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Betting on a Breakup at Harrah's

By Jeff Hwang - Updated Nov 15, 2016 at 5:01PM

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Asset sales are likely at a post-buyout Harrah's.

On Tuesday, Harrah's Entertainment (NYSE:HET) officially announced an agreement to sell the company to private equity firms Apollo Management and Texas Pacific Group (TPG) for $90 per share in cash, beating out a rival cash-and-stock bid from a group led by Penn National Gaming (NASDAQ:PENN). Including the assumption of $10.7 billion in debt, that brings the total purchase price to $27.8 billion -- making this easily the largest leveraged buyout in the history of the gaming industry, and one of the largest LBOs ever.

The question now is: Does Harrah's and Co. continue as is, and develop the Las Vegas Strip, Atlantic City Boardwalk, and Biloxi properties as previously planned? Or will the group sell off chunks of its properties?

For its part, Harrah's management has said both in its press release and in the accompanying interviews that its new sponsors Apollo and TPG are "fully supportive" of the company's current strategy, citing the company's diversified casino portfolio, strong brands, and reliable cash flow as reasons for the interest from the private equity firms. And while Harrah's bailed from the bidding process for Singapore's second casino (Las Vegas Sands (NYSE:LVS) will build the first one) in the time since it received the initial $25 billion bid from Apollo and TPG in October, the company has stayed the course on its projects in Europe, and has also since completed the purchase of U.K. casino group London Clubs.

However, despite the company's insistence that nothing will change, that scenario carries considerable challenges. Even if you take management at its word, there are two key considerations -- one being the company's new debt load, and the other being the size and nature of the potential development plans.

A large debt load and a massive undertaking
According to an AP report citing CEO Gary Loveman, Harrah's debt load is expected to nearly double from $10.7 billion to $21 billion. As a natural result of the LBO, Harrah's goes from having a manageable debt load and being the only casino operator with investment-grade debt, to having a potentially burdensome debt load and one of the worst Debt/EBITDA ratios among casino operators.

Casino Operators: Debt/EBITDA Ratios

Debt

TTM EBITDA

Debt/EBITDA

Harrah's Post-Sale

$21.0B***

$2.43B

8.6

Harrah's Pre-Sale

$10.7B**

$2.43B

4.4

MGM Mirage (NYSE:MGM)

$12.96B

$2.36B

5.5

Boyd Gaming (NYSE:BYD)

$2.69B

$662.7M

4.1

Penn National Gaming

$2.83B

$621.3M

4.6

Ameristar Casinos

$859.0M

$268.6M

3.2

Pinnacle Entertainment

$637.4M

$194.2M

3.3

Isle of Capri (NASDAQ:ISLE)

$1.22B

$232.1M

5.3

*Data provided by Capital IQ as of most recent quarter.
**Debt figure provided in Harrah's sale press release.
***AP report

Meanwhile, the company faces the prospect of a massive undertaking on the Strip, potentially covering 180 acres of land east of Las Vegas Blvd. Consider for a moment that MGM Mirage's Project CityCenter will cost $7 billion while spanning 66 acres, and that Boyd Gaming's Echelon Place will cover 63 acres (plus 24 acres acquired from Harrah's in exchange for the Barbary Coast) and cost $4 billion. Not only is Harrah's redevelopment site larger than both Project CityCenter and Echelon Place combined, but development costs in Las Vegas are reportedly on the rise. Plus, Harrah's must also find somebody to build its project -- Project CityCenter alone hogs 7,000 workers, leaving a dearth of available construction labor.

The situation is worse in Biloxi, where management indefinitely postponed a potential $1 billion redevelopment project. I think a big part of the issue there is that Harrah's Grand Casino Biloxi is located at the eastern tip of Biloxi, at the base of the U.S. 90 bridge. That bridge was obliterated by Hurricane Katrina, leaving the Grand and the neighboring Isle of Capri stranded at a dead end a few miles from the main I-110 entrance to the market, and competing from a difficult position. The Isle of Capri, in fact, has reportedly laid off 200 workers.

The property sitting at the end of I-110 is MGM Mirage's Beau Rivage -- basically a smaller version of Bellagio but without the dancing fountains -- which doesn't help matters. While the U.S. 90 bridge is out, the burden would be on Harrah's to build a reason to drive past Beau Rivage. And that's a losing proposition.

Development takes a back seat
I think I underestimated Harrah's management's desire to go private. I figured they were just curious about what they could get before continuing as previously planned. That clearly is not the case.

As I said a few weeks ago, management had postponed any announcements of master redevelopment plans for the Strip and AC Boardwalk, and put off indefinitely the redevelopment in Biloxi; all three of those announcements had been expected during the summer, prior to receiving the first takeover bid in October. Meanwhile, in late July/early August, management was staring at a dirt cheap stock and a mammoth Strip project. So the notion that Harrah's management went looking for someone with deep enough pockets to buy the company does hold some water.

That said, the likelihood is that the company's development will slow as paring down debt becomes a priority. The Strip project might be modified or delayed. Moreover, future development on the Strip doesn't preclude the company from selling, say, the Bally's/Paris block (also on the Strip) and keeping the rest. The company could sell properties that don't figure into the long-term plans, such as Rio Las Vegas or Showboat Atlantic City. But I think Harrah's has maximized Rio's value by hosting the World Series of Poker there; any prospective buyer would have lower expectations, and as such the property would probably be worth more to Harrah's than it would be worth in a sale.

Also, Apollo and TPG could face licensing hurdles in a variety of jurisdictions, which might lead to sales in certain markets. In the end -- even taking Harrah's management at its word -- something is likely to be sold.

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Fool contributor Jeff Hwang owns shares of Ameristar Casinos, a Motley Fool Hidden Gemsrecommendation. The Fool's disclosure policy is always a safe bet.

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