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UVA-F-1771 Rev. Mar. 1, 2017

This fictional case was prepared by Michael J. Schill, Professor of Business Administration. It was based on Robert S. Harris and Kenneth M. Eades, “Hope Enterprises,” UVA-F-1219 (Charlottesville, VA: Darden Business Publishing, 1998). It was written as a basis for class discussion rather than to

illustrate effective or ineffective handling of an administrative situation. Copyright  2016 by the University of Virginia Darden School Foundation,

Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.

Carter International

Chris Smith had only joined the corporate finance team of the prestigious hotel concern Carter International (Carter) four weeks ago in early 2016, but was already advising the CEO in critical matters. Just that morning he had received a memo request (Exhibit 1) to provide analysis related to a possible acquisition of Hope Enterprises (Hope) and a change in capital structure. With some reassurance that he knew the basics of financial management, it was time to get to work.

Carter International

Carter had a long history in the hotel business. The Carter name was recognized internationally as synonymous with quality accommodations. Its flagship hotels were the Carter-Plaza in New York, the Carter- Beverly in Los Angeles, California, and the Carter-Ashelworth and Carter-Westminster in London. Carter owned and operated additional hotel properties in Australia, Great Britain, New Zealand, Turkey, and the United States, and two casino properties in Las Vegas, Nevada. In total, Carter maintained 79,000 rooms with an average occupancy of 71%. Management had previously sought to sell off Carter’s gambling segment, but the new management team was now pushing to increase Carter’s participation in this growth segment.

Carter’s new president and CEO, Jane Scarret, had recently taken over from longtime CEO Francis Carter- Hellman, a member of one of Carter’s founding families. Carter-Hellman remained the chair, and 25% of Carter’s 45 million shares of stock was owned by officers and directors (some of whom were family members). Scarret was well regarded in the financial community. According to one analyst, Scarret brought “the reputation of an astute finance person who would be able to create value-enhancing initiatives for the company.” Carter’s recent share price of $100 seemed to reflect this market confidence in Scarret.

The hotel industry had experienced strong performance as of late. An equity analyst summarized the state of the industry in the United States:

Demand for rooms stateside are apt to remain favorable in 2016, as economic expansion and high employment augurs well for leisure and corporate travel. Although companies will be hard pressed to continue to increase average daily rates at a pace comparable to those of recent years, high occupancy levels should give lodgers more pricing power. There is a caveat. Six straight years of auspicious operating conditions have resulted in greater hotel construction activity, with sector behemoths Marriott International and Hilton Worldwide accounting for a significant portion of the sector’s development pipeline.1

1 Dominic B. Silva, “Hotel/Gaming Industry,” Value Line Publishing, February 2016.

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Some acquisition activity in the industry was in progress. Marriott had recently announced an offer to purchase rival Starwood Hotels for $12 billion, representing an enterprise-value-to-EBITDA ratio of about 9.5 times.

The Gaming Industry

The worldwide gaming industry had experienced spectacular growth over the past 30 years, but its future was less certain. The ongoing aging of the population in developed markets meant that a growing portion of the population was looking for relatively passive activities with attractive amenities. Increasingly, the public found casino gambling to be an acceptable form of entertainment. In the United States, access to legalized gambling had increased greatly since the 1980s as states and localities looked to stimulate both business and tax revenues. There was some concern about saturation in the gaming markets, and that increased competition would bring margin compression. Some evidence showed that newer casinos had been failing financially.

Internet gambling had grown dramatically in popularity over the past 20 years. The U.S. government regulated Internet gambling, and both interstate and international transactions remained illegal. Gambling activity in gaming ventures in Las Vegas continued to be strong. Internationally, there had been massive investment and success in Macao, and currently most of the world’s largest casinos were located in that special administrative region of China. With the recent tightening of Chinese government regulation, it was clear that gaming demand in Macao was softening. The reduced attendance was particularly evident among the high- roller gamblers. The market contraction in Macao had had a particularly strong effect on those firms that were heavily invested there. Stock prices for gaming companies that were heavily invested in Macao (i.e., Las Vegas Sands and Wynn Resorts) were down 20% to 50% in the past year. Exhibit 2 provides financial summary data on the participants in both the hotel and gaming industries.

Some observers believed that the gaming industry was ripe for consolidation. There were rumors that gaming companies as well as hotel concerns were on the hunt for gaming acquisitions as the industry was reaching maturity. Analysts believed that adequate capital resources would be critical to companies that were going to see their way through this new phase of the casino business.

