** Please note ** The write-up was completed prior to Hurricane Sandy and does not factor potential shortfall to financial results from further weakness in the Atlantic City gaming market. Also, CZR announced earnings on October 31, which does not change the thesis of this idea.

 

RECOMMENDATION:

I am recommending a short position in the common stock of Caesars Entertainment Corp (ticker CZR).  I believe this is an unsustainable capital structure, and while the company has so far been successful in delaying its day of reckoning through creative exchange offers, debt for equity swaps, and an amend and extend transaction involving its credit facility, the market is slowly but surely realizing that there is simply no equity value in this company.  I think the company will be forced to materially dilute its stock in order to stave off a forced bankruptcy with its enormous 2015 maturity wall looming. 

Net debt, pro forma for the sale of Harrah’s St Louis casino ($610M in proceeds), stands at $18.8B, and the company has seen its EBITDA decline from a peak of $2.8B in 2007 (coincident with the ill-fated LBO) to a current run-rate of around $2.0B (9.4X leverage).  The Achilles heel of this story is a remnant of the original LBO: $4.8B of its debt sits in the CMBS subsidiary (“PropCo”).  This debt bears interest at 3.3% (L+300) which allows the entity to generate free cash flow estimated at about $250M annually at the current run-rate which can partially fund cash operating deficits at the “OpCo” subsidiary Caesars Operating Company (“CEOC”), in turn estimated at about $600M annually.  This CMBS debt currently trades at the high 70s for a yield to maturity in February 2015 of roughly 16%, partly due to the high leverage (net debt/EBITDA of nearly 10.5X at “OpCo”).  Free cash flow at PropCo would be wiped out at an interest rate of just 8%.  The CMBS loans have been syndicated and require unanimous consent to be refinanced and must be done as an entire package. 

Caesars’ sponsors Apollo and TPG have done a nice job kicking the can down the road, but I believe the buck stops in 2015, and Caesars’ common equity will be sacrificed or at a minimum heavily diluted in every imaginable scenario.  As for timing, I believe CEO Gary Loveman does not want to leave this to the 11^th hour, so we could see another large debt for equity swap sometime in 2013. 

BUSINESS BACKGROUND:

Caesars Entertainment Corp, formerly Harrah’s Entertainment, is the country’s largest regional gaming operator with 53 casinos owned, operated or managed in 12 US states and 7 foreign countries.  In the US, the casinos mainly operate under the Caesars, Harrah’s and Horseshoe brands.  The company also owns and operates several thoroughbred racetracks, including Bluegrass Downs and Turfway Park in Kentucky, and Thistledown Racetrack in Ohio.  The company has a growing presence in the online gaming market through its Caesars Interactive Entertainment (CIE) subsidiary.  CIE offers real-money gaming in the UK, France and Italy, as well as social and mobile gaming through its Playtika brand which was acquired in December 2011.  CIE owns the World Series of Poker brand which offers real-money land-based tournaments, and will be used to promote its online platform upon legalization in the US. 

Caesars was taken private in January 2008 by a consortium led by TPG and Apollo for $31B ($6B of equity put in).  The recession took a toll on the company, and it was forced to enter a series of distressed debt for equity exchanges with holders of the LBO debt.  In February 2012 the company did an IPO at $9.00 per share, raising just $19M.  The company currently has 125M shares outstanding of which Apollo/TPG own 70%, and Paulson & Co own 10%.  All of Paulson’s shares (10%) plus another 9% were immediately tradeable after the IPO (and have not been sold down per public filings) and a final 9% piece became tradeable after a 180-day lockup expired on August 5, 2012.  On March 15, 2012, Caesars filed an S-3 enabling it to sell $500M in primary shares in a public offering.  As the current market cap is roughly $730M, this would be 68% dilutive. 

Las Vegas (40% of LTM EBITDA):  Caesars has the second largest footprint on the Las Vegas Strip behind MGM with over 23K hotel rooms (25% market share behind MGM’s 44%), 9,500 slots and 880 table games.  Overall Las Vegas gaming revenue peaked in 2007 at $6.8B and after troughing at $5.6B in 2009 is running at about $6.0B currently.  This segment includes Caesars Palace, Bally’s Las Vegas, Flamingo Las Vegas, and Planet Hollywood Resort & Casino, among others.  The company expanded Caesars Palace in early 2012 through the addition of Octavius Tower (incremental $40M in EBITDA expected vs $120M construction cost) and plans on opening a new outdoor retail, dining and entertainment corridor called Project Linq in mid 2013, adding up to $100M in incremental EBITDA by 2014 vs a project cost of $520M.  LTM EBITDA for this segment of about $810M is down 30% from peak levels in 2007.

