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EX-32.2 - EXHIBIT 32.2 - Hard Rock Hotel Holdings, LLCc04421exv32w2.htm
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EX-31.2 - EXHIBIT 31.2 - Hard Rock Hotel Holdings, LLCc04421exv31w2.htm
EX-31.1 - EXHIBIT 31.1 - Hard Rock Hotel Holdings, LLCc04421exv31w1.htm
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
     
    For the quarterly period ended June 30, 2010
Or
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
     
    For the transition period from                      to                     
Commission File Number: 000-52992
Hard Rock Hotel Holdings, LLC
(Exact name of registrant as specified in its charter)
     
Delaware   16-1782658
(State or other jurisdiction of   (I.R.S. employer
incorporation or organization)   identification no.)
     
4455 Paradise Road, Las Vegas, NV   89169
(Address of principal executive office)   (Zip Code)
(702) 693-5000
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of Securities Exchange Act of 1934.
             
Large accelerated filer o   Accelerated filer o   Non-accelerated filer þ
(Do not check if a smaller reporting company)
  Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
 
 

 

 


 

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 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2

 


Table of Contents

Forward-Looking Statements
The Private Securities Litigation Reform Act of 1995 and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), provide a safe harbor for “forward-looking statements” made by or on behalf of a company. We may from time to time make written or oral statements that are “forward-looking,” including statements contained in this report and other filings with the Securities and Exchange Commission (“SEC”), which represent our expectations or beliefs concerning future events. Statements containing expressions such as “believes,” “anticipates,” “expects” or other similar words or expressions are intended to identify forward-looking statements. We caution that these and similar statements are subject to risks, uncertainties, assumptions and changes in circumstances that may cause our actual results to differ significantly from those expressed in any forward-looking statement. Although we believe our expectations are based upon reasonable assumptions within the bounds of our knowledge of our business and operations, we cannot guarantee future results, levels of activity, performance or achievements. Important risks and factors that could cause our actual results to differ materially from any forward-looking statements include, but are not limited to, continued downturns in economic and market conditions, particularly levels of spending in the hotel, resort and casino industry; changes in the competitive environment in our industry; hostilities, including future terrorist attacks, or fear of hostilities that affect travel; the seasonal nature of the hotel, casino and resort industry; the use of the “Hard Rock” brand name by entities other than us; costs associated with compliance with extensive regulatory requirements; increases in interest rates and operating costs; increases in uninsured and underinsured losses; risks associated with conflicts of interest with entities which control us; the loss of key members of our senior management; the impact of any material litigation; risks related to natural disasters, such as earthquakes and floods; and other risks discussed in our Annual Report on Form 10-K for the year ended December 31, 2009 and subsequently filed Quarterly Reports on Form 10-Q in the section entitled “Risk Factors” and in this report in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date thereof. We undertake no obligation to publicly release any revisions to such forward-looking statements to reflect events or circumstances after the date hereof.
References in this report to “Company,” “we,” “our,” or “us” refer to Hard Rock Hotel Holdings, LLC, a Delaware limited liability company, and its consolidated subsidiaries.

 

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PART I—FINANCIAL INFORMATION
Item 1.   Financial Statements
HARD ROCK HOTEL HOLDINGS, LLC
CONSOLIDATED BALANCE SHEETS
(in thousands)
                 
    June 30, 2010     Dec 31, 2009  
    (unaudited)          
ASSETS
               
Current assets:
               
Cash and cash equivalents
  $ 13,910     $ 12,277  
Accounts receivable, net
    13,858       11,259  
Inventories
    3,138       3,062  
Prepaid expenses and other current assets
    3,106       3,631  
Related party receivable
    9       2  
Restricted cash
    51,010       66,349  
 
           
Total current assets
    85,031       96,580  
Property and equipment, net of accumulated depreciation and amortization
    1,180,910       1,151,839  
Intangible assets, net
    47,134       49,007  
Deferred financing costs, net
    2,574       3,656  
Interest rate caps, at fair value
    60        
 
           
TOTAL ASSETS
  $ 1,315,709     $ 1,301,082  
 
           
 
               
LIABILITIES AND MEMBERS’ EQUITY
               
Current liabilities:
               
Accounts payable
  $ 12,870     $ 9,954  
Construction related payables
    2,733       51,905  
Related party payables
    6,634       6,010  
Accrued expenses
    30,358       27,774  
Interest payable
    12,140       2,585  
Short term deferred tax liability
    1,739       1,739  
 
           
Total current liabilities
    66,474       99,967  
 
               
Long term deferred tax liability
    55,366       55,114  
Long-term debt
    1,305,910       1,210,874  
 
           
Total long-term liabilities
    1,361,276       1,265,988  
 
           
Total liabilities
    1,427,750       1,365,955  
 
           
 
               
Commitments and Contingencies (see Note 5)
               
Members’ deficit:
               
Paid-in capital
    500,218       500,218  
Accumulated other comprehensive loss
    (839 )     (2,311 )
Accumulated deficit
    (611,420 )     (562,780 )
 
           
Total members’ deficit
    (112,041 )     (64,873 )
 
           
 
               
TOTAL LIABILITIES AND MEMBERS’ DEFICIT
  $ 1,315,709     $ 1,301,082  
 
           
The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

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HARD ROCK HOTEL HOLDINGS, LLC
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(in thousands)
(unaudited)
                                 
    Quarter     Quarter     Six Month Period     Six Month Period  
    Ended     Ended     Ended     Ended  
    June 30, 2010     June 30, 2009     June 30, 2010     June 30, 2009  
Revenues:
                               
Casino
  $ 13,496     $ 12,548     $ 32,516     $ 24,859  
Lodging
    16,412       8,803       28,333       15,842  
Food and beverage
    31,621       21,391       53,345       33,598  
Retail
    1,297       1,539       2,329       2,622  
Other income
    8,617       10,107       15,560       12,384  
 
                       
 
                               
Gross revenues
    71,443       54,388       132,083       89,305  
 
                       
 
                               
Less: promotional allowances
    (6,798 )     (7,252 )     (13,280 )     (12,184 )
 
                       
 
                               
Net revenues
    64,645       47,136       118,803       77,121  
 
                       
 
                               
Costs and expenses:
                               
Casino
    12,296       9,634       25,381       19,818  
Lodging
    4,949       1,566       8,891       2,905  
Food and beverage
    16,201       10,578       28,202       18,045  
Retail
    822       928       1,453       1,456  
Other
    6,684       5,629       11,583       7,454  
Marketing
    2,459       715       4,257       1,898  
Fees and expense reimbursements – related party
    2,916       2,109       4,960       3,288  
General and administrative
    10,582       7,375       20,714       13,727  
Depreciation and amortization
    11,237       4,876       25,528       10,373  
Loss on disposal of assets
    3       3       1        
Pre-opening
    275       4,737       712       6,147  
 
                       
 
                               
Total costs and expenses
    68,424       48,150       131,682       85,111  
 
                       
 
                               
Loss From Operations
    (3,779 )     (1,014 )     (12,879 )     (7,990 )
 
                       
 
                               
Other income (expense):
                               
Interest income
    3       66       4       321  
Interest expense, net of capitalized interest
    (16,510 )     (20,115 )     (35,513 )     (40,067 )
 
                       
 
                               
Other expenses, net
    (16,507 )     (20,049 )     (35,509 )     (39,746 )
 
                       
 
                               
Net loss before income tax expense
    (20,286 )     (21,063 )     (48,388 )     (47,736 )
Income tax expense
    252             252        
 
                       
Net loss
    (20,538 )     (21,063 )     (48,640 )     (47,736 )
Other comprehensive loss:
                               
Interest rate cap fair market value adjustment, net of tax
    (93 )     3,557       1,472       5,898  
 
                       
 
                               
Comprehensive loss
  $ (20,631 )   $ (17,506 )   $ (47,168 )   $ (41,838 )
 
                       
The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

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HARD ROCK HOTEL HOLDINGS, LLC
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
                 
    Six Month Period     Six Month Period  
    Ended     Ended  
    June 30, 2010     June 30, 2009  
Cash flows from operating activities:
               
Net loss
  $ (48,640 )   $ (47,736 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation
    23,655       7,834  
Provision for (write off of) losses on accounts receivable
    (3,797 )     123  
Amortization of loan fees and costs
    1,970       10,800  
Amortization of intangibles
    1,873       2,539  
Change in value of interest rate caps net of premium amortization included in net loss
    1,412       6,001  
Loss on sale of assets
    1        
Increase in deferred income taxes
    252        
(Increase) decrease in assets:
               
Accounts receivable
    1,198       (4,915 )
Inventories
    (76 )     150  
Prepaid expenses
    525       (167 )
Related party receivable
    (7 )     278  
Increase (decrease) in liabilities:
               
Accounts payable
    2,916       3,729  
Related party payables
    624       3,026  
Accrued interest payable
    9,555       (276 )
Other accrued liabilities
    2,584       3,520  
 
           
Net cash used in operating activities
    (5,955 )     (15,094 )
 
           
Cash flows from investing activities:
               
Purchases of property and equipment
    (52,727 )     (224,261 )
Construction payables
    (49,172 )     (30,684 )
Restricted cash
    15,339       138,485  
 
           
Net cash used in investing activities
    (86,560 )     (116,460 )
 
           
Cash flows from financing activities:
               
Net proceeds from borrowings
    95,036       123,211  
Capital investment
          11,203  
Financing costs on debt
    (888 )     (45 )
 
           
Net cash provided by financing activities
    94,148       134,369  
 
           
Net increase in cash and cash equivalents
    1,633       2,815  
Cash and cash equivalents, beginning of period
    12,277       10,148  
 
           
Cash and cash equivalents, end of period
  $ 13,910     $ 12,963  
 
           
Supplemental cash flow information
               
Cash paid during the period for interest, net of amounts capitalized
  $ 13,998     $ 32,884  
 
           
Supplemental schedule of non-cash investing and financing activities:
               
Capitalized interest
  $     $ 9,342  
 
           
Construction payables
  $ 2,733     $ (38,277 )
 
           
The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

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HARD ROCK HOTEL HOLDINGS, LLC
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
1. COMPANY STRUCTURE AND SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation and Nature of Business
Hard Rock Hotel Holdings, LLC (the “Company”) is a Delaware limited liability company that was formed on January 16, 2007 by DLJ Merchant Banking Partners (“DLJMBP”) and Morgans Hotel Group Co. (“Morgans”) to acquire Hard Rock Hotel, Inc. (“HRHI” ), a Nevada corporation incorporated on August 30, 1993, and certain related assets. The Company owns the Hard Rock Hotel & Casino in Las Vegas (the “Hard Rock”). DLJMB HRH VoteCo, LLC, DLJ MB IV HRH, LLC and DLJ Merchant Banking Partners IV, L.P., each of which is a member of the Company and an affiliate of DLJMBP, are referred to collectively as the “DLJMB Parties” and Morgans and its affiliate Morgans Group LLC, each of which is also a member of the Company, are referred to collectively as the “Morgans Parties.”
The accompanying consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures herein are adequate to make the information presented not misleading. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary for a fair presentation of the results for the interim periods have been made.
The results for the quarter ended and six month period ended June 30, 2010 are not necessarily indicative of results to be expected for the full fiscal year ending December 31, 2010. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.
The Company’s operations are conducted in the destination resort segment, which includes casino, lodging, food and beverage, retail and other related operations. Because of the integrated nature of these operations, the Company is considered to have one operating segment.
Revenues and Complimentaries
Casino revenues are derived from patrons wagering on table games, slot machines, sporting events and races. Table games generally include Blackjack or Twenty-One, Craps, Baccarat and Roulette. Casino revenue is defined as the win from gaming activities, computed as the difference between gaming wins and losses, not the total amounts wagered. Casino revenue is recognized at the end of each gaming day.
Lodging revenues are derived from rooms and suites rented to guests and include related revenues for telephones, movies and other room amenities. Room revenue is recognized at the time the room or service is provided to the guest.
Food and beverage revenues are derived from sales in the food and beverage outlets located at the Hard Rock, including restaurants, room service, banquets and a nightclub. Food and beverage revenue is recognized at the time the food and/or beverage is provided to the guest.
Retail and other revenues include retail sales, spa income, sponsorship income and commissions, estimated income for gaming chips and tokens not expected to be redeemed, payments under tenant leases, license fees and other miscellaneous income at the Hard Rock. Retail and other revenues are recognized at the point in time the sale occurs, when services are provided to the guest, when lease payments, sponsorship commissions or license fees become due under the agreements or the Company determines gaming chips and tokens are not expected to be redeemed.

