NOT AN ANALYST

Background One of the most discussed topics in HY is Harrah Operating Company, one of the largest casino entertainment providers in the world. The enterprise has been taken private in January 2008 by a group of investors (Apollo, TPG and Paulson & Co. Inc) through an LBO and since then it has been cutting expenditures, reducing costs and initiating several debt-to-equity exchanges to avoid Chapter 11 filing. Despite those actions, Harrah continues to be a highly leveraged Company with a 10.3x Net Debt/Projected 2010 EBITDA and a 1.1 Projected 2010 EBITDA/Interest Expense.

Valuation and Leverage Harrah’s EBITDA has decreased in recent years, dropping to a projected 2 billion in 2010 from a peak of 2.8 billion in 2007. Despite debt exchanges, which have eliminated about 5 billion of debt, and substantial cost reductions, which have helped offset some of the decline in EBITDA, Harrah’s leverage in 2010 will be at 10.3x EBITDA and EBITDA coverage will be barely above 1. However, in 2011 the story is going to be a different. In June the equity sponsors announced a debt-to-equity swap that will cut about 1.118 billion in debt. Hence, in 2011 Harrah will have approximately 19.5 billion in net debt outstanding, assuming cash on hand remains constant. EBITDA will have to rise up to 2.4 billion or 20% (assuming 2010 EBITDA will be 2 billion) to reduce the multiple to 8.1x. At that level, Harrah’s debt is certainly something worth looking at, especially the second lien notes. Don’t get me wrong, this is still a leveraged capital structure, but certainly manageable giving the ample liquidity and an EBITDA at 2.4 billion/year. Although I expect the gaming industry to rebound next year, I don’t expect Harrah to reach its 2007 peak levels anytime soon. 

Public Offering and Implied Valuation A few weeks ago, Harrah Entertainment announced a plan to raise 575 million through an IPO for 9.75% of the Company to finance projects in Las Vegas and Ohio. The decision to invest capital rather than use it to reduce the already high debt level underlined the confidence of management in the turnaround of the business. Management probably expected to earn an IRR on the incremental capital that far exceeded the 13-15% pre-tax yield on the bonds if they were bought in the open market. However, the deal fell apart shortly after its announcement as market conditions were deemed hostile for private-equity backed IPOs but this scenario opened up a whole new valuation for Harrah. Let’s take a look. The IPO would have raised 575 million for a 9.75% stake in the Company, giving an implied equity value of 6.183 billion and an implied enterprise value of 25.63 billion after the 1.118 billion debt-to-equity exchange planned for next year. Considering that EBITDA for 2011 will probably be around 2.2 billion the implied EV/EBITDA multiple is 11.7x. Management is obviously extremely optimistic abut the outlook of the gaming industry but I think their projections and valuation are too generous and that the IPO is a bit pricy. However, I expect Harrah to launch another equity offering attempt next year, which will give us more information about the value of the enterprise.

What looks good? The first lien debt seems to be well covered in case of bankruptcy (see below) even if EBITDA will be 1.6 billion, which is very conservative. The second lien debt will experience above par recovery only if EV will be between 17.6 to 20.8 billion, the high end of the valuation. If you believe in the rebound of the gaming industry, the 10% Senior Secured Noted due 2018 are a good investment. They are currently trading at 89, with a CY of 12% and an YTM of 12.8%. All the Unsecured Notes trade at a significant discount to par, ranging from 60 cents to 90 cents on the dollar, but I don’t expect any meaningful recovery since Harrah has been exchanging them for equity at rates significantly below par.

Risks Harrah is a highly levered company; hence it would take a less significant decline in EBITDA to generate a payment default compared to a less levered company. S&P uses multiples of 5x to 8x EBITDA to value gaming companies, with an average multiple of 6.7x. This compares with the 5x to 7x used for most industrial sectors.

Bondholders will be pushed down the capital structure if the Revolver gets fully drawn (1,500 in available borrowing at the moment)

The presence of junior debt in the capital structures has resulted in higher recoveries for the loans senior to these obligations because senior lenders would have a priority claim to the total enterprise value of a firm. Harrah’s capital structure doesn’t contain many junior or subordinate notes.

Conclusion Although I don’t expect the economic recovery to allow the company to grow back to its 2007 peak, Harrah’ credit profile will get stronger in the next years. Looking at the capital structure, the best investment is to own the 10% Senior Secured Notes due 2018. Based on my calculations, above par recovery is possible if we apply a multiple of 8 to 2.4 billion in EBITDA, a plausible scenario in 2011 or 2012.