Caesars (CZR) | Current Price: $45 | 24-Mo Price Target: $150

Caesars is the largest gaming operator in the U.S. with over 50 properties between Las Vegas and regional markets. 

Equity represents tremendous value, offering investors a +15% normalized FCF yield with multiple drivers of growth that is underpinned by a business with an unreplaceable asset base, competitive moats, and an exceptional management team. Shares are down approx. 60% from their October 2021 highs given expectations of a forthcoming recession and associated investor disinterest in equities with perceived cyclical and balance sheet risk. However, we think investors are overly discounting these risks in CZR’s equity (discussed below).

At current valuation, we estimate that CZR’s owned real estate portfolio, which underlies properties that account for 50% of earnings, alone provides well over 1.5x equity coverage when applying a gaming REIT multiple to the underlying earnings stream ⁽¹⁾. This valuation discount deepens when considering value from CZR’s operating assets where FCF growth should accelerate due to 1) the return of high-value convention and international visitors to Las Vegas; 2) normalization of growth capex and economic returns from $2bn of capital is harvested over the next 12-24 months; 3) $1bn-revenue run-rate Digital business inflects to profitability and benefits from improved i-gaming traction and robust industry growth; and 4) interest expense is reduced through debt-repayment.

While macroeconomic uncertainty obviates our ability precisely forecast the timing of cash flows, we estimate the business should generate $2.5bn to $3.0bn of unlevered FCF (excl. growth capex) within 24 months. Applying a 15x multiple, which we view as appropriate given our view of business quality and growth, would yield a $150 per share value (+200% upside) at the mid-point. As such, investors can participate in the equity at a massive discount to our estimate of intrinsic value and should benefit from ongoing value creation as the business compounds capital at high ROIC and utilizes excess FCF to retire debt – a combination that should unlock valuation multiple expansion over time.

We believe the current undervaluation is explained by a miscalibration of cyclical and leverage risks:

Cyclical: Investors appear to be misjudging the durability of CZR’s earnings power through a cycle given the memory of the GFC and its devasting impact on Las Vegas. However, an analysis of present conditions with those preceding the GFC reveals such a comparison to be deeply flawed for numerous reasons: 1) Las Vegas hotel supply surged by 12% in 2009 relative to 2007 as unemployment climbed to 10%. This extreme supply-demand imbalance was accentuated by a market structure that was less consolidated than it is today with CZR and MGM now collectively controlling 60% of rooms on the Strip, limiting promotional intensity. Furthermore, prospective supply growth is benign (<1% annually) and unemployment, although a lagging indicator, is at 3.7% vs an average of 5.7% since 1948; 2) during other recessionary periods, such as 1990-92 and 2000-03 when unemployment levels increased markedly, Las Vegas revenue grew low single digits annually. Las Vegas was both less mature and diversified during these periods than it is today, making the relevancy of such historical comparisons imperfect; 3) throughout the GFC, leisure visitation to Las Vegas was remarkably stable, with 32.8mm visitors in 2010 vs 32.9mm visitors in 2007. In contrast, convention visitation was acutely weak, declining by +25% peak-to-trough. Today, CZR is generating record Las Vegas profits despite convention attendance still down close to 30% from pre-pandemic levels – a similar baseline decline than the GFC. While business travel is economically sensitive, 2-3 years of pent-up demand bodes well for the continuation of the convention recovery in Las Vegas. Considering convention customers are 2-3x more valuable than leisure customers, in our estimate, the recovery of this cohort should drive fixed cost leverage and earnings growth over time; 4) Las Vegas demand drivers have diversified meaningfully over the past 15 years, with the city becoming a de facto sports and entertainment capital. Gaming revenue mix has declined by 1,000bps over this period as result, making the city less susceptible to substitution from regional casinos which offer more affordable access to gaming; 5) importantly, 60% of CZR’s revenue is derived from its regional casinos, which performed exceedingly well in the last cycle in part due to this substitution effect. Penn Entertainment, the largest regional gaming operator, had modestly higher revenue in 2010 vs 2007; and 6) CZR’s operating margins are 1,200bps higher today than pre-pandemic levels, which reduces downside operating leverage. With the stock reflecting an estimated 20%-30% impairment to near-term earnings, we think investors are greatly overestimating the magnitude of downside cyclical risks.

Leverage: We think investors are miscalculating risks from financial leverage. When screening the business on Bloomberg, CZR appears 7.7x levered vs our calculation of less than 4.0x. The difference is due to two items that Bloomberg does not adjust for: 1) $1bn of one-time losses in the Digital business; and 2) treatment of capitalized leases as debt. CZR expects Digital to operate at breakeven to modest profitability in 2023, thus these losses will roll-off from the leverage calculation. While leases are economic liabilities that bear some characteristics that are less favorable than traditional debt, treating leases as tantamount to debt would be a mistake for numerous reasons: 1) capital leases bear no principal, meaning there is no balloon payment at a specified future date that poses refinancing risk; 2) lessor has no recourse to the corporate assets of the lessee in event of a default; 3) NPV calculation of the lease liability is inherently an imprecise and theoretical exercise. As a corollary, investors appear to capitalize leases at higher multiples than the associated OpCo earnings, a practice that arbitrarily destroys equity value; and 4) capitalizing vs expensing rent is a function of lease duration; in this way, having a 40-year lease structure, which essentially provides perpetual financing and thus limits operating risk, arbitrarily makes the lessee appear more financially risky than if it had shorter-term leases. This is an example of accounting not reflecting economic reality. In summary, when adjusting for digital losses and capitalized leases, CZR is approximately 4.0x levered, which is reasonable for a business with diversified revenues, strong operating margins (40%), and minimal maintenance capex as a percentage of revenue (5%). At current levels, EBITDAR would have to decline by at least 40% before CZR could not cover its fixed charges, not including the potential for cost controls. CZR is intent on reducing debt levels by using FCF to retire bonds at discounted rates and, selectively, by pursuing accretive sales. On this note, if it wished to accelerate its deleveraging, CZR has the contractual right to sell the real estate underlying its Centaur assets (i.e., two properties in Indiana) to Vici for 12.5x EBITDA in a transaction that could generate $2bn to $2.5bn of tax-sheltered proceeds before 2025. This transaction would be accretive as CZR currently trades at 7x EBITDA. Assuming no asset sales, the business should naturally de-lever from 4.0x to 3.0x by the end of 2024.