 

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Revenues in the accompanying statements of operations include the retail value of rooms, food and beverage and other complimentaries provided to guests without charge, all of which are then subtracted as promotional allowances to arrive at net revenues. The estimated costs of providing such complimentaries have been classified as casino operating expenses through interdepartmental allocations as follows (in thousands):
                                 
                    Six Month     Six Month  
    Quarter Ended     Quarter Ended     Period Ended     Period Ended  
    June 30, 2010     June 30, 2009     June 30, 2010     June 30, 2009  
Food and beverage
  $ 2,256     $ 1,808     $ 5,152     $ 3,769  
Lodging
    851       551       1,739       1,207  
Other
    501       1,260       862       1,476  
 
                       
 
                               
Total costs allocated to casino operating costs
  $ 3,608     $ 3,619     $ 7,753     $ 6,452  
 
                       
Revenues are recognized net of certain sales incentives in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 605-50, Revenue Recognition, Customer Payments and Incentives (prior authoritative literature: Emerging Issues Task Force consensus on Issue 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products )) (“FASB ASC 605-50 (EITF 01-9)”). FASB ASC 605-50 (EITF 01-9) requires that sales incentives be recorded as a reduction of revenue; consequently, the Company’s revenues are reduced by points redeemed from customers within the player’s club loyalty program. Casino revenues are net of cash incentives earned in the Company’s “Rock Star” slot club. For the six month period and the quarter ended June 30, 2010, the amount of such sales incentives awarded was $8,800 and $2,900, respectively. For the six month period and the quarter ended June 30, 2009, the amount of such sales incentives awarded was $34,000 and $19,000, respectively.
Recently Issued And Adopted Accounting Pronouncements
FASB ASC 105-10, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles (prior authoritative literature: FASB SFAS No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles, issued June 2009) (“FASB ASC 105-10-65 (SFAS No. 168)”), establishes the FASB Accounting Standards Codification (the “Codification”) as the single source of authoritative nongovernmental generally accepted accounting principles. The Codification is effective for fiscal years and interim periods ending after September 15, 2009. The adoption of FASB ASC 105-10-65 (SFAS No. 168) did not have a material impact on the Company’s consolidated financial statements.
FASB ASC 820-10, (Accounting Standards Update No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements (“ASU No. 2010-06”)), was adopted in the first quarter of 2010 by the Company. The provisions of ASU No. 2010-06 amended ASC 820-10, Fair Value Measurements and Disclosures, by requiring additional disclosures for transfers in and out of Level 1 and Level 2 fair value measurements, as well as requiring fair value measurement disclosures for each “class” of assets and liabilities, a subset of the captions disclosed in our consolidated balance sheets. The adoption did not have a material impact on the Company’s consolidated financial statements or its disclosures, as the Company did not have any transfers between Level 1 and Level 2 fair value measurements and did not have material classes of assets and liabilities that required additional disclosure.
FASB ASC 855-10, (Accounting Standards Update No. 2010-09 Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements (“ASU No. 2010-09”)) was adopted in the first quarter of 2010 by the Company. ASU No. 2010-09 amended ASC 855-10, Subsequent Events — Overall by removing the requirement for an SEC registrant to disclose a date, in both issued and revised financial statements, through which that filer had evaluated subsequent events. Accordingly, the Company removed the related disclosure and the adoption did not have a material impact on the Company’s consolidated financial statements.
In April 2010, the FASB issued ASU No. 2010-16, Entertainment-Casinos (Topic 924): Accruals for Casino Jackpot Liabilities. The authoritative guidance for companies that generate revenue from gaming activities that involve base jackpots, which requires companies to accrue for a liability and charge a jackpot (or portion thereof) to revenue at the time the company has the obligation to pay the jackpot. The guidance is effective for interim and annual reporting periods beginning on or after December 15, 2010. Base jackpots are currently not accrued for by the Company until it has the obligation to pay such jackpots. As such, the application of this guidance will not have a material effect on the Company‘s financial condition, results of operations or cash flows.

 

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Derivative Instruments and Hedging Activities
FASB ASC 815-10 (SFAS No. 133), Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. As required by FASB ASC 815-10 (SFAS No. 133), the Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative and the resulting designation. Derivatives used to hedge the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives used to hedge the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges.
For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivative is initially reported in other comprehensive income (outside of earnings) and subsequently reclassified to earnings when the hedged transaction affects earnings, and the ineffective portion of changes in the fair value of the derivative is recognized directly in earnings. The Company assesses the effectiveness of each hedging relationship under the hypothetical derivative method, which means that the Company compares the cumulative change in fair value of the actual cap to the cumulative change in fair value of a hypothetical cap having terms that exactly match the critical terms of the hedged transaction. For derivatives that do not qualify for hedge accounting or when hedge accounting is discontinued, the changes in fair value of the derivative instrument are recognized directly in earnings.
The Company’s objective in using derivative instruments is to add stability to its interest expense and to manage its exposure to interest rate movements or other identified risks. To accomplish this objective, the Company primarily uses interest rate swaps and caps as part of its cash flow hedging strategy. Interest rate swaps designated as cash flow hedges involve the receipt of fixed-rate payments in exchange for variable-rate amounts over the life of the agreements without exchange of the underlying principal amount. During the six month period ended June 30, 2010, the Company used interest rate caps to hedge the variable cash flows associated with its existing variable-rate debt.
In connection with satisfying the conditions to draw on the construction loan provided under its commercial mortgage-backed securities (“CMBS”) facility on May 30, 2008, the Company purchased five interest rate cap agreements with an aggregate notional amount of $871.0 million with a LIBOR cap of 2.5%. Under one of the interest rate cap agreements, the aggregate notional amount would have accreted over the life of the cap based on the draw schedule for the construction loan so that the aggregate notional amount of all of the caps would have been equal to $1.285 billion. The Company purchased these interest rate cap agreements for an amount equal to approximately $19.1 million, which was funded through a cash contribution made by the DLJMB Parties. The Company determined that all five of the caps qualified for hedge accounting and the caps were designated as cash flow hedges.
On September 22, 2008, the Company amended the accreting interest rate cap agreement to adjust its notional amount upward in order to meet a lender-required cap on future debt. In addition, the Company determined that the amended interest rate cap qualified for hedge accounting and, therefore, was designated as a cash flow hedge.
On February 9, 2010, the Company purchased five new interest rate cap agreements with an aggregate notional amount of $1.285 billion with a LIBOR cap of 1.23313%. The Company purchased the new interest rate cap agreements for an amount equal to approximately $1.6 million. These new interest rate cap agreements replaced the interest rate cap agreements described above which expired on February 9, 2010. The Company designated four out of the five interest rate caps for hedge accounting as cash flow hedges. The changes in fair value of the remaining one interest rate cap that does not qualify for hedge accounting are recognized directly in earnings.
As of June 30, 2010, the Company held five interest rate caps as follows (amounts in thousands):
                 
Notional Amount   Type of Instrument   Maturity Date   Strike Rate  
$364,811 (1)
  Interest Cap   February 9, 2011     1.23 %
$595,419 (2)
  Interest Cap   February 9, 2011     1.23 %
$177,956 (1)
  Interest Cap   February 9, 2011     1.23 %
$88,978 (1)
  Interest Cap   February 9, 2011     1.23 %
$57,836 (1)
  Interest Cap   February 9, 2011     1.23 %
     
(1)   The Company has determined that the derivative qualifies for hedge accounting.
 
(2)   The Company has determined that the derivative does not qualify for hedge accounting.
Four of the derivative instruments have been designated as hedges according to FASB ASC 815-10 (SFAS No. 133) and, accordingly, the effective portion of the change in fair value of these derivative instruments is recognized in other comprehensive income in the Company’s consolidated financial statements.

 

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As of June 30, 2010 and December 31, 2009, the total fair value of derivative instruments was $60,000 and $0, respectively. The change in fair value included in comprehensive income for the quarters ended June 30, 2010 and 2009 was $0.1 million and $3.6 million, net of premium amortization, respectively, and the change in fair value included in comprehensive income for the six month periods ended June 30, 2010 and 2009 was $1.5 million and $5.9 million, net of premium amortization, respectively. Amounts reported in accumulated other comprehensive income/loss related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate debt. The Company reflects the change in fair value of all hedging instruments in cash flows from operating activities. The net gain or loss recognized in earnings during the reporting period representing the amount of the hedges’ ineffectiveness is insignificant. For the quarters ended June 30, 2010 and 2009, the Company expensed $0 and $3.0 million to interest expense accumulated in other comprehensive income and attributable to the derivatives not designated as hedges according to FASB ASC 815-10 (SFAS No. 133), respectively. For the six month periods ended June 30, 2010 and 2009, the Company expensed $3.0 million and $6.0 million to interest expense accumulated in other comprehensive income and attributable to the derivatives not designated as hedges according to FASB ASC 815-10 (SFAS No. 133), respectively.
CMBS Facility
In connection with the Company’s acquisition of the Hard Rock, it entered into a debt financing in the form of a real estate loan in the CMBS market. The CMBS facility provides for, among other borrowing availability, a construction loan of up to $620.0 million for the expansion project at the Hard Rock and an acquisition loan of $760.0 million which we used to pay a portion of the purchase price and costs and expenses for our acquisition of the Hard Rock and related assets. As of June 30, 2010, the Company had fully drawn the $620.0 million under the construction loan. In conjunction with fully drawing the construction loan, the Company paid down $32.9 million of the acquisition loan, paid $0.8 million in exit fees, funded $3.6 million into the interest reserve, funded $20.0 million into a general reserve account and $11.3 million into an equity/accrual subaccount, as required under the loan agreement. The equity accrual subaccount holds amounts funded into the general reserve in excess of $20 million at any time. If a debt service coverage ratio of 1.2:1 is satisfied, then the amounts held in such account will be released to make certain payments to the DLJMB Parties on account of their equity contributions to the Company. If the debt service coverage ratio is not satisfied within one year from the date of the deposits into the equity accrual/subaccount, then such amounts may be used to repay the mortgage loan. The current maturity date of the $1.3 billion outstanding under the CMBS facility is February 9, 2011, with three one-year options to extend the maturity date provided that we satisfy certain conditions.
The financing incurs interest payable through a funded interest reserve initially, then through cash, at a rate (blended among the debt secured by assets and the junior and senior mezzanine debt, if applicable) of LIBOR plus 4.25%, subject to adjustment upwards in certain circumstances (i.e., extension of the term of the financing). The loan agreements under the CMBS facility include customary affirmative and negative covenants for similar financings, including, among others, restrictive covenants regarding incurrence of liens, sales of assets, distributions to affiliates, changes in business, cancellation of indebtedness, dissolutions, mergers and consolidations, as well as limitations on security issuances, transfers of any of our real property and removal of any material article of furniture, fixture or equipment from our real property. The Company has evaluated these requirements and determined that it was in compliance as of June 30, 2010.
Fair Value Measurements
FASB ASC 820-10 (SFAS No. 157) emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, FASB ASC 820-10 (SFAS No. 157) establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy). The Company has applied FASB ASC 820-10 (SFAS 157) to recognize the asset related to its derivative instruments at fair value and considers the changes in the creditworthiness of the Company and its counterparties in determining any credit valuation adjustments.
Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, which is typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

 

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Currently, the Company uses interest rate caps to manage its interest rate risk. The valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. To comply with the provisions of FASB ASC 820-10 (SFAS No. 157), the Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. The Company is exposed to credit loss in the event of a non-performance by the counterparties to its interest rate cap agreements; however, the Company believes that this risk is minimized because it monitors the credit ratings of the counterparties to such agreements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts, and guarantees.
Although the Company has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties. However, as of June 30, 2010 and December 31, 2009, the Company has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives. As a result, the Company has determined that its derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy. As of June 30, 2010, the total value of the interest rate caps valued under FASB ASC 820-10 (SFAS No. 157) included in other assets is approximately $0.1 million.
Although the Company has determined that the majority of the inputs used to value its long-term debt fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its long-term debt utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself or its lenders. However, as of June 30, 2010, the Company has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its long-term debt and has determined that the credit valuation adjustments are not significant to the overall valuation of its long-term debt. As a result, the Company has determined that its long-term debt valuations in their entirety are classified in Level 2 of the fair value hierarchy. As of June 30, 2010, the total fair value of the Company’s long-term debt valued under FASB ASC 820-10 (SFAS No. 157) does not materially differ from its carrying value of approximately $1.3 billion.
2. INVENTORIES
Inventories are stated at the lower of cost (determined using the first-in, first-out method), or market. Inventories consist of the following (in thousands):
                 
    June 30, 2010     December 31, 2009  
Retail merchandise
  $ 1,246     $ 1,068  
Restaurants and bars
    1,803       1,769  
Other inventory and operating supplies
    89       225  
 
           
 
               
Total inventories
  $ 3,138     $ 3,062  
 
           
3. PROPERTY AND EQUIPMENT
Property and equipment consists of the following (in thousands):
                 
    June 30, 2010     December 31, 2009  
Land
  $ 351,250     $ 351,250  
Buildings and improvements
    738,843       461,176  
Furniture, fixtures and equipment
    154,623       105,087  
Memorabilia
    4,435       4,267  
 
           
Subtotal
    1,249,151       921,780  
Less accumulated depreciation and amortization
    (68,704 )     (45,049 )
Construction in process
    463       275,108  
 
           
 
               
Total property and equipment, net
  $ 1,180,910     $ 1,151,839  
 
           
Depreciation and amortization relating to property and equipment for the six month periods ended June 30, 2010 and 2009 was $23.7 million and $7.8 million, respectively. Capitalized interest included in construction in process for the six month periods ended June 30, 2010 and 2009 was $0 and $9.3 million, respectively.

