Description

Aztar is a casino company which owns five properties. 2/3 of the economics is the Tropicana Atlantic City. Also of interest is the big parcel of land on the Vegas strip located under the Tropicana Las Vegas.

Aztar is a well run company with some near-term uncertainty. It has a 15% free cash flow yield (based on maintenance cap-ex) and a pretty good balance sheet. There is a hidden asset that is not earning much, but is probably worth at least half the market cap. And they just announced a big share repurchase. In an industry where deals are a way of life. I think I get $25 for this stock in the next 18 months either from the market or a takeover.

What makes this stock interesting is superb management and $75-85 million of free cash flow earnings power vs. a $525 million equity valuation.

The balance sheet is solid, with debt of 3.2 times EBITDA (Mandalay and MGM are over 4 times).

Casino analysts are obsessed with EBITDA and monthly numbers. I’m obsessed with free cash flow – last time I went to buy a burger they wouldn’t take EBITDA and don’t ask me what the monthly numbers are on Aztar’s casinos – I wouldn’t know. Aztar looks cheap, but not obscenely so relative to other smaller cap casino stocks on EBITDA. And I’m sure their monthly numbers the last couple months haven’t been perfect. But a 15% free cash flow yield that looks like it will probably grow substantially in the next couple years and a hidden asset on the balance sheet gets me excited.

It looks like the last conference call is no longer available on the website, which is a shame. Listen to the next one. CEO Paul Rubeli doesn’t pull punches. I’ve owned this for about a year and a half now and never get tired of listening to the conference calls. I’ve never met Rubeli, but what he’s about really comes through on the calls. Opinionated and smart as hell. And he doesn’t think in EBITDA or “click-throughs”, he thinks in cash. On the last conference call he said emphatically, over and over again, that the stock is undervalued (I think it was at about 13 at the time, with the market in free fall). I met with the CFO subsequently and urged a share repurchase, and he sounded reluctant. But a few days ago they announced a repurchase of over 10% of shares outstanding, and the stock didn’t do much. This is not something to be taken lightly. Aztar has put to pasture 20% of its shares outstanding since 1998, while reducing debt and increasing cash in the bank. This company produces gobs of cash and when they buy back stock they do it for real.

The fundamentals center around the Tropicana Atlantic City, 2/3 of operating income. Its not the best located property in Atlantic City, but it may be the best run. I’ve met with the guy who runs the property and he is just first class. Atlantic City is a slot machine market and the Tropicana management keeps coming up with innovative promotions to draw the customers to their slot floor, including a chicken that has never lost at Tic Tac Toe. (I kid you not). They manage the property for profitability, foregoing the big expensive title fights and premier bands and shooting for consistent margins based on everyday performance. They led an effort to reduce the market’s reliance on bus coinage (free money they give people who come by bus to Atlantic City), and are tight on comps. The Atlantic City Trop is 64% of operating income. That reliance on one property explains part of the valuation discount.

What makes investors (myself included) even more nervous is that Aztar is a few months into construction of a new tower on the Atlantic City Trop. It is going to cost about $200 million, so the cash flow statement isn’t going to be so pretty going forward. They are going to spend the next two years of free cash flow on a discretionary project that scares investors to death.. Management expects a return of $50 million EBITDA, roughly $40 million free cash flow on the property when the new tower is finished in early 2004, a 20% ROIC if it goes according to plan.

There are two big concerns – whether the new tower gets finished on time/without disruption and the impact on the supply/demand of the Atlantic City market. This is real because its not just Aztar. Boyd/Wynn are developing the Borgata, which is going to be a 2000 room megaresort off the boardwalk. Showboat and Resorts are also building new towers on their properties. And Harrahs just finished a 480 room new tower. So we have a 12,000 room hotel/casino market adding nearly 4,000 rooms in the next couple of years.