Atlantic City (13% of LTM EBITDA):  Caesars has a 40% share of the Atlantic City market, which has declined from $5.2B in gaming revenue in 2006 to $3.2B at the current run-rate.  This segment includes Harrah’s AC, Showboat AC, Bally’s AC, Caesars AC and Harrah’s Philadelphia.  Rising competition from Pennsylvania, Delaware and New York, and the recent opening of the competing Revel casino have put tremendous pressure on this division of Caesars, and while the company has stemmed some of the bleeding through aggressive cost-cutting efforts, LTM EBITDA of $280M is down 55% from peak levels in 2007 and the outlook from here is pretty dim. 

Regional Markets (37% of LTM EBITDA):  Caesars divides its other gaming jurisdictions into 4 other regions: Louisiana/Mississippi (12%), Iowa/Missouri (10%), Illinois/Indiana (11%), and Other Nevada (4%).  Louisiana/Mississippi is facing increased competition from Oklahoma-based Native American casinos, as well as new entrants along the Gulf Coast.  Iowa/Missouri is losing a third of its EBITDA due to the sale of Harrah’s St Louis to Penn National Gaming.  Penn just opened Hollywood Casino in Kansas City, the first expansion in that market in several years – this could be a problem for Caesars.  Illinois/Indiana also faces increased competition particularly from the launch of a city-owned casino in Chicago.  In addition a new casino near O’Hare airport opened last year and has already begun to impact Caesars’ Horseshoe Hammond casino.  Finally, Other Nevada faces increased competition from Native American properties in California.  Offsetting these competitive pressures, Caesars does have a decent pipeline of development projects in Ohio and Baltimore.  LTM EBITDA from the whole group at about $750M is down 25% from peak levels in 2007. 

Managed, International, Other (10% of EBITDA): Caesars manages the operations of 3 Native American casinos in the US: Harrah’s Ak-Chin in Arizona, Harrah’s Cherokee in North Carolina and Harrah’s Rincon in California.  This segment also includes the company’s international assets.  Caesars owns and manages the Conrad Punta del Este in Uruguay, owns the Caesars Windsor in Canada, and owns, operates or manages 13 hotels and casinos across the UK, Egypt and South Africa, collectively known as London Clubs International.  Caesars Interactive Entertainment results are also reported in this segment.  This segment is the growth driver of the company.  With Horseshoe Cleveland and Horseshoe Cincinnati added to the mix in 2012 and 2013, respectively, and good growth in online and social gaming from the Playtika acquisition, EBITDA could grow from $140M in 2011 to over $300M in 2014.

MODEL, VALUATION:

Below I’ve laid out a simplified consolidated model of Caesars Entertainment Corp from the perspective of the parent company.  Note that Caesar’s principal operating subsidiary is CEOC, which operates all of the company’s properties except the CMBS properties in Nevada (Rio, Flamingo, Harrah’s Las Vegas, Paris, and Harrah’s Laughlin) and the company’s interactive division CIE.  Of the roughly $2.0B in EBITDA expected at the consolidated level in 2012, $450M will come from PropCo (the CMBS properties) with the remaining $1.5B from OpCo (CEOC) and CIE.  CEOC’s credit facility has a covenant requiring that Caesars maintain a 4.75X first lien net debt/LTM adjusted EBITDA ratio (currently we’re at about 4.3X – not a lot of breathing room).  In addition, funds raised from asset sales from within the restricted group of properties within CEOC must be reinvested within the restricted group within 15 months of the sale.  Harrah’s St Louis was part of this restricted group.  As this was sold at a EV/EBITDA of 7.8X, it was a leveraging transaction (EV/EBITDA for Caesars is 10.2X).  Most assets that the company might consider selling would result in leveraging events. 

What I’d like to stress is that even using fairly generous assumptions (I assume good growth in the Las Vegas segment and in the Managed, International, Online & Other segment) the company will be loss-making through 2014 (right up to the $8B Maturity Wall).  The one call option that could potentially give new life to Caesar’s equity is legalization of online gaming in the US.  However in response to a question on the last conference call, the CEO said “I’m not terribly optimistic.  I think it’s possible but I think there are some very pressing issues for the country’s finances that remain in front of the Congress in the lame duck session, and surely we all hope that they get attention.  It’s possible that the online gaming question will be called in that period, but I think it’s probably less likely rather than more likely.”  At the state level, we do see some movement in the right direction with 10 states attempting to legalize some form of online gambling, but without a federal bill, the economics don’t work very well – liquidity (number of players and availability of tables/games) is one of the most important factors in choosing an online casino. 

In the comp table below, it should be pretty clear that CZR is valued well above the regional peer group (3 multiples higher than the average on an EV/EBITDA basis) despite middle-of-the-pack EBITDA margins and the only declining sales base of its peer group (-4% CAGR from 2007 to 2012E vs a range of 0 to +6% for the peer group).  I have not included Las Vegas Sands (LVS), MGM Resorts (MGM) or Wynn International (WYNN) in the comps as this group has significant exposure to the fast growing Macao gaming market. 