 

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4. AGREEMENTS WITH RELATED PARTIES
Management Agreement
The Company’s subsidiaries, HRHH Hotel/Casino, LLC, HRHH Development, LLC and HRHH Cafe, LLC, have entered into an Amended and Restated Property Management Agreement, dated as of May 30, 2008, (the “Management Agreement”) with Morgans Hotel Group Management LLC (“Morgans Management”), pursuant to which the Company has engaged Morgans Management as (i) the exclusive operator and manager of the Hard Rock (excluding the operation of the gaming facilities which are operated by the Company’s subsidiary, HRHH Gaming, LLC) and (ii) the asset manager of the approximately 23-acre parcel adjacent to the Hard Rock and the land on which the Hard Rock Cafe restaurant is situated (which is subject to a lease between the Company’s subsidiary, HRHH Cafe, LLC, as landlord, and Hard Rock Cafe International (USA), Inc., as tenant).
The Management Agreement originally commenced on February 2, 2007 and has an initial term of 20 years. Morgans Management may elect to extend this initial term for two additional 10-year periods. The Management Agreement provides certain termination rights for the Company and Morgans Management. Morgans Management may be entitled to a termination fee if such a termination occurs in connection with a sale of the Company or the hotel at the Hard Rock.
As compensation for its services, Morgans Management receives a management fee equal to 4% of defined net non-gaming revenues including casino rents and all other rental income, a gaming facilities support fee equal to $828,000 per year and a chain service expense reimbursement, which reimbursement is subject to a cap of 1.5% of defined non-gaming revenues and all other income. Morgans Management was also entitled to receive an annual incentive fee of 10.0% of the Hotel EBITDA (as defined in the Management Agreement) in excess of certain threshold amounts, which increased each calendar year. However, as a result of the completion of the expansion project at the Hard Rock, the amount of such annual incentive fee now is equal to 10% of annual Hotel EBITDA in excess of 90% of annual projected post-expansion EBITDA of the Hard Rock, the property on which the Hard Rock Cafe restaurant is situated and the property adjacent to the Hard Rock (excluding any portion of the adjacent property not being used for the expansion). For purposes of the Management Agreement, “EBITDA” generally is defined as earnings before interest, taxes, depreciation and amortization in accordance with generally accepted accounting principles applicable to the operation of hotels and the uniform system of accounts used in the lodging industry, but excluding income, gain, expenses or loss that is extraordinary, unusual, non-recurring or non-operating. “Hotel EBITDA” generally is defined as EBITDA of the Hard Rock, the property on which the Hard Rock Cafe restaurant is situated and the adjacent property (excluding any portion of the adjacent property not being used for the expansion), excluding an annual consulting fee payable to DLJMB HRH VoteCo, LLC (“DLJMB VoteCo”) under the JV Agreement (as defined below). Hotel EBITDA generally does not include any EBITDA attributable to any facilities operated by third parties at the Hard Rock, unless the Company owns or holds an interest in the earnings or profits of, or any equity interests in, such third party facility.
For the quarters ended June 30, 2010 and 2009, the Company accrued or paid to Morgans Management a base management fee of $2.0 million and $1.4 million and a gaming facilities support fee of $0.2 million and $0.2 million, respectively, and accrued or reimbursed Morgans Management for chain services expenses of $0.8 million and $0.5 million, respectively. For the six month periods ended June 30, 2010 and 2009, the Company accrued or paid to Morgans Management a base management fee of $3.3 million and $2.1 million and a gaming facilities support fee of $0.4 million and $0.4 million, respectively, and accrued or reimbursed Morgans Management for chain services expenses of $1.3 million and $0.8 million, respectively.
Joint Venture Agreement Consulting Fee
Under the Company’s Second Amended and Restated Limited Liability Company Agreement (as amended, the “JV Agreement”), subject to certain conditions, the Company is required to pay DLJMB VoteCo (or its designee) a consulting fee of $250,000 each quarter in advance. In the event the Company is not permitted to pay the consulting fee when required (pursuant to the terms of any financing or other agreement approved by its board of directors), then the payment of such fee will be deferred until such time as it may be permitted under such agreement. DLJMB VoteCo is a member of the Company.
Technical Services Agreement
On February 2, 2007, a subsidiary of the Company, HRHH Hotel/Casino, LLC, entered into a Technical Services Agreement with Morgans Management, pursuant to which Morgans Management provided technical services for the expansion project at the Hard Rock prior to its opening. Under the Technical Services Agreement, the Company is required to reimburse Morgans Management for certain expenses it incurs in accordance with the terms and conditions of the agreement. For the quarters ended June 30, 2010 and 2009, the Company reimbursed Morgans Management an aggregate amount equal to approximately $0.1 million and $0.2 million, respectively, under the Technical Services Agreement. For the six month periods ended June 30, 2010 and 2009, the Company reimbursed Morgans Management an aggregate amount equal to approximately $1.9 million and $1.4 million, respectively, under the Technical Services Agreement.
CMBS Facility
The chairman of the Morgans’ board of directors and a former director of the Company is currently the president, chief executive officer and an equity holder of NorthStar Realty Finance Corp. (“NorthStar”), a subsidiary of which is a participant lender in the CMBS facility.

 

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Intercompany Land Acquisition Financing
Northstar is a lender under the land acquisition financing the Company has entered into with respect to an approximately 11-acre parcel of land located adjacent to the Hard Rock.
5. COMMITMENTS AND CONTINGENCIES
Cafe Lease
The Company is party to a lease with the operator of the Hard Rock Cafe, pursuant to which the Company is entitled to (a) minimum ground rent in an amount equal to $15,000 per month and (b) additional rent, if any, equal to the amount by which six percent of the annual Gross Income (as defined in the lease) of the operator exceeds the minimum ground rent for the year. For the six month period ended June 30, 2010, the Company received $162,900 in rent from the Hard Rock Cafe, which consisted of $90,000 in base rent and $72,900 in percentage rent. The current term of the lease expires on June 30, 2015. Under the lease, the operator has one five-year option to extend the lease, so long as it is not in default at the time of the extension.
Employment Agreement
Morgans and the Company (for the purposes of specified provisions only) have entered into a four-year Employment Agreement with Joseph A. Magliarditi, Chief Operating Officer of the Company and Chief Executive Officer of HRHI, dated May 23, 2010 (the “Employment Agreement”). Under the Employment Agreement, among other benefits Mr. Magliarditi is entitled to receive an annual base salary of $650,000, subject to increase in Morgans Management’s discretion, and an annual cash bonus with a maximum level of 75% of his annual base salary based on reasonable annual performance targets. The exact amount of the bonus, if any, will be determined by Morgans Management in its sole discretion. Mr. Magliarditi’s annual bonus for 2010, if any, will be prorated for the amount of time he works for Morgans Management during 2010, and Mr. Magliarditi and Morgans Management are expected to set reasonable performance goals upon which the 2010 annual bonus may be based. Pursuant to the Employment Agreement, Mr. Magliarditi also is entitled to a grant of phantom equity awards that is tied to the value of common stock of Morgans in the form of 50,000 phantom restricted stock units under Morgans’ Amended and Restated 2007 Omnibus Stock Incentive Plan, which is referred to as the initial phantom equity grant. One-third of the initial phantom equity grant will vest on each of the first three anniversaries of the date of the grant.
The Employment Agreement provides Mr. Magliarditi severance as described immediately below in each of the following circumstances:
    if, during his employment period, Morgans Management terminates Mr. Magliarditi without Cause (as defined in the Employment Agreement), he resigns for Good Reason (as defined in the Employment Agreement), or a successor to Morgans Management fails to assume its obligations under the Employment Agreement;
 
    if, at the time of, or during the 12 month period following the effective date of, any Change in Control (as defined in the Employment Agreement), Morgans Management terminates Mr. Magliarditi’s employment with or without Cause, or he resigns for Good Reason;
 
    if Mr. Magliarditi’s employment terminates due to a termination of the Management Agreement and he rejects or does not receive any Morgans employment notice and does not receive a qualifying Hard Rock employment offer; or
 
    if Mr. Magliarditi’s employment terminates at the end of the four-year employment period.
In each of the cases described above, other than under the indemnification provisions in the Employment Agreement, Morgans Management’s only obligations to Mr. Magliarditi will be:
    to pay his annual base salary through the date of termination to the extent it is unpaid and reimburse him for any business expenses not previously reimbursed,
 
    to continue to pay his annual base salary for a period of 18 months after the date of termination (or six months after the date of termination in the case employment terminates at the end of the four-year employment period),
 
    to continue to provide him medical and dental insurance benefits on the same basis as Morgans Management’s other executive employees for 18 months after the date of termination (or six months after the date of termination in the case employment terminates at the end of the four-year employment period),

 

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    to the extent not paid or provided, to pay or provide him any other amounts or benefits required to be paid or provided or which he is eligible to receive under any plan, program, policy or practice or other contract or agreement of Morgans Management through the date of termination, including, without limitation, any accrued but unused vacation, and
 
    except in the case employment terminates at the end of the four-year employment period, to fully vest any unvested portion, if any, of the initial phantom equity grant, which, in the case of a termination of the Management Agreement, will be paid in a lump sum amount of equal value.
If, during his employment period, Mr. Magliarditi’s employment is terminated for Cause, due to death or Disability, or he resigns without Good Reason, Morgans Management will have the obligations described below. In addition, if Mr. Magliarditi’s employment terminates due to a termination of the Management Agreement, and he rejects or does not receive a Morgans employment notice and receives and rejects or fails to timely respond to a qualifying Hard Rock employment offer, then Morgans Management will have no further obligations to Mr. Magliarditi other than as described below. In each of these cases, other than under the indemnification provisions in the Employment Agreement, Morgans Management’s only obligations to Mr. Magliarditi, or his estate or beneficiaries, as applicable, will be:
    to pay his base salary through the date of termination,
 
    to pay for any accrued, unused vacation time as of the date of termination,
 
    to pay any reasonable business expenses incurred as of the date of termination, and
 
    if his employment terminates due to death or disability, to immediately vest the initial phantom equity grant in accordance with the terms of the applicable award agreement.
Construction Commitments
The expansion project at the Hard Rock included the addition of approximately 865 guest rooms and suites, approximately 490 of which are in the new Paradise Tower that opened in July 2009 and the remaining 375 of which are in the new all-suite HRH Tower that opened in late December 2009. As part of the expansion project, in April 2009, the Company opened approximately 74,000 square feet of additional meeting and convention space, several new food and beverage outlets and a new and larger The Joint live entertainment venue with a doubled maximum capacity of 4,100. In December 2009, the Company opened approximately 30,000 square feet of new casino space, a new spa, salon and fitness center, Reliquary and a new nightclub, Vanity. The expansion project also included the addition of a new authentic rock lounge, Wasted Space, a new Poker Lounge and upgrades to existing suites, restaurants and bars, retail shops and common areas, each of which were completed in 2008. In March 2010, the Company completed the expansion of the hotel pool, outdoor gaming and additional food and beverage outlets. The Company completed the expansion as scheduled and within the parameters of the original budget. The project was funded from the Company’s existing debt funding under its CMBS facility.
The Company entered into a construction management and general contractor’s agreement with M.J. Dean Construction, Inc. (“M.J. Dean”), which set forth the terms and conditions for M.J. Dean’s work on the expansion project. The contract provided that the project would be broken into multiple phases, each of which was governed by a separate guaranteed maximum price work authorization order. As of June 30, 2010, the Company delivered work authorization orders to M.J. Dean for an aggregate of $512.4 million of work, which has been completed.
The Company also entered into a design build agreement with Pacific Custom Pools, Inc (“PCI”), which set forth the terms and conditions pursuant to which PCI constructed the new west pool project at the Hard Rock. The contract included all conceptual design, design development, construction documents, construction administration, engineering and construction for the site as it pertained to the pools, spas, lounge pool, site service structures, service bars, cabanas, perimeter walls, landscape, audio visual system, site lighting, pool pavilion building, grading and gravity site drainage within the perimeter. The project called for an aggregate of $23.9 million of work. The west pool project opened in March of 2010.
The Company signed construction commitments for an aggregate of approximately $595.4 million, which consists of commitments to the general contractor and for other items related to the expansion and renovation of the Hard Rock. As of June 30, 2010, approximately $0.1 million of these commitments remained outstanding.
Self-Insurance
The Company is self-insured for workers’ compensation claims for an annual stop-loss of up to $350,000 per claim. Management has established reserves it considers adequate to cover estimated future payments on existing claims incurred and claims incurred but not reported.

 