Sounds scary? Yeah. A few points I’d make.
1) I hope not to own the stock when Atlantic City has to prove it can absorb 4,000 rooms not to say that I think its going to be a disaster. I think I either get $23 or a takeover before that.
2) The top management of this company are real estate developers. This is not a company built by acquisition. They claim that every project they’ve developed has been on time/on budget and hit its numbers except for one riverboat.
3) Aztar has executed precisely this game plan three times in Atlantic City – the Tropicana is a strange looking property, but that reveals something important about its history. It is three towers on three corners of a square. They have built them one by one – the last one in 1996, and now they are completing the square. The last three were successful. They are using the same contractor they used before. I think they know what they’re doing here, and that this project is not as risky as it looks.
4) Management strongly believes that the Atlantic City market has too few rooms, and if you build it they will come. Some evidence is provided by the 95% occupancy of the Tropicana property. This is a long argument with two sides, but I do know that the last time there was a major building boom in a casino market (Bellagio, Venetian, etc. in Vegas four years ago) I visited the city, did an intensive real estate analysis, and I passed on the stocks, even shorted one. Big mistake. The stocks were at a bottom. They built it, they came, I learned.
5) The first development out of the gate in Atlantic City was Harrahs addition of 480 rooms which recently opened. Aztar management thinks Harrahs is doing a 30% ROIC. I know, they’re the first one out of the gate, so they’re not facing the competition yet. But it is an early sign that Aztar management is right that the Atlantic City market is starved for new capital.
6) I like management’s strategy for the project. The problem with Atlantic City is that there is nothing to do except gamble. Its not like Vegas – there is nowhere to shop. The addition will add casino floor and a new hotel tower, but its draw is its retail/dining street frontage, which could be something unique in the Atlantic City market if they do it right. They have not started to announce tenants yet, but I look forward to seeing this come together.
7) The last point I’d make about this $200 million investment is that it is not in the valuation. We’ve got a 15% free cash flow yield TRAILING. They are going to spend the next two years of free cash flow on this property – debt isn’t going to go up by a lot. Coming out the other side, free cash flow should be well north of $100 million with the same balance sheet and the same shares outstanding. Perhaps they choose to bet on themselves and repurchase stock at these prices – in that case you come out more leveraged, but if they execute the upside would be that much greater.

Lets finish with the Trop Las Vegas. This property sucks and they are just managing it for cash. It is worth more dead than alive because of the huge parcel of land on the Vegas strip on which it stands currently. I don’t think it will stand there for more than three years. The property is a minor amount of Aztar’s operating income. So maybe call this 5 or 6 million of the free cash flow and back it out because it will take a wrecking ball to realize the value here. The point is that this is a substantial hidden asset that is not earning much of anything relative to its value.

Thoughts about valuing the Trop Las Vegas
1) Until early 2002 Aztar owned half the property with an option to acquire the other half for $120 million. They exercised the option in February 2002. Ahah! Unless management is stupid, which they’re not, it would follow that the whole must be worth north of $240 million. Eliminate a small part of free cash flow so as not to double count and you’ve got a big hidden asset here relative to a $525 million market cap and a billion dollar enterprise value.
2) Las Vegas strip real estate is a scarce asset. Location, Location, Location. Based on recent transactions $8 million an acre is not unreasonable. That gets you to about $270 million. Management won’t go any farther than that in giving hints, but they exercised the option, which spoke volumes to me.
3) The property is located across the street from the MGM, and could be part of a South Four Corners strategy for somebody in the future, perhaps MGM. MGM would have the West half of the corner and Mandalay the East half. With the success of the Mandalay Bay Resort at the South end of the strip, which looked very risky at the time they built it, the value of the Trop’s real estate increased significantly.
4) When Aztar exercised the option, there was talk about the property supporting two $700 million mega resorts. That was the peak of the stock – investors fled in droves. I don’t think Aztar ever spends that money. They will either sell this development or get taken over. Vegas goes in what, 5-7 year development cycles? The last one was in 1997-1998. This real estate Aztar owns is going to interest people in the next couple years.

Catalyst

Catalysts
There is nothing that makes this stock go up next week, but I consider the 6-18 month catalysts pretty strong given the valuation. Major share repurchase at low valuation and a sitting duck for a takeover. Major development project just starting which will start getting Wall Street excited in mid-2003. I think the stock either goes back into the 20s or the company will be taken over within 18 months.