image of water amidst the driest desert in the United States had a certain fetching appeal to people on vacation. By the way, we can do championship surfing on that beachfront outside this meeting room.

Our convention center is the largest privately owned convention space in the world. The 1.5 million square feet of convention space only makes sense if you also control the 17,000 hotel rooms that surround it. One of the things to keep in mind when looking at our company is that this convention center gives us the power today to replace our lowest-priced customers - the wholesale package customers - with high-priced, mid-week rooms to conventioneers. The difference in price per room between the wholesale and the convention customer is about 50%. Our costs don't change between these two customers. Our incremental margin on room rate is 90%.

In the old days, we would have built more casino or more rooms to grow our business by units. Now that we are out of land on the Las Vegas Strip, we will get our growth through marketing and pricing power. Today, we are a resort destination company whose future growth in earnings is more dependent on the hotel side of our business than the casino side. This is not a bad thing because the ratio of hotel rooms to slot machines is two to one. The item that we have the most inventory of - hotel rooms - also is the item for which prices are growing the fastest, a multiples of the inflation rate, where we also get our highest profit margin. Most other companies in consumer-land cannot say the same thing.

This might sound odd coming from a company formerly known as Circus Circus and as a slot machine operator, but we are twice as sensitive today with respect to our cash earnings to room rate as we are to casino revenue. For either a Luxor or a Mandalay Bay, our rooms can run in the range of a 70% profit margin. A casino has a profit margin of about 60%.

What we care about and what Legg Mason cares about is economic profit. Economic profit is the amount of free cash flow (owners' profit) relative to share or market cap. The economic profit of just the Las Vegas Strip over the last 20 years has an upward bias, like the stock market, only better. The American stock market is alleged to go up 10% per year on average. I've been around the stock market for 20 years, and I haven't seen a 10% year yet. It will be up 2%, down 3%, up 12%, etc. The Las Vegas Strip goes up 5% each and every year, unless there are geopolitical disruptions like 9/11/01. Because our convention center is a catalyst for our pricing, we will grow two or three points faster than the rest of the Strip. This means that our earnings will grow faster.

We instituted a dividend, which is a feature that Legg Mason pays close attention to in a company. We believe in distributing capital back to the owners. We were the most aggressive company listed on the NYSE with respect to share repurchase during the year of the late, great Bear Market. We bought in 40% of our shares over a four-year period. We started with 110M shares and cut back to about 60M today. Just at the point where our prices will start to go up, our free cash flow will grow because of that increase in pricing, and we will have fewer shares to distribute to. We instituted a 3% dividend in June. No consumer company had ever leaped immediately from no dividend to a 3% dividend. We are in the top quintile of dividend payers in the country, who are not utilities or REITs. We raised the dividend on our first payment 8.5%, and I think it is a fair expectation for people to see a good-sized growth rate in our quarterly dividends going forward.

If you look at 100 years of stock market data and erase dividends and dividend growth from the S&P 500, then you should own bonds. The stock market without dividends provides about 50% of the return of the stock market with dividends. Our dividend rate is higher than that of the S&P 500. Dividends represent 45% of shareholder returns from 1926 through 2002.

People who own our stock should own it for the right reasons. Do not buy our stock for promised earnings, but for free cash flow. We will prove it by sending you a check every quarter.

Five years from now, after opening a new store, we will have a smaller balance sheet than we do today. We will take capital out of this business in the next five years while at the same time adding more assets and driving up our earning power. Typically, in the American stock market, this kind of company deserves multiple expansion.

That is a view of how we see ourselves and a changing Las Vegas market. We have been an initiator and leader in that change. We are a transformed company because we listen to what consumers want and we offer the things that they buy. We have morphed from a slot machine operator to a luxury hotel operator because the value proposition of offering people more than they can get anywhere else for a better price will never go out of favor. Bear market or bull, this formula will always work.

Question: How do you raise capital for construction?

Glenn: In the past, we did it the old-fashioned way - we borrowed. This worked out well because our rates of return on invested capital have been higher than our blended cost of capital, and decidedly higher than our borrowed cost of capital. For construction going forward (if nothing else goes wrong in the world), we are a company on the brink of having $5 per share of free cash flow. We can build any project that we see today with no new capital. We will do it out of free cash flow. We will not be a net acquirer of capital in this company over the next three to five years.

Question: Recently, two of your largest shareholders sold some stock. How should individual investors and fund managers deal with this information?

Glenn: It is a funny thing in the stock market - there are so many people around, and so few of them look at their data. Two of our largest shareholders did sell stock. They are older than I am, and they have owned those shares for a long time. If you look at the history of the stock market, there is no positive correlation between insider sales and stock price direction. The only positive correlation exists between insider buying and future stock price direction. This correlation is very high. As an executive in 2001, I made the single largest insider purchase decision of anyone in ten years. Do you know how many phone calls I received? Zero. I bought the stock at $14.

Question: You are the founder of the International Institute of Modern Letters. Can you tell us a little bit about that group and its members? Why was this organization formed?

Glenn: The International Institute of Modern Letters is a literary philanthropy whose mission is to support, rescue, and provide sustenance for writers of dissent and conscience in third world countries. Las Vegas has become a home for dissident writers, and the Institute publishes them and provides them with a place where they can work in safety. The free pen remains, as it has been for the last 500 years, the best antidote to illiberal society and tyranny

Question: You have invested in art and books. Would you talk a little bit about investing in alternative assets?

Glenn: A bull market brings all good things. I personally own an art gallery on the bridge between Luxor and Mandalay. Works on paper (which is the core business of this gallery) have had a higher rate of return over 40 or 50 years than the stock market, although I wouldn't put all of my money there. It is an illiquid market, but the right pieces from the right artist tend to have staying power. It is another form of currency. Rare books have actually risen even faster, but the man to ask about rare books is Bill Miller. Bill Miller is on his way to becoming the most prominent rare book collector in the United States.

Question: How do you respond to online gaming?

Glenn: Online gaming is a different animal than destination resort gaming. Just because people have money does not mean they have the desire to gamble. We know that gambling is a social activity for the customers that we draw. They come because they want to see and be seen. They want to socialize, and they tend to navigate in groups. Online gaming looks to us like a solitary experience. We do not think it is a crossover customer. More importantly, it looks like a flattening trend. For a while, it looked like the things working best on the Internet were pornography, online gaming and travel. The online gaming numbers have flattened out. Several of my competitors took a stab at this market and failed at it. I don't think that any of us today would consider that to be an avenue of growth for our companies.