At Harrah's, Good Odds for Investors
By Thomas Graves
We at Standard & Poor's think Harrah's Entertainment (HET ) remains the best bet in the casino industry. We look for this stock to benefit from its attractive valuation relative to Harrah's industry peers -- and from the gaming company's expected ability to generate free cash flow that can be used to pay down debt, repurchase common stock, invest in a joint venture or acquisition, or initiate a cash dividend. The stock carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy.
Through both internal growth and a series of acquisitions, Harrah's has become the most geographically diversified casino company in North America. It operates or has ownership interests in about 26 gaming properties, including seven in Nevada and two in Atlantic City. In 2002, we believe Harrah's $3.7 billion in casino winnings was first among publicly owned companies, followed by $3.3 billion for Park Place Entertainment (PPE ) and $2.2 billion for MGM Mirage (MGG ).
In southern Nevada, the company operates Harrah's Las Vegas, Rio, and Harrah's Laughlin. Revenue and operating profit in 2002 from this region was $824 million and $133 million, respectively. (Operating profit figures discussed here include depreciation and amortization charges, but exclude certain nonrecurring items, such as project opening costs.)
In northern Nevada, operations include Harrah's Reno, Harrah's Lake Tahoe, Harveys Lake Tahoe, and Bill's Lake Tahoe Casino. Another gaming property, Harveys Wagon Wheel in Central City, Colo., was recently sold. Revenue and profit in 2002 from northern Nevada and Colorado totaled $441 million and $68 million, respectively.
In Atlantic City, the company operates casino-hotels under the Harrah's and Showboat names. Revenue and profit in 2002 from the New Jersey properties totaled $778 million and $217 million, respectively.
Harrah's also operates casinos on boats or barges in locations that include Joliet and Metropolis, Ill., Vicksburg and Tunica, Miss., Lake Charles and Shreveport, La., North Kansas City, Mo., Maryland Heights, Mo., and East Chicago, Ind. It has a joint-venture partner in at least one of these projects, and some include at least two Harrah's casinos.
In addition, Harrah's now has a 100%-ownership interest in and manages a land-based New Orleans casino that opened in 1999. In 2002, Harrah's had consolidated revenue and profit from casino-boat (or -barge) projects, plus the New Orleans casino and an Iowa dog-racing facility, of $2 billion and $398 million, respectively.
In addition to owning casinos and hotels, Harrah's is represented in the growing business of gaming facilities operating on Native American land. It manages such casinos in North Carolina, Arizona, California, and Kansas. And Harrah's recently entered a new segment, "racino" gaming, as its majority-owned Louisiana Downs racetrack has added slot machines.
We expect Harray's competitive position to be enhanced by its customer reward program, Total Rewards, in which customers get cash and other offers in the form of mailed coupons that are redeemable on a subsequent visit to a Harrah's property.
BIGGER TAX BITE?
In 2003, excluding pre-opening costs for new facilities and unusual items, we estimate that Harrah's net income will reach $314 million ($2.88 a share), and we project noncash depreciation and amortization at $322 million. We look for capital spending to total about $425 million, with roughly 50% of this being used to maintain existing facilities and the remainder for growth initiatives and implementing coinless slot machines.
After all capital spending, we look for Harrah's to produce close to $210 million of free cash flow in 2003 (approximately $1.95 a share), and we expect that some of it will be used for debt reduction and stock repurchases. We project earnings per share of $2.90 in 2004, rising to $3.23 in 2005, and look for free cash flow to exceed $200 million in both years. If Harrah's were to sharply reduce its new construction spending, annual free cash flow could top $300 million.
In both the second half of 2003 and in 2004, we expect growth in earnings and cash flow to be limited by higher taxes on casino winnings. In Illinois, where Harrah's has a casino in Joliet, the legislature recently approved higher tax rates that are expected to go into effect on July 1, 2003. We look for the higher Illinois taxes (including an increased admission tax) to cost Harrah's about 16 cents a share in 2003 and 30 cents in 2004. By Thomas Graves
WELL SPREAD OUT.
