Wednesday, October 11, 2006

Harrah's Arbitrage

“[O]ur insurance subsidiaries sometimes engage in arbitrage as an alternative to holding short-term cash equivalents. We prefer, of course, to make major long-term commitments, but we often have more cash than good ideas. At such times, arbitrage sometimes promises much greater returns than Treasury Bills and, equally important, cools any temptation we may have to relax our standards for long term investments. (Charlie’s sign off after we’ve talked about an arbitrage commitment is usually: “Okay, at least it will keep you out of bars.”)”
Warren Buffett, 1988 Chairman’s Letter

In his 1988 Chairman’s Letter, Buffett allocated one section to arbitrage. He considers risk arbitrage a short-term substitute for cash, assuming of course that the transaction will provide a probability adjusted return in excess of the risk-free rate. At least back then, Berkshire invested a sizable sum in only a few opportunities a year. Perhaps most importantly, he invested only in already publicly announced transactions. Forget rumors or which companies may be potential targets.

This brings us to the recent buy-out offer for Harrah’s Entertainment (NYSE: HET) by a private-equity group which may offer an intriguing arbitrage opportunity. On October 2nd, news broke out that Harrah’s had received an offer for $81. The shares leapt from a previous close of $66.43 to a high of $80.01 before closing at $75.68. The seemingly wide gap between the stock’s closing price and the offer price is attributable to the uncertainties about the deal closing (financing, management’s refusal to sell, etc.) and the time it may take to close the deal. The casino licensing requirements alone could take up to a year and prove a challenge, although certain waivers could apply to institutional investors thus reducing some of the uncertainty. You are probably thinking a 7% potential return is not much of an arbitrage opportunity. But you know I am not a proponent of Efficient Market Theory. Just because the market says 7% is the best you can do, it doesn’t mean it’s so. Here is why.

I expect the initial $81 offer to be just a starting point (in fact the offer was raised to $83.5 today but the stock settled back near $76 after opening above $77). If you read the Wall Street Journal article on October 3rd, you will note that as early as September 15th, the buyers were exploring the casino licensing requirements in Missouri and potentially other states. Their lawyer had already obtained a waiver from Harrah’s to work with the private-equity outfits. I believe Harrah’s management expected an offer to be on its way.

The fact that they granted a waiver weeks before an offer was submitted also demonstrates that an offer was not unwelcome. Indeed, given Harrah’s was one of the cheapest casino stocks among peers, perhaps management got tired of Mr. Market’s treatment and decided to go about its business as a private entity instead. The trick will be to make existing shareholders happy by putting up a ‘fight’ and demanding a higher price from the buyers. Perhaps this smells of conspiracy theory to you but I don’t find it too farfetched.

Let’s assume the deal will take a year to close. The probability of a deal closing is quite high. Even if the deal falls through, the cat is out of the bag. Shareholders would demand that management maintain and boost the current stock price through a special dividend or buybacks. For example, this could be financed by borrowing against the company’s vast real estate holdings – apparently a strategy contemplated by the buyers to fund their buy-out. Furthermore, there is a high likelihood that other suitors will emerge boosting the offer price further. I think the private equity players can pay up to $86 and still enjoy a nice free cash flow yield given that Harrah’s is a cash machine. Finally, Harrah’s pays close to a 2% dividend. Add all that up and the shares look like a nice place to park some of your cash at $76 a share until you find a juicy long-term opportunity.

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