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The Company has a partial self-insurance plan for general liability claims for an annual stop-loss of up to $100,000 per claim.
Legal and Regulatory Proceeding
The Company is a defendant in various lawsuits relating to routine matters incidental to its business. Management provides an accrual for estimated losses that may occur and does not believe that the outcome of any pending claims or litigation, individually or in the aggregate, will have a material adverse effect on the Company’s financial position, results of operations or liquidity beyond the amounts recorded in the accompanying balance sheet as of June 30, 2010.
Indemnification
The JV Agreement provides that neither the Company’s members nor the affiliates, agents, officers, partners, employees, representatives, directors, members or shareholders of any member, affiliate or the Company (collectively, “Indemnitees”) will be liable to the Company or any of its members for any act or omission if: (a) the act or omission was in good faith, within the scope of such Indemnitee’s authority and in a manner it reasonably believed to be in the best interest of the Company, and (b) the conduct of such person did not constitute fraud, willful misconduct, gross negligence or a material breach of, or default under, the JV Agreement.
Subject to certain limitations, the Company will indemnify and hold harmless any Indemnitee to the greatest extent permitted by law against any liability or loss as a result of any claim or legal proceeding by any person relating to the performance or nonperformance of any act concerning the activities of the Company if: (a) the act or failure to act of such Indemnitee was in good faith, within the scope of such Indemnitee’s authority and in a manner it reasonably believed to be in the best interest of the Company, and (b) the conduct of such person did not constitute fraud, willful misconduct, gross negligence or a material breach of, or default under, the JV Agreement. The JV Agreement provides that the Company will, in the case of its members and their affiliates, and may, in the discretion of the members with respect to other Indemnitees advance such attorneys’ fees and other expenses prior to the final disposition of such claims or proceedings upon receipt by the Company of an undertaking by or on behalf of such Indemnitee to repay such amounts if it is determined that such Indemnitee is not entitled to be indemnified.
Any indemnification provided under the JV Agreement will be satisfied first out of assets of the Company as an expense of the Company. In the event the assets of the Company are insufficient to satisfy the Company’s indemnification obligations, the members will, for indemnification of the members or their affiliates, and may (in their sole discretion), for indemnification of other indemnitees, require the members to make further capital contributions to satisfy all or any portion of the indemnification obligations of the Company pursuant to the JV Agreement.
6. PROFITS INTERESTS
On September 10, 2008, the board of directors of the Company adopted the Company’s 2008 Profits Interest Award Plan (the “Plan”). The purpose of the Plan is to provide eligible officers and employees with an opportunity to participate in the Company’s future by granting them profits interest awards in the form of Class C Units of the Company so as to enhance the Company’s ability to attract and retain certain valuable individuals. The Class C Units are membership interests in the Company whose terms are governed by the JV Agreement, the Plan and an individual profits interest Award Agreement. The maximum aggregate number of Class C Units available for issuance under the Plan is one million units.
On January 14, 2009, the Company’s named executive officers received aggregate awards totaling 360,000 Class C Units which included an aggregate award of 300,000 Class C Units to the Company’s former principal executive officer, Andrew A. Kwasniewski, and 60,000 Class C Units to the Company’s principal financial officer, Arnold D. Boswell. Each grantee’s award consists of the following three vesting components, which are equally spread and are generally subject to the grantee’s continued employment with the Company: (i) a time-based vesting award that vests over the period commencing on the grant date and continuing through December 31, 2010; (ii) a performance-based vesting award that vests with respect to 25% of the units on the date of grant and the remaining 75% of the units based on the Company’s attainment of pre-established EBITDA targets for each of the Company’s fiscal years through December 31, 2010; and (iii) a “milestone” vesting award that vests based on the Company’s timely completion of the expansion project at the Hard Rock in accordance with the development budget approved by the Company’s board of directors. As of June 30, 2010, 15,000 of the 360,000 Class C Units issued to the above named executive officers remain unvested.
If a “Sale of the Company” (as defined in the Plan) occurs prior to December 31, 2010 and the grantee remains employed with the Company until the closing of the Sale of the Company, 100% of the remaining outstanding unvested Class C Units covered by the award will vest immediately prior to the closing. Vesting is also accelerated if the grantee’s employment with the Company is terminated without cause (as defined in the grantee’s Award Agreement) or by the grantee for good reason (as defined in the grantee’s Award Agreement). Awards of Class C Units will be forfeited to the extent that the award is not vested as of the date of a termination of the grantee’s employment or to the extent that the award fails to satisfy the performance or milestone targets set forth in the Award Agreement. The entire award, whether vested or unvested, will be forfeited upon a termination of the grantee’s employment for cause (as defined in his or her Aware Agreement). The Award Agreements include a number of restrictions permitted under the Plan, including, without limitation, that the Company will have a right to repurchase any or all vested Class C Units from the holder within a specified period of time following the holder’s termination of employment or December 31, 2010, if later. The repurchase price per unit is determined pursuant to a methodology set forth in the Award Agreement that is intended to approximate the fair market value of a Class C Unit as of the date on which the repurchase right arises.

 

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The Company accounts for share-based compensation in accordance with FASB ASC 718 (SFAS No. 123R). The Class C Units granted during January 2009 are equity classified awards and have a grant date fair value of zero. Accordingly, no compensation expense has been recorded related to these Class C Units.
7. CAPITAL CONTRIBUTIONS BY MEMBERS
During the six month period ended June 30, 2010, the Company’s members did not contribute any cash to, or post any letters of credit on behalf of, the Company. For the period from the closing of the acquisition of the Hard Rock on February 2, 2007 through June 30, 2010, the DLJMB Parties had cumulatively contributed an aggregate of $424.4 million in cash to the Company and the Morgans Parties had cumulatively contributed an aggregate of $75.8 million in cash to the Company.
8. SUBSEQUENT EVENTS
None.
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2009 and our consolidated financial statements and related notes appearing elsewhere in this report. In addition to historical information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in any forward-looking statements as a result of certain factors, including but not limited to, those factors set forth in the section entitled “Forward-Looking Statements” and elsewhere in this report and in the section entitled “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009 and subsequently filed Quarterly Reports on Form 10-Q.
Overview
We own and operate the Hard Rock, which we believe is a premier destination entertainment resort with a rock music theme. As recently expanded, the Hard Rock consists of, among other amenities, three hotel towers with approximately 1,500 stylishly furnished hotel rooms, an approximately 60,000 square-foot uniquely styled casino, a retail store, a jewelry store, a lingerie store, a nightclub, a banquet facility, a concert hall, a beach club, quality restaurants, cocktail lounges and a spa. We believe that we have successfully differentiated the Hard Rock in the Las Vegas hotel, resort and casino market by targeting a predominantly youthful and “hip” customer base, which consists primarily of rock music fans and youthful individuals, as well as actors, musicians and other members of the entertainment industry.
Substantially all of our current business is comprised of our operations at the Hard Rock. For the quarter ended June 30, 2010, our gross revenues were derived 44.3% from food and beverage operations, 18.9% from gaming operations, 13.8% from retail and other sales and 23.0% from lodging. For the six month period ended June 30, 2010, our gross revenues were derived 40.4% from food and beverage operations, 24.6% from gaming operations, 21.5% from lodging and 13.5% from retail and other sales. Our business strategy is to provide our guests with an energetic and exciting gaming and entertainment environment with the services and amenities of a luxury boutique hotel. In March 2010, we completed a large-scale expansion project at the Hard Rock. The expansion included the addition of approximately 865 guest rooms and suites, approximately 490 of which are in our new Paradise Tower that opened in July 2009 and the remaining approximately 375 of which are in our new all-suite HRH Tower that opened in late December 2009. As part of the expansion project, in April 2009, we opened approximately 74,000 square feet of additional meeting and convention space, several new food and beverage outlets and a new and larger The Joint live entertainment venue. In December 2009, we opened approximately 30,000 square feet of new casino space, a new spa, salon and fitness center, Reliquary and a new nightclub, Vanity. The expansion project also included the addition of a new authentic rock lounge, Wasted Space, a new Poker Lounge and upgrades to existing suites, restaurants and bars, retail shops and common areas, each of which were completed in 2008. In March 2010, we opened an expanded hotel pool, outdoor gaming and additional food and beverage outlets, which completed the remaining portions of the expansion project on schedule and within the parameters of the original budget.

 

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Due to a number of factors affecting consumers, including continued recessionary conditions in local, national and global economies, contracted credit markets, and reduced consumer spending, the outlook for the gaming, travel, and entertainment industries both domestically and abroad remains highly uncertain. Auto traffic into Las Vegas and air travel to McCarran International airport has declined, resulting in lower casino volumes and a reduced demand for hotel rooms. Based on these adverse circumstances, we believe that we will continue to experience lower hotel occupancy rates and casino volumes as compared to that of periods prior to the recession. Changes in discretionary consumer spending has resulted in fewer customers visiting, or customers spending less, at our property, which has adversely impacted and may continue to adversely impact our revenues and results of operations. The current situation in the world credit markets may adversely impact the availability and cost of credit, which could adversely affect our liquidity, future growth and operations.
As is customary for companies in the gaming industry, we present average occupancy rate and average daily rate for the Hard Rock including rooms provided on a complimentary basis. Operators of hotels in the lodging industry generally may not follow this practice, as they may present average occupancy rate and average daily rate net of rooms provided on a complimentary basis. We calculate (a) average daily rate by dividing total daily lodging revenue by total daily rooms rented and (b) average occupancy rate by dividing total rooms occupied by total number of rooms available. We account for lodging revenue on a daily basis. Rooms provided on a complimentary basis include rooms provided free of charge or at a discount to the rate normally charged to customers as an incentive to use the casino. Complimentary rooms reduce average daily rate for a given period to the extent the provision of such rooms reduces the amount of revenue we would otherwise receive. We do not separately account for the number of occupied rooms that are provided on a complimentary basis, and obtaining such information would require unreasonable effort and expense within the meaning of Rule 12b-21 under the Exchange Act.
The following are key gaming industry-specific measurements we use to evaluate casino revenues. “Table game drop,” “slot machine handle” and “race and sports book write” are used to identify the amount wagered by patrons for a casino table game, slot machine or racing events and sports games, respectively. “Drop” and “handle” are abbreviations for table game drop and slot machine handle. “Table game hold percentage,” “slot machine hold percentage” and “race and sports book hold percentage” represent the percentage of the total amount wagered by patrons that the casino has won. Such hold percentages are derived by dividing the amount won by the casino by the amount wagered by patrons. Based on historical experience, in the normal course of business we expect table games hold percentage for any period to be within the range of 12% to 16%, slot machine hold percentage for any period to be within the range of 4% to 7% and race and sports book hold percentage to be within the range of 4% to 8%.
Results of Operations
Comparison of the Quarter Ended June 30, 2010 to the Quarter Ended June 30, 2009
The following table presents our consolidated operating results for the quarters ended June 30, 2010 and 2009, and the change in such data between the two periods.
                                 
    Quarter Ended     Quarter Ended     Change     Change  
    June 30, 2010     June 30, 2009     ($)     (%)  
    (in thousands)                  
INCOME STATEMENT DATA:
                               
REVENUES:
                               
Casino
  $ 13,496     $ 12,548     $ 948       7.6 %
Lodging
    16,412       8,803       7,609       86.4 %
Food and beverage
    31,621       21,391       10,230       47.8 %
Retail
    1,297       1,539       (242 )     -15.7 %
Other
    8,617       10,107       (1,490 )     -14.7 %
 
                       
Gross Revenues
    71,443       54,388       17,055       31.4 %
Less: promotional allowances
    (6,798 )     (7,252 )     454       -6.3 %
 
                       
Net revenues
    64,645       47,136       17,509       37.1 %
 
                       
COSTS AND EXPENSES:
                               
Casino
    12,296       9,634       (2,662 )     -27.6 %
Lodging
    4,949       1,566       (3,383 )     -216.0 %
Food and beverage
    16,201       10,578       (5,623 )     -53.2 %
Retail
    822       928       106       11.4 %
Other
    6,684       5,629       (1,055 )     -18.7 %
Marketing
    2,459       715       (1,744 )     -243.9 %
Fees and expenses—related party
    2,916       2,109       (807 )     -38.3 %
General and administrative
    10,582       7,375       (3,207 )     -43.5 %
Depreciation and amortization
    11,237       4,876       (6,361 )     -130.5 %
Loss on disposal of assets
    3       3             0.0 %
Pre-opening
    275       4,737       4,462       94.2 %
 
                       

 

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    Quarter Ended     Quarter Ended     Change     Change  
    June 30, 2010     June 30, 2009     ($)     (%)  
    (in thousands)                  
Total costs and expenses
    68,424       48,150       (20,274 )     -42.1 %
 
                       
 
                               
LOSS FROM OPERATIONS
    (3,779 )     (1,014 )     (2,765 )     272.7 %
Interest income
    3       66       (63 )     -95.5 %
Interest expense, net of capitalized interest
    (16,510 )     (20,115 )     3,605       -17.9 %
 
                       
Loss before income tax expense
    (20,286 )     (21,063 )     777       -3.7 %
Income tax expense
    252             252       100.0 %
Net loss
    (20,538 )     (21,063 )     525       -2.5 %
Other Comprehensive Loss:
                               
Interest rate cap fair market value adjustment, net of tax
    (93 )     3,557       (3,650 )     -102.6 %
 
                       
Comprehensive loss
  $ (20,631 )   $ (17,506 )   $ (3,125 )     17.9 %
 
                       
Results of Operations for the Quarter Ended June 30, 2010 Compared to the Results of Operations for the Quarter Ended June 30, 2009
Net Revenues. Net revenues increased $17.5 million or 37.1% for the quarter ended June 30, 2010 to $64.6 million, compared to $47.1 million for the quarter ended June 30, 2009. The increase in net revenues was primarily due to a $0.9 million or 7.6% increase in casino revenue, a $7.6 million or 86.4% increase in lodging revenue, a $10.2 million or a 47.8% increase in food and beverage revenue and $0.5 million or 6.3% decrease in promotional allowances related to items furnished to guests on a complimentary basis. These increases in net revenue were partially offset by a $1.5 million or 14.7% decrease in other revenues and a $0.2 million or 15.7% decrease in retail revenue.
Casino Revenues. Casino revenues increased $0.9 million to $13.5 million for the quarter ended June 30, 2010, compared to $12.5 million for the quarter ended June 30, 2009. The increase in casino revenues was primarily due to a $0.9 million or 11.7% increase in table games revenue and a $0.1 million or 2.5% increase in slot revenue, slightly offset by a $0.1 million or 23.8% decrease in race and sports revenue. Poker revenue remained flat at $0.4 million period over period. The increase in table games revenues was due to an increase in table game drop, partially offset by a decrease in table game hold percentage. Management believes that table game drop increased due to an increase in visitation to the casino at the Hard Rock, resulting from the completion of the expansion project. Table game drop increased $15.9 million or 23.4% to $83.7 million from $67.8 million. The table game hold percentage decreased 110 basis points to 10.5% from 11.6%, which was less than the expected range of 12% to 16%. The average number of table games in operations was increased from 87 tables in 2009 to 127 tables in 2010. The net result of these changes in table game drop and table game hold percentage was a decrease in win per table game per day to $765 from $997, a decrease of $232 or 23.3%. We have historically reported table game hold percentage using the gross method, while casinos on the Las Vegas Strip report table game hold percentage using the net method (which reduces the table game drop by marker repayments made in the gaming pit area). For the purpose of comparison to properties on the Las Vegas Strip, our net hold percentage for the quarter ended June 30, 2010 was 13.6%, compared to 14.8% for the quarter ended June 30, 2009. Slot machine revenues increased $0.1 million to $4.1 million from $4.0 million. Slot machine handle increased $2.7 million to $84.1 million from $81.4 million. Slot machine hold percentage remained constant at 4.9%, which was within the expected range of 4% to 7%. The average number of slot machines in operation increased to 815 from 513, an increase of 302 slot machines or 58.9%. The net result of these changes in handle, hold percentage and average number of slot machines in operation was a decrease in win per slot machine per day to $55.49 from $86.02, a decrease of $30.53 or 35.5%. Race and sports book revenue decreased $0.1 million due to an increase in race and sports book write and a decrease in hold percentage. The race and sports book write increased $0.4 million to $3.4 million from $3.0 million. Race and sports book hold percentage decreased 2.4% to 5.1% from 7.5%, which was within the expected range of 4% to 8%.
Lodging Revenues. Lodging revenues increased $7.6 million to $16.4 million for the quarter ended June 30, 2010, compared to $8.8 million for the quarter ended June 30, 2009. The increase in lodging revenues was primarily due to an increase in occupied rooms to 85,735 from 51,718, an increase of 34,017 or 65.8%. The increase in occupied rooms was a result of completing the expansion project which added approximately 865 additional guest rooms. The average daily rate increased to $191 from $170, an increase of $21 or 12.5%. Hotel occupancy decreased 700 basis points to 85.2% from 92.3%.

