Low stock prices cause Strip executives to consider going private

Gary Thompson

Thursday, Oct. 8, 1998 | 12:08 p.m.

Fed up with plunging stock prices, executives at some publicly owned gaming and lodging companies are considering going private through leveraged buyouts or accelerated stock repurchase programs, analysts say.

The recent stock market selloff has pushed share prices for many such companies to historic lows, some even below net asset values, says Bjorn Hanson of the Price Waterhouse Coopers gaming and lodging group.

"That creates opportunity for company managements or private investment funds to acquire these companies at substantial discounts while still offering company shareholders a premium over current share prices," he says.

The "privatization" could take the form of stock repurchase programs such as that recently announced by MGM Grand Inc.

Stock buybacks reduce the number of shares in circulation, putting upward pressure on the price of the remaining stock outstanding.

If a company pays dividends, its profits are subject to double taxation -- when the company earns them and when the shareholders are paid from them.

But like most gaming-related growth companies, MGM doesn't pay dividends, preferring instead to use its cash flow for expansion, debt reduction or stock buybacks.

It recently completed a six million-share stock repurchase, leaving less than 12 million of its 59 million shares in public hands. The rest are owned by financier Kirk Kerkorian, and some analysts expect him to buy back the remainder either personally or through the company.

Another privatization method involves leveraged buyouts (LBOs). In a typical LBO scenario, private investors buy an equity interest in an LBO partnership, which then acquires control of targeted takeover candidates using a small amount of equity plus high-yield bonds or bank debt.

The LBOs are usually able to borrow $4 for each dollar of equity, thus the term "leveraged buyout." Because of the large amount of debt compared with equity, the debt is usually rated below investment grade. As such, the so-called "junk bonds" pay higher interest rates than their investment-grade counterparts.

The LBO firm then attempts to "de-lever" the acquired company's balance sheet, which is saddled with the new borrowings, often by selling assets and using the proceeds to reduce the debt.

So far this year, LBOs have amassed $80 billion to $90 billion of equity, giving them the potential for $320 billion to $360 billion of such deals. With so much ammunition to fire, they're looking for targets susceptible to either hostile or friendly takeovers.

Analysts say potential LBO candidates include Circus Circus Enterprises Inc., which is trading more than 35 percent below per-share book value, and Starwood Hotels & Resorts Inc., which has plunged to Wednesday's close of $21.25 from $61.50 in the past year.

"I think Circus would make a terrific LBO because it's trading at a very low multiple and generating substantial cash flow," says Jason Ader, a managing director of Bear Stearns & Co.

"There's a lot of risk in Las Vegas today, but if you did it after Mandalay Bay opens, it might be a way for management to maximize shareholder values."

Says another analyst who requested anonymity: "When you can acquire a company for 70 percent of net asset value, it pops up on the radar screens of LBO firms. That would put Circus into play.

"And I hear that Barry Sternlicht sat down with Henry Kravis recently, and you know Henry," the analyst says.

Sternlicht is Starwood's chairman, while Kravis is a principle in Kohlberg Kravis Roberts & Co., perhaps the most well-known of the nation's 800 or so LBO firms.

In the 1980s, KKR parlayed equity funds and junk-bond issues into control of RJR Nabisco (a saga chronicled in the book and movie "Barbarians at the Gate"), Safeway, Beatrice Foods and Owens-Illinois.

Although LBO mania slowed through the mid-1990s, KKR continued in the game through deals with Bank of New England, Denny's and Hardee's restaurants, Duracell, Stop & Shop and other businesses. Earlier this year, KKR raised $5.8 billion in additional equity and has been looking for places to invest it.

Other big LBO players include Thomas H. Lee Co., Forstman Little, the Blackstone Group and financiers such as Marvin Davis, Ronald Perelman, George Soros and Carl Icahn, who has already acquired controlled of the distressed Las Vegas casino operators Stratosphere Corp. and Arizona Charlie's.

While Circus Circus executives declined to comment, analysts say the argument for a Circus LBO might go like this:

Circus stock closed Wednesday at $7.75, down 31 cents on the day and off $18.75 from its 52-week high of $26.50. The closing price is about $4.50 -- or 37 percent -- below the company's per-share book value, or total assets minus debt and intangible assets divided by the 95.1 million outstanding Circus shares.

At its current price, Circus is appearing on a lot of LBO radar screens.

About 57.1 million of those outstanding shares are in the public "float." The rest are owned by Circus insiders who, if they entertained an LBO firm's friendly takeover proposal, would keep their shares in cooperation with the LBO plan.

