Executives face tough choice but have new owners‘ backing

With new Strip resorts competing for the high-end market, the world’s largest gaming company is faced with a momentous decision: whether to join the chase or do what it does best – cultivate middle-class gamblers who prefer frequent casino incentives over opulent surroundings.

That’s one of the big questions facing the new owners of Harrah’s Entertainment as they finalize their USD 30 billion acquisition early next year. The deal between Harrah’s and private equity firms Apollo Management and Texas Pacific Group received final regulatory approval in Nevada last week.

Today, Harrah’s is doing both – playing to rank-and-file gamblers while spending USD 1 billion to expand its Caesars Palace flagship – a property that recently raised its table game limits to court high rollers and will undergo yet another casino upgrade to compete with a slew of upcoming luxury resorts.

With the new, multibillion-dollar resorts all but forced by expensive real estate and construction costs to charge top dollar, Harrah’s properties – including the Flamingo, Imperial Palace, Harrah’s and the Rio – seem a refuge to travelers on sensible budgets. Is it worth it to the company to invest in expensive makeovers – only to compete in an already crowded high-end market?

Before the buyout emerged a year ago, Harrah’s discussed a bold plan to remodel its east Strip properties by creating a linked, „resort destination“ experience. No budget was disclosed, though analysts speculated the project could cost several billion dollars, while idling several profitable casinos for years during construction.

While Harrah’s – with new owners but the same basic executive team – decides which route to take, competition for luxury customers has stiffened with at least nine towers under construction on the Strip.

The two private equity firms say they won’t make decisions for Harrah’s executives. Instead, they will use their Wall Street contacts to help executives make more informed, and therefore more profitable, decisions.

Apollo and TPG, born in the 1990s, have attracted an enviable brain trust managing USD 70 billion from some of the country’s richest endowments, pensions and charities. They can help companies such as Harrah’s secure cheap financing while vetting acquisitions and other transactions using sophisticated risk-reward scenarios.

Buyout firms make money by financing takeovers at low cost and by making companies more efficient. In many cases, cost-cutting and new business strategies can turn around bloated, inept or stale businesses.

With other investors, TPG raised Burger King’s market value by USD 700 million in less than four years by replacing senior management; cutting losses for franchise owners; designing smaller, less expensive and more efficient restaurants; and creating new menu items.

Apollo’s acquisition of Vail Resorts, a failing ski resort company and the major employer in Vail, Colo., is most similar to the Harrah’s deal because of the company’s resort business and its community significance, executives said. Skepticism there about whether Apollo’s New York financiers would be sensitive to local jobs and the company’s culture turned into „real remorse“ when Apollo sold the company a few years ago, Apollo co-founder Marc Rohan told the Nevada Gaming Commission last week. After 14 years of Apollo ownership, Vail Resorts has blossomed into a profitable, diverse business with hotels in other resort locales, he said.

Harrah’s, a solid performer with a well-defined business strategy, is atypical of companies normally targeted by private equity companies.

The new owners will be challenged to find innovative ways of making money rather than cutting costs, said Michael Guttentag, a securities law professor at UNLV.

But improved performance doesn’t come without pain.

One of Texas Pacific Group’s first and best-known deals was the acquisition in 1993 of Continental Airlines, which it brought out of bankruptcy. The airline – one of many struggling carriers at the time – almost fell back into bankruptcy a year later. The investment group used bold strokes to wring a big profit in 1995, making more than 10 times its initial investment over the next decade. Thousands of jobs were lost, business strategies were scuttled and planes were grounded. But billions went into new planes and initiatives such as upgrading airline hubs.

Harrah’s „is about to go through a period of tremendous growth“ and therefore will benefit by being private rather than being shackled to Wall Street’s quarterly profit expectations, Apollo’s Rohan told regulators last week.

With USD 25 billion of debt on its books after the deal, Harrah’s is unlikely to pursue any major projects in Las Vegas beyond the Caesars tower, analysts say.

Harrah’s has used outside consultants to downsize its management ranks somewhat, though executives say future profits will come from spending more money, not less. The company has earmarked at least USD 4 billion for new projects by 2012, some of which is already being spent in Las Vegas, Atlantic City and Indiana. A major redevelopment here would require raising more money, experts say.

At a state Gaming Control Board meeting last week, Harrah’s Entertainment Chief Executive Gary Loveman said the company’s already „bright growth prospects“ will benefit from private equity investment, which will stimulate more investment here.

But clouds are gathering on the horizon. Harrah’s has been shut out of a casino in Macau, where competitors Wynn Resorts, Las Vegas Sands and MGM Mirage are cultivating a gambling-hungry population that will end up feeding their Strip resorts.

Apollo and TPG say they expect to own Harrah’s for seven to 10 years – a longer than average investment horizon in the private equity world.

Meanwhile, returns on Strip projects have declined precipitously from years past. Companies that used to make more than 20 percent on their cash are now looking at investment returns in the low to mid-teens – profits that are less compelling to private equity companies boasting 30 percent returns for investors.

So far, the best case study for private equity investment in gaming is a dramatic one. In 2004, Colony Capital purchased the Las Vegas Hilton for USD 280 million. Through its Resorts International affiliate, Colony has invested more than USD 100 million in upgrades in the long-neglected property, remodeling rooms and public areas, and bringing in headliner Barry Manilow. Operating profit has more than doubled since 2004, annual gaming taxes rose by USD 3 million and other taxes paid to the state grew by more than USD 10 million over that period.

It’s unknown whether the new owners will help accelerate Harrah’s growth, as they have suggested, or keep the company on a conservative path.

The immediate benefits – for executives, at least – are obvious.

Earnings growth needs to be „meaningful“ to impress Wall Street, while stocks can suffer if they are a penny below analysts‘ estimates, Loveman told regulators.

But Harrah’s is now off the hook.

„We are even more enthusiastic about this transaction today,“ he said.