 

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Food and Beverage Revenues. Food and beverage revenues increased $10.2 million to $31.6 million for the quarter ended June 30, 2010, compared to $21.4 million for the quarter ended June 30, 2009. The increase in food and beverage revenues was partially due to a $3.5 million increase from Vanity (which replaced Body English), a $1.4 million increase in banquet revenue, a $0.6 million increase from Mr. Lucky’s, a $0.6 million increase from Beach Club, a $0.6 million increase in room service, a $0.3 million increase from Rare 120, a $0.1 million increase from Pink Taco, a $0.1 million increase from Starbucks and a $0.1 million increase from Ago. The increase also was partially due to $1.3 million in revenue from West Pool, $0.6 million in revenue from Luxe Bar, $0.4 million in revenue from Johnny Smalls, $0.2 million in revenue from Espumoso, $0.2 million in revenue from Midway Bar, $0.1 million in revenue from Sports Deluxe and $0.1 million in revenue from Skybar, Juice Bar and Helles Bells Bar, which were not open during the second quarter of 2009. Management believes that the increase in visitation to the Hard Rock, as a result of completing the expansion project, has had a positive effect on food and beverage revenues.
Retail Revenues. Retail revenues decreased $0.2 million to $1.3 million for the quarter ended June 30, 2010, compared to $1.5 million for the quarter ended June 30, 2009. As a result of the expansion, the Retail store lost 10% of the square footage and roughly 25% of the available merchandising capacity. Management believes that this, coupled with the additional retail tenants and poor market conditions, has caused the retail revenue to decline year over year.
Other Revenues. Other revenues decreased $1.5 million to $8.6 million for the quarter ended June 30, 2010, compared to $10.1 million for the quarter ended June 30, 2009. The decrease in other revenues was due to a $1.7 million decrease in entertainment revenue, which was slightly offset by a $0.2 million increase in sundries. We hosted 34 entertainment events during the quarter ended June 30, 2010, compared to 32 entertainment events during the quarter ended June 30, 2009.
Promotional Allowances. Promotional allowances decreased $0.5 million or 6.3% in the quarter ended June 30, 2010, compared to the quarter ended June 30, 2009. Promotional allowances decreased as a percentage of total revenues to 9.5% from 13.3% between periods.
Casino Expenses. Casino expenses increased $2.7 million or 27.6% to $12.3 million for the quarter ended June 30, 2010, compared to $9.6 million for the quarter ended June 30, 2009. The increase in casino expenses was primarily due to a $1.3 million increase in returned markers, a $1.0 million increase in payroll and related expenses, a $0.8 million increase in complimentary expenses (items furnished to customers on a complimentary basis) and a $0.3 million increase in miscellaneous operating expenses. These increases were slightly offset by a $0.7 million decrease in customer discounts. We issue credit in the form of “markers” to approved casino customers following investigations of creditworthiness. Non-performance by these parties results in losses up to the recorded amount of the related receivables. Business or economic conditions or other significant events could affect the collectability of such receivables. Our provision and allowance for doubtful accounts are based on estimates by management of the collectability of the receivable balances at each period end. Management’s estimates consider, among other factors, the age of the receivables, the type or source of the receivables and the results of collection efforts to date, especially with regard to significant accounts.
Lodging Expenses. Lodging costs and expenses increased 216.0% or $3.4 million to $5.0 million for the quarter ended June 30, 2010, compared to $1.6 million for the quarter ended June 30, 2009. The increase in lodging expenses was primarily due to a $1.8 million increase in labor and related expenses, a $0.7 million increase in laundry expense, a $0.4 million increase in travel agent commissions, a $0.2 million increase in credit card fees, a $0.2 million increase in contract maintenance and a $0.1 million increase in other miscellaneous operating supplies. The increase in lodging expenses are a result of completing the expansion project which increased the total available rooms by approximately 865 rooms per night.
Food and Beverage Costs and Expenses. Food and beverage costs and expenses increased by 53.2% or $5.6 million to $16.2 million for the quarter ended June 30, 2010, compared to $10.6 million for the quarter ended June 30, 2009. Food and beverage costs and expenses in relation to food and beverage revenues increased to 51.2% from 49.5% in the prior year on increases in food and beverage revenues of 47.8% to $31.6 million from $21.4 million. The increase in food and beverage costs and expenses was primarily due to a $2.3 million increase in labor and related expenses, a $1.3 million increase in outlet management fees, a $1.2 million increase in food and beverage product costs, a $0.3 million increase in professional services for disc jockeys and special events, a $0.2 million increase in advertising, a $0.2 million increase in miscellaneous operating supplies and a $0.1 million increase in credit card fees. Management believes the increase in food and beverage expenses is a result of increased customer volumes as a result of completing the expansion project.
Retail Costs and Expenses. Retail costs and expenses decreased slightly by 11.4% or $106,000 in the quarter ended June 30, 2010, compared to the quarter ended June 30, 2009.
Other Costs and Expenses. Other costs and expenses increased 18.7% or $1.1 million to $6.7 million for the quarter ended June 30, 2010, compared to $5.6 million for the quarter ended June 30, 2009. Other costs and expenses in relation to other income increased to 77.6% from 55.7%. The increase in other costs and expenses was due to a $0.7 million increase in cost of complimentaries and a $0.4 million increase in labor and related expenses. We hosted 34 entertainment events in the quarter ended June 30, 2010 compared to 32 entertainment events in the second quarter ended June 30, 2009.

 

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Marketing, General and Administrative. Marketing, general and administrative expenses increased 61.2% or $5.0 million in the quarter ended June 30, 2010, compared to the quarter ended June 30, 2009. Marketing, general and administrative expenses in relation to gross revenues increased to 18.3% from 14.9%. The increase in marketing, general and administrative expenses was primarily due to a $1.6 million increase in labor and related expenses, a $1.2 million increase in taxes and insurance, a $0.9 million increase in utilities, a $0.6 million increase in contract maintenance, a $0.5 million increase in advertising and marketing and a $0.2 million increase in contact services.
Management Fee-Related Party. Management fee-related party expenses increased 38.3% to $2.9 million for the quarter ended June 30, 2010. Management fees increased due to increased revenues as a result of the completion of the expansion project. As compensation for its services, Morgans Management receives a management fee equal to four percent of defined non-gaming revenues, including casino rents and all other rental income, and a chain service expense reimbursement. The reimbursement is subject to a cap of 1.5% of defined non-gaming revenues, including casino rents and all other income.
Depreciation and Amortization. Depreciation and amortization expense increased by $6.4 million to $11.2 million for the quarter ended June 30, 2010, compared to $4.9 million for the quarter ended June 30, 2009. The increase in depreciation and amortization expense is a result of additional assets being placed into service, as a result of completing the expansion project.
Interest Expense. Interest expense decreased $3.6 million or 17.9% to $16.5 million for the quarter ended June 30, 2010, compared to $20.1 million for the quarter ended June 30, 2009. The decrease in interest expense reflects a reduction of $5.1 million in loan cost amortization, as the initial loan costs were fully amortized in February 2010, partially offset by an increase in interest expense of $1.5 million. The deferred financing amortization occurred over the 36-month life of the applicable loans at approximately $1.7 million per month. Payments on the debt under the CMBS facility are based upon LIBOR, plus a spread of 4.25%, subject to adjustment upwards in certain circumstances (i.e., extension of the term of the financing). Payments on the debt under the land acquisition financing are based on 30-day LIBOR, plus a blended spread of 17.9%.
Pre-opening Expenses. Pre-opening expenses decreased $4.4 million to $0.3 million for the quarter ended June 30, 2010, compared to $4.7 million for the quarter ended June 30, 2009. The decrease in pre-opening expenses was primarily due to completing the majority of the expansion project in December 2009.
Income Taxes. The Company reported income tax expense of $252,000 for the quarter ended June 30, 2010 because of an increase in the deferred tax liability related to indefinite life intangibles. The Company maintains a full valuation allowance to offset net deferred tax assets due to the uncertainty of future earnings as required under FASB ASC 740-10 (SFAS 109), and as further discussed below. The valuation allowance was established subsequent to the purchase allocation on February 1, 2007 (not including deferred tax liabilities related to indefinite life intangibles) because it could not be determined that it is more likely than not that future taxable income will be realized to recognize deferred tax assets.
Other Comprehensive Loss. For the quarter ended June 30, 2010, the total fair value of derivative instruments that qualified for hedge accounting changed by $3.7 million in comparison to the quarter ended June 30, 2009 and was included in other comprehensive loss. Amounts reported in accumulated other comprehensive loss related to derivative instruments that qualify for hedge accounting will be reclassified to interest expense as interest payments are made on our variable-rate debt. We reflect the change in fair value of all hedging instruments in cash flows from operating activities.
Comprehensive (Loss) Income. Comprehensive loss was $20.6 million for the quarter ended June 30, 2010, compared to a comprehensive loss of $17.5 million for the quarter ended June 30, 2009. The increase in comprehensive loss was due to the factors described above.

 

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Comparison of the Six Month Period Ended June 30, 2010 to the Six Month Period Ended June 30, 2009
The following table presents our consolidated operating results for the six month periods ended June 30, 2010 and 2009, and the change in such data between the two periods.
                                 
    Six Month     Six Month              
    Period Ended     Period Ended     Change     Change  
    June 30, 2010     June 30, 2009     ($)     (%)  
    (in thousands)                  
INCOME STATEMENT DATA:
                               
REVENUES:
                               
Casino
  $ 32,516     $ 24,859     $ 7,657       30.8 %
Lodging
    28,333       15,842       12,491       78.8 %
Food and beverage
    53,345       33,598       19,747       58.8 %
Retail
    2,329       2,622       (293 )     -11.2 %
Other
    15,560       12,384       3,176       25.6 %
 
                       
Gross revenues
    132,083       89,305       42,778       47.9 %
Less: promotional allowances
    (13,280 )     (12,184 )     (1,096 )     9.0 %
 
                       
Net revenues
    118,803       77,121       41,682       54.0 %
 
                       
COSTS AND EXPENSES:
                               
Casino
    25,381       19,818       (5,563 )     -28.1 %
Lodging
    8,891       2,905       (5,986 )     -206.1 %
Food and beverage
    28,202       18,045       (10,157 )     -56.3 %
Retail
    1,453       1,456       3       0.2 %
Other
    11,583       7,454       (4,129 )     -55.4 %
Marketing
    4,257       1,898       (2,359 )     -124.3 %
Management fee—related party
    4,960       3,288       (1,672 )     -50.9 %
General and administrative
    20,714       13,727       (6,987 )     -50.9 %
Depreciation and amortization
    25,528       10,373       (15,155 )     -146.1 %
Loss on disposal of assets
    1             (1 )     100.0 %
Pre-opening
    712       6,147       5,435       88.4 %
 
                       
Total costs and expenses
    131,682       85,111       (46,571 )     -54.7 %
 
                       
INCOME (LOSS) FROM OPERATIONS
    (12,879 )     (7,990 )     (4,889 )     61.2 %
Interest income
    4       321       (317 )     -98.8 %
Interest expense, net of capitalized interest
    (35,513 )     (40,067 )     4,554       -11.4 %
 
                       
Loss before income tax expense
    (48,388 )     (47,736 )     (652 )     1.4 %
Income tax expense
    252             252       100 %
Net Loss
    (48,640 )     (47,736 )     (904 )     1.9 %
Other Comprehensive Loss:
                               
Interest rate cap fair market value adjustment, net of tax
    1,472       5,898       (4,426 )     -75.0 %
 
                       
Comprehensive loss
  $ (47,168 )   $ (41,838 )   $ (5,330 )     12.7 %
 
                       
Results of Operations for the Six Month Period Ended June 30, 2010 Compared to the Results of Operations for the Six Month Period Ended June 30, 2009
Net Revenues. Net revenues increased $41.7 million or 54.0% to $118.9 million for the six month period ended June 30, 2010, compared to $77.1 million for the six month period ended June 30, 2009. The increase in net revenues was primarily due to a $7.7 million or 30.8% increase in casino revenue, a $12.5 million or 78.8% increase in lodging revenue, a $19.7 million or 58.8% increase in food and beverage revenue and a $3.2 million increases in other revenue. These increases were slightly offset by a $0.3 million or 11.2% decrease in retail revenues and a $1.1 million or 9.0% increase in promotional allowances related to items furnished to customers on a complimentary basis.