Thus, an offer to buy the 57.1 million shares at, for example $10 a share -- a 22.5 percent premium over the current price -- might be acceptable to the institutions that control the bulk of the non-insider stock.

Why would such public shareholders be willing to sell?

"Assume debt peaks at $2.3 billion when Mandalay Bay opens, add the current (stock) market capitalization of a little over $700 million, and you've got a $3 billion enterprise value for Circus," says a gaming analyst who asked not to be identified.

"Circus is going to have cash flow" -- earnings before interest, taxes, depreciation and amortization (EBITDA) -- "of about $450 million in 1999," the analyst says. "The total debt and equity valuation would be about 6.7 times cash flow."

Cash-flow multiples and price-earnings ratios (stock price divided by per-share earnings) are the most common methods of valuing stocks. Growth companies are afforded higher multiples by investors who anticipate greater capital appreciation than those in more mature industries.

But as growth opportunities have waned, gaming companies' multiples have fallen from the double-digit range two years ago to the current mean of about six times cash flow. That's still higher than the multiples of companies such as General Motors or Merrill Lynch, which are trading below five times cash flow, but below the current 6.7 multiple of Circus.

"With the compression of gaming-stock multiples in this market, that's probably too high," one analysts says.

Circus' multiple would decline further if cash flow drops and enterprise value remains the same, or vice versa. Since the company's cash flow is expected to be stable and debt can't be trimmed without early repayments, investors are adjusting the equity portion of enterprise value by trashing Circus' stock price, thereby dropping the multiple closer to the mean for all gaming stocks.

Round off the imagined $10-a-share offer for the publicly held shares, and an LBO firm might buy the outside equity of Circus for $600 million.

Circus executives also might opt to do an LBO themselves. The company has filed a "shelf registration" for a $550 million debt offering that calls for paying down bank debt. Alternatively, those proceeds plus the $60 million or so of cash in Circus' coffers would more than cover a $10-per-share offer.

Using the typical 4-to-1 debt-to-equity ratio for such a transaction would mean the LBO firm would put up $125 million of equity and tack $475 million of debt on the now-private company's balance sheet.

"The theory is that an LBO firm would wind up with 50 percent of the new private company for putting up $600 million, and the insiders would get the rest," the analyst says.

Assume a blended interest rate of 8 percent on $2.3 billion of debt, thus interest payments of $184 million annually, and EBITDA of $450 million, an analyst says. "You'd still have interest covered 2.4 times by cash flow," he says.

Add the $475 million of new debt at a slightly higher rate, and annual interest payments would climb to about half of EBITDA.

"An LBO firm could be very comfortable with a 2-to-1 coverage ratio," the analyst says. "They'd pay $225 million interest and generate $150 million a year in after-tax income on a $125 million equity investment." And own half the company.

That theoretical 100 percent annual "internal rate of return" is used by LBO firms to entice equity investors into such deals. The actual return to the investors is usually far lower, though, because the firms take a management fee and 20 percent or so of the profits.

"But if interest rates go up or the market goes into a recession, the LBO people could get crushed," the analyst says.

For many gaming executives, LBOs might offer both tangible and benefits.

The sharp decline in gaming-share prices has put the stock-option packages used to lure scores of highly sought after professionals "out of the money." Unless the companies lower the strike price for the options -- a tactic that would probably enrage most shareholders -- the total compensation paid such executives is far lower than they expected.

An LBO, however, would give them a bigger equity stake in the company and the potential of a much higher return if it goes public again once the current downcycle ends.

The current dearth of growth opportunities for gaming companies also makes LBOs tempting to their management. And Circus executives must be tiring of facing the daily mound of phone messages from angry stockholders demanding to know when the rout will end. A private company would ease some of the pressures.

"In certain cases, LBOs make sense," says Bruce Turner of Salomon Smith Barney. "If you don't think you'll need access to the public equity market and believe the business is more stable than the public thinks and can get financing, then you can do it.

"But it's very risky. If you're wrong, if cash flows collapse in a possible recessionary climate or due to increased competition and you can't support the debt, the insiders would eventually lose everything.

"Another problem is that the capital markets on both the debt and equity sides are currently in such disarray that it's difficult to assess the possibilities of raising funding for LBOs," Turner says.

"The big LBO houses don't want you when you're sick, but when you're one step away from the grave. And I don't think the leisure industry is one step away from the grave."

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