The $81-per-share cash buyout offer by private-equity firms Texas Pacific Group and Apollo Management for Harrah's Entertainment Inc. (HET) spotlights a classic business controversy: current profitability versus heavy expenditures in the present to generate an even bigger payoff down the road. Private equity saw an opportunity to pounce when Wall Street failed to fully appreciate Harrah's preference for the latter, and similar situations may lie elsewhere among casino/gaming firms.
Students of securities analysis have traditionally been taught that over the long haul, annual capital spending (capex) should more-or-less equal annual depreciation charges, the theory being that new investments in the asset base ought to equal the pace of deterioration. Another rule of thumb holds that the long-term growth rates for capex and sales should be about equal, the idea being that new sales need to be supported by new plants.
In the real world, companies don't always adhere to that rule. The variations can produce interesting investment opportunities.
Table A shows that the casino/gaming group in general and Harrah's in particular are atypical relative to the S&P 500 and companies in general in the sense that capex is well above rule-of-thumb levels.
Wall Street doesn't always appreciate such situations.
On Sept. 11, with Harrah's trading at $62, David Anders of Merrill Lynch explained his cautious stance by stating that "the cost of pursuing growth is much higher than we initially thought" and that "like others in the industry, Harrah's is embarking on a two to three year period of aggressive capital spending."
Yesterday, David Katz of CIBC World Markets articulated a more specific concern involving strategic focus: "[O]ne of the key challenges for HET has been mapping out its growth plans in a way that is pleasing to shareholders. While management has spoken of focusing on key brands, it presently operates approximately eight" with some that are "not necessarily key to the company's branding strategy."
On paper, such concerns are addressable so it's tempting to hold management's feet to the fire: articulate the strategy with full clarity, bring the projects in on time and on budget, and so forth. Often, though, major growth efforts often don't proceed as smoothly in reality as they do in PowerPoint. Concerns such as those being expressed in connection with Harrah's stock are endemic to such situations.
That tends to frustrate analysts and shareholders. But as we see with Harrah's, it can produce the sort of valuations that attract buyouts.
Table B shows various general, back-of-the-envelope fair values we derived for Harrah's and the casino/gaming industry as a whole.
For starters, we estimate how much pre-tax income is available to potentially service new acquisition-related debt assuming the buyer targets a 2.00 interest coverage ratio. Rather than using the most recent pretax income figures, we seek a forest-rather-than-trees view by projecting seven years out, when, presumably, the current spending binge will be well over, using a growth rate we derive from analyst projections. We then convert that to a here-and-now figure using standard present value calculations. Given the real-estate intense nature of this industry, one could argue that depreciation, a non-cash charge for asset deterioration that doesn't necessarily occur at anything near the real-world pace, is not a realistic expense and ought to be added back into the pool. Despite the limitations of depreciation, we can't entirely ignore asset degradation, which does still occur over time, even if not at a textbook pace. So besides adding depreciation back into the mix, we ought to also subtract capital spending. That brings us to the unique casino/gaming situation: the currently extreme and unsustainable level of expenditures. A here-and-now capex adjustment also at odds with our desire for a seven-year view, which presumably, would give us a more normal picture. Moreover, if we subtract capex dollar-for-dollar, our valuations will come out below zero, a situation that is obviously not meaningful. Working backward, we subtracted 22 percent of capex, that being the percentage that would make our Harrah's valuation approximately equal to the value of the current offer.
Table B shows our calculations under the aforementioned scenarios.
The answers we get are not precise. We don't know for sure that 22 is the best choice for the percent of capex that should be subtracted from depreciation; we don't know that seven years is an optimal look-forward period; the reasonableness of the assumption changes it would take to show the industry as a whole to be undervalued is a matter of conjecture; and so forth.
But the table suggests that on the whole opportunities may exist for more Harrah's-type situations.
One cynical spin would suggest that public shareholders bear the burden of capex and leave to private equity the long-term cash flows it produces. Another might be that private equity would slash spending and get for themselves the economic benefit that might accrue to shareholders if management were to follow such a course.
A more positive interpretation would be that aggressive future-oriented spending, with all its fits and starts and uncertainties, is inherently distasteful to the public equity market and that private equity is presenting shareholders better deals than they could legitimately expect from day-to-day share-price trends.
It's also possible that managements could decide to buy back some equity and add debt, thus enabling the firms to stay public while generating some of the equity value a buyout might otherwise bring.
Identifying additional candidates that might be attractive to private equity or ripe for financial restructuring is, necessarily, something that requires case-by-case study. But Table C might provide a useful starting point. It identifies casino operators that, like Harrah's, have been especially aggressive on the spending front.
At the time of publication, Marc H. Gerstein did not own shares of any of the aforementioned companies. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.
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