 

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Casino Revenues. Casino revenues increased $7.7 million to $32.5 million for the six month period ended June 30, 2010, compared to $24.9 million for the six month period ended June 30, 2009. The increase in casino revenues was primarily due to a $6.5 million or 39.6% increase in table games revenue and a $1.5 million or 21.4% increase in slot revenue, which was partially offset by a $0.3 million decrease in race and sports revenue. Poker revenue remained flat at $0.8 million. The increase in table games revenues was due to an increase in table game hold percentage and an increase in table game drop. Management believes that table game drop increased due to an increase in visitation to the Hard Rock as a result of completing the expansion project. Table game hold percentage increased 80 basis points to 13.1% from 12.3%, which was within the expected range of 12% to 16%. Table game drop increased $40.5 million or 30.3% to $174.2 million from $133.6 million. The average number of table games in operations was increased from 87 tables in 2009 to 125 tables in 2010. The net result of these changes in table game drop and table game hold percentage was a decrease in win per table game per day to $1,013 from $1,076, a decrease of $63 or 5.8%. We have historically reported table game hold percentage using the gross method, while casinos on the Las Vegas Strip report hold percentage using the net method (which reduces the table game drop by marker repayments made in the gaming pit area). For the purpose of comparison to properties on the Las Vegas Strip, our net hold percentage for the six month period ended June 30, 2010 was 16.7%, compared to 15.4% for the six month period ended June 30, 2009. Slot machine revenues increased $1.5 million to $8.5 million from $7.0 million. Slot machine handle increased $19.6 million to $181.3 million from $161.6 million. Slot machine hold percentage increased 40 basis points to 4.7% from 4.3%, which was within the expected range of 4% to 7%. The average number of slot machines in operation increased to 827 from 522, an increase of 305 slot machines or 58.3%. The net result of these changes in handle, hold percentage and average number of slot machines in operation was a decrease in win per slot machine per day to $56.87 from $74.16, a decrease of $17.29 or 23.3%. Race and sports book revenue decreased $0.3 million due to a decrease in hold percentage, partially offset by an increase in race and sports book write. The race and sports book write increased $3.7 million to $14.4 million from $10.7 million. Race and sports book hold percentage decreased 3.8% to 2.5% from 6.3%, which was less than the expected range of 4% to 8%.
Lodging Revenues. Lodging revenues increased $12.5 million to $28.3 million for the six month period ended June 30, 2010, compared to $15.8 million for the six month period ended June 30, 2009. The increase in lodging revenues was primarily due to an increase in occupied rooms to 167,689 from 101,140, an increase of 66,549 or 65.8%. The increase in occupied rooms was a result of completing the expansion project which added approximately 865 additional guest rooms. Hotel occupancy decreased to 83.6% from 90.8% between periods and average daily rate increased to $169 from $157, an increase of 7.9% between periods.
Food and Beverage Revenues. Food and beverage revenues increased $19.7 million to $53.3 million for the six month period ended June 30, 2010, compared to $33.6 million for the six month period ended June 30, 2009. The increase in food and beverage revenues was partially due to a $7.4 million increase in Vanity (which replaced Body English), a $1.6 million increase from Rare 120, a $1.1 million increase from Mr. Lucky’s, a $1.0 million increase from room service, a $0.4 million increase from Pink Taco, a $0.4 million increase from Beach Club, a $0.3 million increase from banquet revenue, a $0.2 million increase from Starbucks, a $0.1 million increase from The Joint Bar and a $0.1 million increase from Ago. This increase also was partially due to $1.5 million in revenue from West Pool, $1.0 million in revenue from Luxe Bar, $0.4 million in revenue from Midway Bar, $0.3 million in revenue from Espumoso, $0.3 million in revenue from Johnny Smalls, $0.2 million in revenue from Sports Deluxe and $0.1 million in revenue from Skybar, Helles Bells Bar, and Juice Bar which were not open in the six months ended June 30, 2009. Management believes these increases are a result of increased visitation as a result of completing the expansion project.
Retail Revenues. Retail revenues decreased $0.3 million to $2.3 million for the six month period ended June 30, 2010, compared to $2.6 million for the six month period ended June 30, 2009. As a result of the expansion, the Retail store lost 10% of the square footage and roughly 25% of the available merchandising capacity. Management believes that this, coupled with the additional retail tenants and poor market conditions, has caused the retail revenue to decline year over year.
Other Revenues. Other revenues increased $3.2 million to $15.6 million for the six month period ended June 30, 2010, compared to $12.4 million for the six month period ended June 30, 2009. The increase in other revenues was due to a $0.7 million increase in entertainment revenue, a $0.4 million increase in Reliquary and Rock Spa revenue and a $2.1 million increase in other miscellaneous revenue resulting from retail tenants and licensees. Management believes the entertainment revenue increased due to additional patron volume as a result of opening the new expanded The Joint in April 2009. We hosted 52 entertainment events during the six month period ended June 30, 2010, compared to 37 during the six month period ended June 30, 2009.
Promotional Allowances. Promotional allowances increased $1.1 million or 9.0% to $13.3 million for the six month period ended June 30, 2010, compared to $12.2 million for the six month period ended June 30, 2009. Promotional allowances decreased as a percentage of total revenues to 10.1% from 13.6% between periods.
Casino Expenses. Casino expenses increased $5.6 million or 28.1% to $25.4 million for the six month period ended June 30, 2010, compared to $19.8 million for the six month period ended June 30, 2009. The increase in casino expenses was primarily due to a $2.1 million increase in complimentary expenses (items furnished to customers on a complimentary basis), a $1.9 million increase in labor and related expenses, a $1.1 million increase in returned markers, a $0.7 million increase in taxes and licenses, and a $0.2 million increase in miscellaneous operating supplies, which were slightly offset by a $0.4 million decrease in customer discounts. We issue credit in the form of “markers” to approved casino customers following investigations of creditworthiness. Non-performance by these parties results in losses up to the recorded amount of the related receivables. Business or economic conditions or other significant events could affect the collectability of such receivables. Our provision and allowance for doubtful accounts are based on estimates by management of the collectability of the receivable balances at each period end. Management’s estimates consider, among other factors, the age of the receivables, the type or source of the receivables and the results of collection efforts to date, especially with regard to significant accounts. Management believes bad debt is increasing due to a number of factors affecting consumers, including a slowdown in the economy and other economic factors.

 

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Lodging Expenses. Lodging costs and expenses increased 206.1% or $6.0 million to $8.9 million for the six month period ended June 30, 2010, compared to $2.9 million for the six month period ended June 30, 2009. Lodging expenses in relation to lodging revenues increased to 31.4% from 18.3% in the prior period. The increase in lodging expenses was primarily due to a $3.4 million increase in labor and related expenses, a $1.2 million increase in laundry expense, a $0.5 million increase in travel agent commissions, a $0.4 million increase in miscellaneous operating supplies, a $0.3 million increase in credit card fees and a $0.2 million increase in room amenities. The increase in lodging expenses are a result of completing the expansion project which increased the total available rooms by approximately 865 rooms per night.
Food and Beverage Costs and Expenses. Food and beverage costs and expenses increased by 56.3% or $10.2 million to $28.2 million for the six month period ended June 30, 2010, compared to $18.0 million for the six month period ended June 30, 2009. Food and beverage costs and expenses in relation to food and beverage revenues decreased slightly to 52.9% from 53.7% in the prior year due primarily to increases in food and beverage revenues of 58.8% to $53.3 million from $33.6 million. The increase in food and beverage costs and expenses was primarily due to a $4.4 million increase in labor and related expenses, a $2.9 million increase in food and beverage product costs, a $1.7 million increase in management fees, a $0.6 million increase in professional services for disc jockeys and special events and a $0.4 million increase in advertising expense.
Retail Costs and Expenses. Retail costs and expenses remained constant at $1.5 million in the six month period ended June 30, 2010, compared to the six month period ended June 30, 2009.
Other Costs and Expenses. Other costs and expenses increased 55.4% or $4.1 million in the six month period ended June 30, 2010, compared to the six month period ended June 30, 2009. Other costs and expenses in relation to other income increased to 74.4% from 60.2%. The increase in other costs and expenses was primarily due to a $1.9 million increase in entertainment expense, a $0.9 million increase in labor and related expenses, a $0.7 million increase in complimentaries expense, a $0.2 million increase in product costs, a $0.1 million increase in repairs and maintenance and a $0.3 million increase in miscellaneous operating supplies.
Marketing, General and Administrative. Marketing, general and administrative expenses increased 59.8% or $9.3 million in the six month period ended June 30, 2010, compared to the six month period ended June 30, 2009. Marketing, general and administrative expenses in relation to gross revenues increased to 18.9% from 17.5%. The increase in marketing, general and administrative expenses was primarily due to a $3.6 million increase in payroll and related expenses, a $2.0 million increase in taxes, a $1.9 million increase in contract maintenance and a $1.8 million increase in utilities.
Management Fee-Related Party. Management fee-related party expenses increased $1.7 million or 50.9% to $5.0 million for the six month period ended June 30, 2010, compared to $3.3 million for the six month period ended June 30, 2009, due to increased revenues as a result of completing our expansion project. As compensation for its services, Morgans Management receives a management fee equal to 4% of defined non-gaming revenues, including casino rents and all other rental income, and a chain service expense reimbursement. The reimbursement is subject to a cap of 1.5% of defined non-gaming revenues, including casino rental and all other income.
Depreciation and Amortization. Depreciation and amortization expense increased by $15.1 million to $25.5 million for the six month period ended June 30, 2010, compared to $10.4 million for the six month period ended June 30, 2009. The increase in depreciation and amortization expense is a result of additional assets being placed into service, as a result of completing the expansion project.
Interest Expense. Interest expense decreased $4.6 million or 11.4% to $35.5 million for the six month period ended June 30, 2010, compared to $40.1 million for the six month period ended June 30, 2009. The decrease in interest expense reflects a reduction of $8.8 million in loan cost amortization, as the initial loan costs were fully amortized in February 2010, partially offset by an increase in interest expense of $4.3 million. The deferred financing amortization occurred over the 36-month life of the applicable loans at approximately $1.7 million per month. Payments on the debt under the CMBS facility are based upon LIBOR, plus a spread of 4.25%, subject to adjustment upwards in certain circumstances (i.e., extension of the term of the financing). Payments on the debt under the land acquisition financing are based on 30-day LIBOR, plus a blended spread of 17.9%.
Pre-opening Expenses. Pre-opening expenses decreased $5.4 million to $0.7 million for the six month period ended June 30, 2010, compared to $6.1 million for the six month period ended June 30, 2009. The decrease in pre-opening expenses was primarily due to completing the majority of the expansion project in December 2009.

 

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Income Taxes. The Company reported income tax expense of $252,000 for the six month period ended June 30, 2010 because of an increase in the deferred tax liability related to indefinite life intangibles. The Company maintains a full valuation allowance to offset net deferred tax assets due to the uncertainty of future earnings as required under FASB ASC 740-10 (SFAS 109), and as further discussed below. The valuation allowance was established subsequent to the purchase allocation on February 1, 2007 (not including deferred tax liabilities related to indefinite life intangibles) because it could not be determined that it is more likely than not that future taxable income will be realized to recognize deferred tax assets.
Other Comprehensive Loss. For the six month period ended June 30, 2010, the total fair value of derivative instruments that qualified for hedge accounting changed by $4.4 million in comparison to the six month period ended June 30, 2009 and was included in other comprehensive loss. Amounts reported in accumulated other comprehensive loss related to derivative instruments that qualify for hedge accounting will be reclassified to interest expense as interest payments are made on our variable-rate debt. We reflect the change in fair value of all hedging instruments in cash flows from operating activities.
Comprehensive Loss. Comprehensive loss was $47.2 million for the six month period ended June 30, 2010, compared to a comprehensive loss of $41.8 million for the six month period ended June 30, 2009. The increase in comprehensive loss was due to the factors described above.
Cash Flows for the Six Month Period Ended June 30, 2010 Compared to Cash Flows for the Six Month Period Ended June 30, 2009
Operating Activities. Net cash used by operating activities amounted to $6.0 million for the six month period ended June 30, 2010, compared to $15.1 million for the six month period ended June 30, 2009. The decrease in net cash used in operating activities was primarily due to a decline in interest expense on the mezzanine loans under the CMBS facility as a result of the interest being deferred which will compound and accrue until either certain cash flow covenants have been met or the maturity date of such loans.
Investing Activities. Net cash used in investing activities amounted to $86.6 million for the six month period ended June 30, 2010, compared to $116.5 million for the six month period ended June 30, 2009. The net cash used in investing activities primarily relates to the construction expenses of the expansion project and the change in restricted reserve accounts under the CMBS facility. The decrease in net cash used in investing activities primarily results from utilizing restricted cash construction reserves to complete the expansion project and the resulting reduction in the investment in new assets.
Financing Activities. Net cash provided by financing activities amounted to $94.1 million for the six month period ended June 30, 2010, compared to $134.4 million for the six month period ended June 30, 2009. The net cash provided by financing activities for the quarter ended June 30, 2010 represents an additional $95.0 million of borrowings under the CMBS facility, offset by a $0.9 million reduction in loan financing costs. The decrease in net cash provided by financing activities primarily results from our completion of the expansion project and the resulting reduction in construction funding under the CMBS facility.
Liquidity and Capital Resources
As of June 30, 2010, we had approximately $13.9 million in available cash and cash equivalents. As of June 30, 2010, our total long-term debt, including the current portion, was approximately $1.3 billion and our total member’s deficit was approximately $112.0 million.
Sources of Liquidity
CMBS Facility. In connection with our acquisition of the Hard Rock, we entered into a debt financing in the form of a real estate loan in the CMBS market. The CMBS facility provided for, among other borrowing availability, a construction loan of up to $620.0 million for the expansion project at the Hard Rock and an acquisition loan of $760.0 million which we used to pay a portion of the purchase price and costs and expenses for our acquisition of the Hard Rock and related assets. As of June 30, 2010, we had fully drawn the $620.0 million under the construction loan. In conjunction with fully drawing the construction loan, we paid down $32.9 million of the acquisition loan, paid $0.8 million in exit fees, funded $3.6 million into the interest reserve, funded $20.0 million into a general reserve account and $11.3 million into an equity/accrual subaccount, as required under the loan agreement. The equity accrual subaccount holds amounts funded into the general reserve in excess of $20 million at any time. If a debt service coverage ratio of 1.2:1 is satisfied, then the amounts held in such account will be released to make certain payments to the DLJMB Parties on account of their equity contributions to us. If the debt service coverage ratio is not satisfied within one year from the date of the deposits into the equity accrual/subaccount, then such amounts may be used to repay the mortgage loan.
The financing incurs interest payable through a funded interest reserve initially, then through cash, at a rate (blended among the debt secured by assets and the junior and senior mezzanine debt, if applicable) of LIBOR plus 4.25%, subject to adjustment upwards in certain circumstances (i.e., extension of the term of the financing). The loan agreements under the CMBS facility include customary affirmative and negative covenants for similar financings, including, among others, restrictive covenants regarding incurrence of liens, sales of assets, distributions to affiliates, changes in business, cancellation of indebtedness, dissolutions, mergers and consolidations, as well as limitations on security issuances, transfers of any of our real property and removal of any material article of furniture, fixture or equipment from our real property. We have evaluated these requirements and determined that we were in compliance as of June 30, 2010.