Also factored into our earnings estimates is the prospect that New Jersey will be imposing higher taxes on casinos. We estimate that this would cost Harrah's a projected 10 cents a share in 2004.
Geographic diversity should provide some insulation from tax-rate hikes in individual gaming markets. In 2003, we look for about 30% of Harrah's projected $4.3 billion in revenue to come from its Western region, which largely consists of properties in Nevada; approximately 17% from its two casino-hotels in Atlantic City; and the remainder from casino businesses in such states as Illinois, Mississippi, Louisiana, Missouri, and Indiana.
We view Harrah's balance sheet and expected cash flow as sufficiently strong to support both future profit growth and a return of cash to shareholders in the form of stock repurchases or a dividend. As of Mar. 31, Harrah's had long-term debt of $3.6 billion, short-term debt of about $12 million, and cash equivalents totaling $338 million. Shareholders' equity was $1.6 billion.
BUYBACK AND DIVIDENDS.
In April, 2003, Harrah's entered into an agreement for just under $2 billion of borrowing capacity, replacing credit facilities with capacity of up to $1.86 billion, under which it had $611.5 million of additional borrowing capacity available as of Mar. 31. The cost of capital appears to have risen somewhat with its new credit facilities, but we're not expecting Harrah's to have difficulty servicing its debt.
Its rising cash flow may be used to buy back more stock. In November, 2002, the board authorized the repurchase of up to 3 million common shares. During 2003's first quarter, Harrah's bought back 250,000 shares at an average price of $32.48, leaving 2.75 million shares available for purchase under this authorization, which expires December 31, 2003. Under earlier repurchase authorizations, Harrah's bought back about 19.9 million shares from April, 2000, to yearend 2002.
Following the June, 2003, announcement that competitor Mandalay Resort Group (MBG ) is initiating a cash dividend, we believe that prospects have risen that Harrah's will do the same. We would not be surprised if Harrah's starts paying a cash dividend of about 15 cents a share quarterly, which would cost about $66 million a year. Based on the current stock price, this would be an annual yield of 1.4%.
BARGAIN OF THE BUNCH.
Our long-term discounted free cash-flow model gives us an intrinsic value for the stock of approximately $49 a share, or about 18% above its current level. Our model assumes an 8.5% weighted average cost of capital, with free cash flow declining in 2003, followed by an average 4% rate of growth (before interest on long-term debt) in subsequent years. We reach a similar 12-month price target by placing a p-e multiple of 17 on projected 2004 EPS of $2.90.
Compared to stocks of major gaming companies that we cover, Harrah's is selling at a discount. Based on 2003 earnings estimates, it has a p-e of 14, vs. an average multiple of 20 for Mandalay, MGM Mirage, and Park Place. When the comparison is extended to projected 2004 earnings, Harrah's stock is trading at a p-e of 14, vs. an average of 19 for the group of peers.
When viewed on the basis of Standard & Poor's Core Earnings methodology, we don't anticipate any major quality-of-earnings issues. In 2003, we look for Harrah's to have S&P Core Earnings of $2.75 per share. The difference between this and our $2.88 operating EPS estimate is 13 cents of option expenses.
Risks Harrah's and the stock, in our view, include the prospect that U.S. economic improvement will be less than anticipated; the chances that the tax rate on gaming revenues will be raised in one or more jurisdictions where Harrah's operates; the extent to which terrorism fears cause fewer people than we expect to visit the casinos; the possibility that a new competitor's expected debut in Atlantic City this summer will affect Harrah's results more than we anticipate; and adverse stock market conditions. Also, Harrah's profits can be affected by levels of luck at the gaming tables that are significantly below or above average.
Analyst Graves follows hotel and gaming stocks for Standard & Poor's