Hope Enterprises

Hope owned and operated three world-class casino-hotel resorts in Atlantic City and Las Vegas, a dockside casino and hotel in Florence, Mississippi, and a riverboat casino in New Orleans, Louisiana. Exhibits 3 and 4 provide financial information on Hope. According to one analyst:

Hope is considered a prime acquisition target because of the strategic location of its holdings and the kind of customers it attracts. The company controls two casinos in Atlantic City, a market that was ignored by some major gambling companies for years but is now booming, prompting a scramble to acquire key locations there. Hope also controls a Las Vegas casino, and its properties serve midmarket gamblers who usually do not patronize high-roller casinos such as Carter’s Las Vegas Palace.

Increasingly analysts suggested that independent casino businesses like Hope needed to partner with larger hotel concerns to remain viable.

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Deal Considerations

From early on, Scarret had made it very evident that she wanted Carter to be an important player in the casino business. The question was not whether Carter would make a gaming acquisition but rather when and who. Although Hope represented an attractive deal candidate, Smith knew that there were other targets under consideration.

Yesterday a team had begun investigating the economics of Hope and how the merged entities might look. Overall, the view of the group was that growth in the industry would continue to keep ahead of broad economic growth for the next five years and then ease down to pace with the general economy in the years beyond. A contracting of economic expectations was a theme for the beginning of 2016. World stock markets were down as investors processed the economic uncertainty associated with depressed commodity prices (oil prices were at a 10-year low), a slowing of the Chinese economy (Chinese GDP growth was at a five-year low), and a volatile U.S. presidential election. Exhibit 5 provides information on financial market conditions.

The motivations for the deal were several. First, Hope looked like a bargain. The stock price had continued to drift down during the past year and now traded at a price-to-earnings ratio of under 10 times. Second, Hope was well run. Hope management was well respected in the industry. An acquisition would allow Carter to retain a talented management team. But this would not be a business-turnaround acquisition. Third, Hope was small. Hope’s small size meant that Carter could add value by providing scale opportunities on both the cost and revenue sides. The team thought Hope’s margins would be substantially improved by taking advantage of Carter’s existing expertise in the industry and exploiting several scale economies. It also believed that revenue would be accelerated for the next few years by leveraging Carter’s brand, its loyalty program, and its reservation system into greater customer volume, although not necessarily higher prices. The merger was expected to keep Hope’s balance sheet largely unaffected. Hope’s cash balance, while large, was about normal for a well-run gaming company and was not expected to be altered. The team didn’t expect to see any material merger efficiencies across Hope’s assets.

There was some debate regarding whether Carter should use debt or equity to finance the $1 billion of cash that was expected to be needed for the acquisition. Joakim Nilsen, a longtime member of the company’s treasury staff, noted that there was significant pride and borrowing-cost advantage in Carter’s credit rating. Carter’s A rating was the highest credit rating among all the major U.S. hotel companies, and Pearson was concerned that the credit rating would be compromised if the $1 billion payment was made using debt financing.

On the other hand, Trishala Shankar, the newest and youngest member of the treasury staff, argued that Carter was far too conservative in its use of debt capital and claimed that an acquisition provided an excellent opportunity for Carter to better leverage its balance sheet. Initial discussions with Carter’s investment bank provided a sense of the borrowing terms for a five-year $1 billion Carter bond. The bank expected the offering would be issued at par if the coupon was set at either 4.7% in U.S. dollars or 4.3% in British pounds. Shankar believed strongly enough about the need to use more debt capital that she recommended that, even if the Hope acquisition fell through, Carter proceed with the debt issuance and use the proceeds to repurchase shares. Her primary argument was based on the ability of debt to shield the company from its high 40% tax rate.

The team recognized that other suitors for Hope might appear, and that Carter would need to be thoughtful in its bidding strategy. It was thought there were other potential acquirers for which the synergy gains with Hope were expected to be even larger than what might be achieved with Carter. Maybe the lack of bidding activity suggested that Hope was in fact overpriced. Alternatively, Hope had traded for more than $30 a share a few years before the recent slide that led to the current $15 price. Could Hope’s stock price rebound if Carter T

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didn’t act now? With 65 million shares outstanding for Hope, such a change in price represented a large swing in value.2

To be successful and with such an important decision on the line, Chris Smith knew that he needed more than hope.

2 Hope’s equity beta had been recently estimated at 1.45.

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Exhibit 1

Carter International

E-mail Message from Jane Scarret to Chris Smith

TO: Chris Smith

FROM: Jane Scarret

SUBJECT: Hope Enterprises

DATE: February 1, 2016

As we discussed yesterday, the operating committee will be meeting tomorrow to consider an acquisition offer for Hope Enterprises. Please draft a recommendation covering the issues below. Thanks for doing this. I look forward to your thoughts. Jane