 

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Equity Contributions. During the six month period ended June 30, 2010, our members did not contribute additional cash or post additional letters of credit to the Company. As of June 30, 2010, the members had funded all of the required capital contributions needed to fund the equity for the expansion project. The JV Agreement provides that in certain cases DLJMB IV HRH, LLC (“DLJMB IV HRH”) may request that our members make necessary capital contributions contemplated by the operating plans and budgets approved by our board of directors, or in the event of an unexpected shortfall in capital. If we require additional capital with respect to matters approved by our board of directors, DLJMB IV HRH also has the right, without the approval of our board of directors, to determine appropriate sources of such capital in the form of debt or equity financing. Such financing must be funded either by third parties who are not specified competitors of Morgans or our existing members or their affiliates on fair market terms (as determined by our board of directors, or, in some cases by a written appraisal or fairness opinion).
Liquidity Requirements
Short-Term Liquidity Requirements. We generally consider our short-term liquidity requirements to consist of those items that are expected to be incurred within the next 12 months and believe those requirements consist primarily of funds necessary to pay operating expenses, debt amortization, expansion project costs and requirements and other expenditures associated with the Hard Rock, including funding our reserve accounts. We expect our short-term liquidity requirements for the next 12 months to include (a) expenditures of $0.1 million (of the total budgeted amount of $760 million) for the expansion and renovation project at the Hard Rock and (b) additional expenses of three percent of our gross revenues for replacements and refurbishments at the Hard Rock.
We expect to meet our short-term liquidity needs through existing working capital, cash provided by operations, licensing of our intellectual property and restricted cash reserves. Management anticipates we will not return to a positive cash position, at the earliest until the economic environment has improved from its current condition. In the event that our expected sources of liquidity do not meet the levels we anticipate, then a further restructuring of debt may be necessary. We believe that these sources of capital will be sufficient to meet our short-term liquidity requirements, however there can be no assurances.
In addition, gaming regulators require that we maintain a certain amount of cash on hand for our gaming operations. Under the CMBS facility, we established a cash management account to hold the cash that we generate from our operations. This account is under the sole control of the lenders under the CMBS facility, which has a first priority security interest in the account and any amounts on deposit therein. The terms of the CMBS facility govern the use of amounts on deposit in the account, and condition our ability to receive such amounts on the satisfaction of other payments required by the CMBS facility.
Long-Term Liquidity Requirements. We generally consider our long-term liquidity requirements to consist of those items that are expected to be incurred beyond the next 12 months and believe these requirements consist primarily of funds necessary to pay interest payments and perform necessary renovations and other non-recurring capital expenditures that need to be made periodically to our property. We intend to satisfy these long-term liquidity requirements through various sources of capital, including our existing working capital, cash provided by operations, licensing of our intellectual property and restricted cash reserves. Other sources may be sales of equity securities and/or cash generated through property dispositions and joint venture transactions. In addition, the current maturity date of the $1.3 billion outstanding under the CMBS facility is February 9, 2011, with three one-year options to extend the maturity date provided that we satisfy certain conditions.
Our ability to incur additional debt is dependent upon our ability to satisfy the borrowing restrictions imposed by our current lenders. In addition, our ability to raise funds through the issuance of equity securities is dependent upon, among other things, general market conditions and market perceptions about us. We will continue to analyze which source of capital is most advantageous to us at any particular point in time, but the equity markets may not be consistently available on terms that are attractive or at all.
Global market and economic conditions continue to be challenging with tight credit conditions and recessionary conditions in most major economies continuing into 2010. As a result of these market conditions, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. These factors also have lead to a decrease in spending by businesses and consumers alike, especially in the markets in which we do business. Continued instability in the U.S. and international markets and economies and a prolonged slowness in business and consumer spending have and may continue to adversely affect our liquidity and financial condition, and the liquidity and financial condition of our customers, including our ability to refinance maturing liabilities and access the capital markets to meet liquidity needs.
We believe that the sources of capital described above will continue to be available to us in the future and will be sufficient to meet our long-term liquidity requirements.

 

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Capital Expenditures, Interest Expense and Reserve Funds
We are obligated to maintain reserve funds for capital expenditures at the Hard Rock as determined pursuant to our CMBS facility. These capital expenditures relate primarily to the periodic replacement or refurbishment of furniture, fixtures and equipment. Our CMBS facility requires us to deposit funds into a replacements and refurbishments reserve fund at amounts equal to three percent of the Hard Rock’s gross revenues and requires that the funds be set aside in restricted cash. As of June 30, 2010, $1.3 million was available in restricted cash reserves for future capital expenditures in the replacements and refurbishments reserve fund.
In addition, we are also obligated to maintain a reserve fund for interest expense as determined pursuant to the CMBS facility. On the closing date of our acquisition of the Hard Rock, we deposited $45 million into an interest reserve fund to be held as additional collateral under the CMBS facility for the payment of interest expense shortfalls and in December 2009 we deposited an additional $1.0 million into the interest reserve fund. The lenders under the CMBS facility will make disbursements from the interest reserve fund upon our satisfaction of conditions to disbursement under the CMBS facility. As of June 30, 2010, $6.6 million was available in restricted cash reserves in the interest reserve fund. Furthermore, as a result of fully drawing the construction loan, we have funded a general reserve account and an equity/accrual subaccount, as required under the loan agreement. As of June 30, 2010, $20.0 million and $11.3 million was available in restricted cash reserves in the general and equity/accrual subaccount reserve funds, respectively. The equity accrual subaccount holds amounts funded into the general reserve in excess of $20 million at any time. If a debt service coverage ratio of 1.2:1 is satisfied, then the amounts held in such account will be released to make certain payments to the DLJMB Parties on account of their equity contributions to us. If the debt service coverage ratio is not satisfied within one year from the date of the deposits into the equity accrual/subaccount, then such amounts may be used to repay the mortgage loan.
We are also obligated to maintain reserve funds for interest expense and property tax as determined pursuant to the $50.0 million land acquisition loan we have entered into with respect to an approximately 11-acre parcel of land located adjacent to the Hard Rock. The lenders will make disbursements from the interest and property tax reserve funds upon our satisfaction of conditions to disbursement under the land acquisition loan. As of June 30, 2010, $3.1 million and $0.7 million was available in restricted cash reserves in the interest and property tax reserve funds, respectively.
Derivative Financial Instruments
We use derivative financial instruments to manage our exposure to the interest rate risks related to the variable rate debt under our CMBS facility. We do not use derivatives for trading or speculative purposes and only enter into contracts with major financial institutions based on their credit rating and other factors. The fair value of our derivative financial instruments is determined by our management. Such methods incorporate standard market conventions and techniques such as discounted cash flow and option pricing models to determine fair value. We believe these methods of estimating fair value result in general approximation of value, and such value may or may not be realized.
On February 9, 2010, we purchased five new interest rate cap agreements with an aggregate notional amount of $1.285 billion with a LIBOR cap of 1.23313%. We purchased the new interest rate cap agreements for an amount equal to approximately $1.6 million. We determined that four out of the five interest rate caps qualify for hedge accounting and the caps are designated as cash flow hedges. The changes in fair value of the remaining interest rate cap that does not qualify for hedge accounting are recognized directly in earnings.
For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivative is initially reported in other comprehensive income (outside of earnings) and subsequently reclassified to earnings when the hedged transaction affects earnings, and the ineffective portion of changes in the fair value of the derivative is recognized directly in earnings. We assess the effectiveness under the hypothetical derivative method where the cumulative change in fair value of the actual cap is compared to the cumulative change in fair value of a hypothetical cap having terms that exactly match the critical terms of the hedged transaction. For derivatives that do not qualify for hedge accounting or when hedge accounting is discontinued, the changes in fair value of the derivative instrument is recognized directly in earnings.
Off-Balance-Sheet Arrangements
We do not have any off-balance-sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, revenue, expenses, results of operations, liquidity, capital expenditures or capital resources. Currently, we have no guarantees, such as performance guarantees, keep-well agreements or indemnities in favor of third parties.
Contractual Obligations and Commitments
We have entered into various contractual obligations as detailed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009. During the six month period ended June 30, 2010, we signed construction commitments bringing the aggregate amount to approximately $595.4 million, which consists of commitments to the general contractor for the expansion project and for other items related to the expansion and renovation of the Hard Rock.

 

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CRITICAL ACCOUNTING POLICIES
Critical accounting policies and estimates are those that are both important to the presentation of our financial condition and results of operations and requires our most difficult, complex or subjective judgments and that have the most significant impact on our financial condition and results of operations.
The preparation of our consolidated financial statements in conformity accounting principles generally accepted in the United States (“GAAP”) require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate our estimates on an ongoing basis. We base our estimates on historical experience, information that is currently available to us and on various other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect the most significant judgments and estimates used in the preparation of our consolidated financial statements.
Impairment of Intangible Assets and Other Long-lived Assets
We evaluate our goodwill, intangible assets and other long-lived assets in accordance with the applications of FASB ASC 350 (prior authoritative literature : SFAS No. 142 , Accounting for Goodwill and Other Intangible Assets, (“SFAS No. 142”)), related to goodwill and other intangible assets and of FASB ASC 360-10 (prior authoritative literature: SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144” )), related to possible impairment of or disposal of long-lived assets. For goodwill and indefinite-life intangible assets, we will review the carrying values on an annual basis and between annual dates in certain circumstances. For assets to be disposed of, we recognize the asset at the lower of carrying value or fair market value less costs of disposal, as estimated based on comparable asset sales, solicited offers, or a discounted cash flow model. For assets to be held and used, we review for impairment whenever indicators of impairment exist.
Inherent in reviewing the carrying amounts of the above assets is the use of various estimates. First, our management must determine the usage of the asset. Impairment of an asset is more likely to be recognized where and to the extent our management decides that such asset may be disposed of or sold. Assets must be tested at the lowest level for which identifiable cash flows exist. This testing means that some assets must be grouped and our management exercises some discretion in grouping those assets. Future cash flow estimates are, by their nature, subjective and actual results may differ materially from our estimates. If our ongoing estimates of future cash flows are not met, we may have to record additional impairment charges in future accounting periods. Our estimates of cash flows are based on the current regulatory, social and economic climates where we conduct our operations as well as recent operating information and budgets for our business. These estimates could be negatively impacted by changes in federal, state or local regulations, economic downturns, or other events affecting various forms of travel and access to our hotel casino.
Indefinite-lived intangible assets must be reviewed for impairment at least annually and between annual test dates in certain circumstances. We perform our annual impairment test for indefinite-lived intangible assets in the fourth quarter of each fiscal year. While certain of the inputs used in our valuation model for assessing the value relative to our indefinite-lived intangible assets potentially constitute Level 2 inputs (observable inputs), we often apply adjustments to the inputs, and, thus, render those inputs as Level 3 (unobservable inputs). As a result, the majority of our inputs used in our valuation model constitute Level 3 inputs. We believe that no significant events occurred during the quarter ended June 30, 2010 that would indicate impairment exists.
Non-financial assets must be reviewed for impairment at least annually and between annual test dates in certain circumstances. We perform our annual impairment test for non-financial assets in the fourth quarter of each fiscal year. Most of the inputs used in our valuation model for assessing the value relative to our non-financial assets constitute Level 2 inputs. We believe that no significant events occurred during the quarter ended June 30, 2010 that would indicate impairment exists.
Depreciation and Amortization Expense
Depreciation expense is based on the estimated useful life of our assets. The respective lives of the assets are based on a number of assumptions made by us, including the cost and timing of capital expenditures to maintain and refurbish our hotel casino, as well as specific market and economic conditions. Depreciation and amortization are computed using the straight-line method over the estimated useful lives for financial reporting purposes and accelerated methods for income tax purposes.
While our management believes its estimates are reasonable, a change in the estimated lives could affect depreciation expense and net income or the gain or loss on the sale of our hotel casino or any of its assets. Substantially all property and equipment is pledged as collateral for long-term debt.