The bottom table shows a simplified capital structure, pro forma for the sale of Harrah’s St Louis.  Liquidity is ample, and again, there are no significant maturities until 2015 – this is not an imminent bust, rather a slow but steady erosion of equity that accelerates as we get closer to 2015.  A nice paired long might be the CMBS securities themselves with a 16% yield to maturity.  While these bonds may be impaired, I believe TPG and Apollo could come up with another creative solution involving coupon step-ups, asset sales and equity issuance that are favorable to the CMBS and detrimental to the common equity

 

Caesars Entertainment Corp (CZR) Simple Model ($mm)
INCOME STATEMENT			2011	2012E	2013E	2014E
Property EBITDA
Las Vegas			824	800	850	950
Atlantic City			278	275	260	260
Louisiana/Mississippi			230	235	240	245
Iowa/Missouri			230	190	160	170
Illinois/Indiana			227	230	235	240
Other Nevada			89	85	87	90
Managed, intl, online, etc			138	240	270	330
Property EBITDA			2,017	2,055	2,102	2,285
Corp expenses/other			-74	-90	-90	-90
Adjusted EBITDA			1,943	1,965	2,012	2,195
D&A			869	897	914	929
Other operating expense			79	80	80	80
EBIT			995	988	1,018	1,186
Interest expense			2,122	2,100	2,050	2,050
Other expense			25	30	30	30
EBT			-1,153	-1,142	-1,062	-894
Tax rate			44%	35%	35%	35%
Income tax			-507	-400	-372	-313
Minority interest			21	21	19	16
Net income			-667	-763	-710	-597
Diluted shares out			125	125	125	125
EPS			-5.33	-6.09	-5.66	-4.77

 

CASH FLOW STATEMENT			2011	2012E	2013E	2014E
Adjusted EBITDA			1,943	1,965	2,012	2,195
Less cash interest			-1,720	-1,760	-1,775	-1,800
Less cash taxes			3	50	-27	-23
Less increase in WC			-26	-90	-50	-50
Less other			-77	0	0	0
Cash flow from operations			123	165	160	322
Less capex			-283	-550	-350	-300
Free cash flow			-160	-385	-190	22
Less other investments/sales			-734	610	0	0
Plus increase in equity			0	0	0	0
Plus increase in debt			812	100	0	0
Net change in cash			-82	325	-190	22
Ending cash			905	1,230	1,040	1,062
CREDIT STATS			2011	2012E	2013E	2014E
Cash			905	1,230	1,040	1,062
Total debt			19,800	19,900	19,900	19,900
Net debt			18,895	18,670	18,860	18,838
EBITDA/cash interest			1.1X	1.1X	1.1X	1.2X
EBITDA-capex/cash interest			1.0X	0.8X	0.9X	1.1X
Net debt/EBITDA			9.7X	9.5X	9.4X	8.6X

 

Caesars Entertainment Corp (CZR) Comps
Ticker	Price	EV ($mm)	EBITDA mgn (LTM '12)		Sales CAGR FY07-FY12E	EV/ EBITDA (FY12E)	EV/ EBITDA (FY13E)		Net debt/ EBITDA (FY13E)
CZR	5.79	20,376	23%		-4%	10.2X	9.5X		9.2X
ASCA	18.15	2,385	28%		2%	6.7X	6.7X		5.0X
BYD	5.52	3,825	18%		4%	8.1X	7.8X		6.8X
ISLE	5.93	1,272	20%		0%	6.5X	6.0X		4.9X
PENN	39.85	4,950	25%		4%	6.5X	5.4X		2.1X
PNK	12.83	2,095	22%		6%	7.0X	6.5X		4.0X
		2,906	22%		3%	7.0X	6.5X	4.6X

 CZR Capitalization and Liquidity as of 9/30/12 (PF)

Debt
Revolver ($1.08B base)				0
First lien term debt				6,197
2nd lien, other secured debt				7,614
CMBS				4,825
Total secured debt				18,635
Senior unsecured debt				1,324
Total debt				19,959
Liquidity
Unrestricted cash				1,189
Total cash				1,189
Revolver base				1,080
Less L/Cs				-98
Less amounts outstanding				0
Revolver availability				982
Total liquidity				2,172

RISKS:

The biggest risk to the short case is federal legalization of online poker.  Caesars is in a great position with its World Series of Poker brand name, deep customer database and significant head start in the segment.  Other risks are a strong recovery in Las Vegas and/or Atlantic City, with the combined regions contributing over 50% of company-wide EBITDA. 

 

 

Any hint of selling by the sponsors and/or Paulson & Co will be negative for the stock due to the thin liquidity created by the IPO. There has been little selling pressure since the 180 day lockup period expired, perhaps due to hopes of a better stock price. The more definitive catalyst is the refinancing of the CMBS debt which will inevitably involve significant dilution to the equity. A simple refinancing at anywhere near the current yield of 16% would result in an accelerated cash drain. Any future property sales are likely to come at multiples well below that of the parent company, putting further pressure on the equity.