 

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Derivative Instruments and Hedging Activities
We manage risks associated with our current and anticipated future borrowings, such as interest rate risk and its potential impact on our variable rate debt. FASB ASC 815-10, Derivatives and Hedging ( prior authoritative literature: SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted) (“FASB ASC 815-10 (SFAS No. 133)”), establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. As required by FASB ASC 815-10 (SFAS No. 133), we record all derivatives on our balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative and the resulting designation. Derivatives used to hedge the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives used to hedge the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges.
For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivative is initially reported in other comprehensive income (outside of earnings) and subsequently reclassified to earnings when the hedged transaction affects earnings, and the ineffective portion of changes in the fair value of the derivative is recognized directly in earnings. We assess the effectiveness under the hypothetical derivative method where the cumulative change in fair value of the actual cap is compared to the cumulative change in fair value of a hypothetical cap having terms that exactly match the critical terms of the hedged transaction. For derivatives that do not qualify for hedge accounting or when hedge accounting is discontinued, the changes in fair value of the derivative instrument is recognized directly in earnings.
Our objective in using derivatives is to add stability to interest expense and to manage its exposure to interest rate movements or other identified risks. To accomplish this objective, we primarily use interest rate caps as part of its cash flow hedging strategy. During the quarter ended June 30, 2010, interest rate caps were used to hedge the variable cash flows associated with existing variable-rate debt.
Derivative instruments and hedging activities require us to make judgments on the nature of our derivatives and their effectiveness as hedges. These judgments determine if the changes in fair value of the derivative instruments are reported as a component of interest expense in the consolidated statements of operations or as a component of equity on our consolidated balance sheets. While we believe our judgments are reasonable, a change in a derivative’s fair value or effectiveness as a hedge could affect expenses, net income and equity.
Fair Value Measurements
FASB ASC 820-10, Fair Value Measurements and Disclosures (prior authoritative literature: SFAS No. 157, Fair Value Measurements, issued September 2006) (“FASB ASC 820-10 (SFAS No. 157)”), emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, FASB ASC 820-10 (SFAS No. 157) establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy). We have applied FASB ASC 820-10 (SFAS No. 157) to recognize the liability related to our derivative instruments at fair value to consider the changes in our creditworthiness and the creditworthiness of our counterparties in determining any credit valuation adjustments.
Level 1 inputs use quoted prices (unadjusted) in active markets for identical assets or liabilities that we have the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates and yield curves that are observable at commonly-quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, which is typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or liability.
Currently, we use interest rate cap agreements to manage our interest rate risk. The valuation of these derivative instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative instrument. This analysis reflects the contractual terms of the derivative instruments, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. To comply with the provisions of FASB ASC 820-10 (SFAS No. 157), we incorporate credit valuation adjustments to appropriately reflect both our own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, we have considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts and guarantees.

 

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Although we have determined that the majority of the inputs used to value our derivative instruments fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with our derivative instruments use Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by us or any of our counterparties. However, as of June 30, 2010, we have assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and have determined that the credit valuation adjustments are not significant to the overall valuation of our derivative instruments. As a result, we have determined that our derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy. As of June 30, 2010, the total value of the interest rate caps valued under FASB ASC 820-10 (SFAS No. 157) included in other assets is approximately $60,000.
Although we have determined that the majority of the inputs used to value our long-term debt fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with our long-term debt use Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by us or our lenders. However, as of June 30, 2010, we have assessed the significance of the impact of the credit valuation adjustments on the overall valuation of our long-term debt and have determined that the credit valuation adjustments are not significant to the overall valuation of our long-term debt. As a result, we have determined that our long-term debt valuations in their entirety are classified in Level 2 of the fair value hierarchy. As of June 30, 2010, the total fair value of our long-term debt valued under FASB ASC 820-10 (SFAS No. 157) did not materially differ from its carrying value of approximately $1.3 billion.
Share-Based Payments
Our only share-based award activity is the grant of Class C Units of the Company to certain executive officers and other employees. Under FASB ASC 718-10, Compensation (prior authoritative literature: SFAS No. 123R, Share-Based Payment), at the issuance date of January 14, 2009, the Class C Units were valued at zero as their value is subordinate to the capital contributions of our other members and all of our outstanding debt, which currently exceeds the fair market value of the Company. The Class C Units contain certain vesting conditions, including time thresholds, our attainment of performance targets and our completion of milestones related to our expansion project. As of June 30, 2010, no GAAP expense has been recorded for the Class C Units. No taxable event occurs with respect to the Class C Units until they fully vest and are available to the respective grantee.
Income Taxes
Under FASB ASC 740-10, an entity is required to record a valuation allowance against some or all of the deferred tax assets if it is more likely than not that some or all of the deferred tax assets will not be realized. To make such determination, we analyze positive and negative evidence, including history of earnings or losses, loss carryback potential, impact of reversing temporary differences, tax planning strategies, and future taxable income. We have reported net operating losses for consecutive years and do not have projected taxable income in the near future. This significant negative evidence causes our management to believe a full valuation allowance should be recorded against the deferred tax assets. The deferred tax liability related to the stepped-up basis on land and indefinite-lived intangibles are the only deferred tax items not offset by the valuation allowance. This treatment is consistent with the valuation allowance calculations in prior periods.
We use estimates related to cash flow projections for the application of FASB ASC 740-10 to the realization of deferred income tax assets. Our estimates are based upon recent operating results and budgets for future operating results. These estimates are made using assumptions about the economic, social and regulatory environments in which we operate. These estimates could be negatively impacted by numerous unforeseen events, including changes to the regulations affecting how we operate our business, changes in the labor market or economic downturns in the areas where we operate.
We assess our projected future taxable income (loss) based on our expansion plans, debt service and history of earnings and losses. Our management could not determine that it is more likely than not that future taxable income will be realized to recognize deferred tax assets. Accordingly, during the quarter ended June 30, 2010, we maintained a valuation allowance equal to our “Net Deferred Tax Assets” (excluding deferred tax liabilities relating to land and indefinite life intangible assets).
On January 1, 2007, we adopted the provisions for uncertain tax positions under FASB ASC 740-10 (formerly FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of SFAS No. 109) . As of December 31, 2009 and June 30, 2010, we had zero unrecognized tax benefits. We do not believe we will have any material changes in our unrecognized tax positions over the next 12 months. We do not have any interest or penalties associated with any unrecognized tax benefits.

 

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Allowance for Uncollectible Receivables
Substantially all of our accounts receivable are unsecured and are due primarily from the our casino and hotel patrons and convention functions. Financial instruments that potentially subject us to concentrations of credit risk consist principally of casino accounts receivable. We issue credit in the form of “markers” to approved casino customers following investigations of creditworthiness. Non-performance by these parties would result in losses up to the recorded amount of the related receivables. Business or economic conditions or other significant events could also affect the collectibility of such receivables.
Accounts receivable, including casino and hotel receivables, are typically non-interest bearing and are initially recorded at cost. Accounts are written off when management deems them to be uncollectible. Recoveries of accounts previously written off are recorded when received. An estimated allowance for doubtful accounts is maintained to reduce our receivables to their carrying amount, which approximates fair value. The allowance is estimated based on specific review of customer accounts as well as our management’s experience with collection trends in the casino industry and current economic and business conditions. Our management’s estimates consider, among other factors, the age of the receivables, the type or source of the receivables, and the results of collection efforts to date, especially with regard to significant accounts. Change in customer liquidity or financial condition could affect the collectability of that account, resulting in the adjustment upward or downward in the provision for bad debts, with a corresponding impact to our results of operations.
Recently Issued and Adopted Accounting Pronouncements
FASB ASC 105-10, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles (prior authoritative literature: FASB SFAS No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles, issued June 2009) (“FASB ASC 105-10-65 (SFAS No. 168)”), establishes the FASB Accounting Standards Codification as the single source of authoritative nongovernmental GAAP. The Codification is effective for fiscal years and interim periods ending after September 15, 2009. The adoption of FASB ASC 105-10-65 (SFAS No. 168) did not have a material impact on our consolidated financial statements.
FASB ASC 820-10, (Accounting Standards Update No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements (“ASU No. 2010-06”)), was adopted in the first quarter of 2010 by us. These provisions of ASU No. 2010-06 amended ASC 820-10, Fair Value Measurements and Disclosures, by requiring additional disclosures for transfers in and out of Level 1 and Level 2 fair value measurements, as well as requiring fair value measurement disclosures for each “class” of assets and liabilities, a subset of the captions disclosed in our consolidated balance sheets. The adoption did not have a material impact on our consolidated financial statements or our disclosures, as we did not have any transfers between Level 1 and Level 2 fair value measurements and did not have material classes of assets and liabilities that required additional disclosure.
FASB ASC 855-10, (Accounting Standards Update No. 2010-09 Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements (“ASU No. 2010-09”)) was adopted in the first quarter of 2010 by us. ASU No. 2010-09 amended ASC 855-10, Subsequent Events — Overall by removing the requirement for an SEC registrant to disclose a date, in both issued and revised financial statements, through which that filer had evaluated subsequent events. Accordingly, we removed the related disclosure from our consolidated financial statements in this report and the adoption did not have a material impact on our consolidated financial statements.
In April 2010, the FASB issued ASU No. 2010-16, Entertainment-Casinos (Topic 924): Accruals for Casino Jackpot Liabilities. The authoritative guidance for companies that generate revenue from gaming activities that involve base jackpots, which requires companies to accrue for a liability and charge a jackpot (or portion thereof) to revenue at the time the company has the obligation to pay the jackpot. The guidance is effective for interim and annual reporting periods beginning on or after December 15, 2010. We currently do not accrue for base jackpots until we have the obligation to pay such jackpots. As such, the application of this guidance will not have a material effect on our financial condition, results of operations or cash flows.
Item 3.   Quantitative and Qualitative Disclosures About Market Risk.
Our future income, cash flows and fair values relevant to financial instruments are dependent upon prevailing market interest rates. Market risk refers to the risk of loss from adverse changes in market prices and interest rates. The outstanding debt under our loan agreements has a variable interest rate. We are therefore most vulnerable to changes in short-term U.S. prime interest rates. We use some derivative financial instruments, primarily interest rate caps, to manage our exposure to interest rate risks related to our floating rate debt. We do not use derivatives for trading or speculative purposes and only enter into contracts with major financial institutions based on their credit rating and other factors. As of June 30, 2010, our total outstanding debt was approximately $1.3 billion, all of which was variable rate debt. We have entered into five interest rate cap agreements for our CMBS facility with an aggregate notional amount of $1.285 billion and with a LIBOR cap of 1.23313%. At June 30, 2010, the LIBOR index rate applicable to us was 0.35% thereby making the caps for the CMBS facility out of the money. Subject to the caps, as of June 30, 2010, an increase in market rates of interest by 0.125% would have increased our annual interest expense by $1.6 million, and a decrease in market interest rates by 0.125% would have decreased our annual interest expense by $1.6 million.

 

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Item 4.   Controls and Procedures.
(a) Disclosure Controls and Procedures. Our management, with the participation of the principal executive officer and principal financial officer of the Company, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on such evaluation, the principal executive officer and principal financial officer have concluded that, as of June 30, 2010, our disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Exchange Act. The principal executive officer and principal financial officer have concluded the controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.
(b) Changes in Internal Control Over Financial Reporting. There have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended June 30, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II—OTHER INFORMATION
Item 1.   Legal Proceedings.
The Company is a defendant in various lawsuits relating to routine matters incidental to its business. Management provides an accrual for estimated losses that may occur and does not believe that the outcome of any pending claims or litigation, individually or in the aggregate, will have a material adverse effect on the Company’s financial position, results of operations or liquidity beyond the amounts recorded in the accompanying balance sheet as of June 30, 2010.
Item 1A.   Risk Factors.
We believe the economic drivers that impact underlying destination resort fundamentals, such as growth in gross domestic product, business investment and employment, are likely to remain weak in 2010. The expected weakness in these drivers may significantly negatively impact revenues in future periods.
In addition to the other information set forth in this report, you should carefully consider the risks discussed in the section entitled “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009 and in our subsequently filed Quarterly Reports on Form 10-Q. These risks and uncertainties have the potential to materially affect our business, financial condition, results of operations, cash flows, projected results and future prospects. We do not believe that there have been any material changes to the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2009.
Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds.
None.
Item 3.   Defaults Upon Senior Securities.
None.
Item 4.   Submission of Matters to a Vote of Security Holders.
None.
Item 5.   Other Information.
None.
Item 6.   Exhibits
See “Exhibit Index” below.

 

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
         
  HARD ROCK HOTEL HOLDINGS, LLC
 
 
August 9, 2010  By:   /S/ JOSEPH A. MAGLIARDITI    
    Name:   Joseph A. Magliarditi   
    Title:   Chief Operating Officer   
     
August 9, 2010  By:   /S/ ARNOLD D. BOSWELL    
    Name:   Arnold D. Boswell   
    Title:   Chief Financial Officer of HRHI   

 

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EXHIBIT INDEX
         
EXHIBIT NUMBER   DESCRIPTION
       
 
  10.1    
Employment Agreement, dated as of May 23, 2010, by and between Morgans Hotel Group Management LLC and Joseph A. Magliarditi (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on May 27, 2010)
       
 
  31.1 *  
Certification of the Company’s Chief Operating Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934 and Section 302 of the Sarbanes-Oxley Act of 2002
       
 
  31.2 *  
Certification of Hard Rock Hotel, Inc.’s Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934 and Section 302 of the Sarbanes-Oxley Act of 2002
       
 
  32.1 *  
Certification of the Company’s Chief Operating Officer pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002. This certification is being furnished solely to accompany this Quarterly Report on Form 10-Q and is not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and is not to be incorporated by reference into any filing of the Company.
       
 
  32.2 *  
Certification of Hard Rock Hotel, Inc.’s Chief Financial Officer pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002. This certification is being furnished solely to accompany this Quarterly Report on Form 10-Q and is not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and is not to be incorporated by reference into any filing of the Company.
     
*   Filed herewith.

 

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