Business Quality

CZR is a high-quality business, which can be appreciated by its strong and improving returns on tangible invested capital (+20%). Distinct economic moats that are present in its three business units – Las Vegas, Regionals, Digital – underpin its ability to sustain excess returns.

In Las Vegas, CZR’s advantage stems from its irreplaceable real estate and loyalty network. CZR owns/operates eight casinos that are contiguously located on the central part of Las Vegas Blvd, controlling 25% of all rooms on the Strip. Even though Las Vegas revenue has grown 4% annually over the last 20 years through two economic downturns, supply formation has been virtually non-existent in the past decade given a lack of developable land. Las Vegas room inventory has grown at a 0.0% CAGR from 2011 to 2022. In addition to the superior location of its precious real estate, CZR enjoys a below-replacement cost position in the market. With its tenured incumbency affording it a low property basis, CZR can better compete for a class of customer that new builds/redevelopments are unlikely to service given the high cost of market entry, which necessitates catering to a more up-scale patron at higher ADRs to drive ROI. Consider that average construction costs for Resorts World and Fontainebleau were roughly $1,500 per key. At this cost of development, CZR’s 20k-room Strip portfolio alone would have a replacement value of $30bn, which is 150% greater than its entire PP&E line item and 30% greater than its enterprise valuation.

CZR’s loyalty network is also an important business advantage. With +60mm members, CZR has the largest loyalty network in gaming, a testament to its iconic brand and unrivaled ecosystem of local and destination properties (51 in total) that’s been amassed over multiple decades and would be impossible to replicate. By tapping this efficient source of recurring customer demand, CZR drives superior utilization – both in terms of occupancy and customer quality – at its Las Vegas hotels. CZR’s Las Vegas EBITDAR margin is 50%, well above competitors. In Regionals, the company’s source of advantage is regulatory. With a scarce supply of gaming licenses and a lack of political will to expand access to gaming, the barriers to competition are high. This leads to a comparatively benign competitive environment. While regional gaming supports attractive returns on capital, the regulatory constraints that underpin its favorable market structure limit growth opportunities.

In Digital, the business benefits from cost structure and retention advantages. Due to 1) not having to pay market access fees given its possession of gaming licenses (i.e., skins); 2) not having to pay technology fees given its vertical integration; 3) having an established brand that requires less marketing to foster customer awareness; and 4) its ability to monetize customers online and in-person, which enhances LTV and thus lowers the return bar for justifying digital marketing, CZR is well positioned to profitably acquire market share. These customer acquisition advantages are compounded by CZR’s ability to deploy cash flow from its brick-and-mortar business to fund growth against digital competitors with higher costs of capital. Furthermore, CZR should have a retention advantage due to its loyalty network and omni-channel value proposition. Crossover play in the land casinos from Digital customers already exceeds over $200mm of revenue (+20% of trailing Digital revenue) that supports 50% incremental margin. Management notes that its Digital customer attrition is less than 40%, which allows the business to dependably stack cohorts, reduce relatively inefficient acquisition marketing, and drive a profitable business over time.

Digital is currently loss-making as management reinvests profits to acquire profitable cohorts in newly legalized states. Given the size of the industry at maturity ($30bn+), combined with its structural business advantages, CZR is investing aggressively behind this opportunity. However, management is wasting no time in achieving profitability as it re-focuses its marketing efforts to drive engagement from its highest value customers. The business has now reached breakeven despite limited traction in i-gaming to-date, which offers significant profit upside with successful execution. Management, under conservative assumptions, projects Digital will earn a +50% ROIC on its $1bn+ cumulative operating loss. This would imply, at a minimum, $500mm of annual EBITDA over the medium-term. Applying a 20x multiple to this cash flow seems reasonable given the growth and high-ROIC characteristics of this business. For a business that we estimate is currently being ascribed a negative value at today’s valuation, Digital could be worth over $10bn over the medium term, which is more than CZR’s entire market cap.

Valuation

Enterprise trading is trading at 7x EBITDA and 9x unlevered FCF (excl. digital losses and growth capex) on a run-rate basis. CZR trades at a meaningful discount relative to gaming comps (LVS, MGM, WYNN, PENN, BOYD), which have averaged 12x EBITDA and 18x unlevered FCF over the past 10 years. CZR’s valuation looks similarly compelling when measured against the broader hospitality complex (casual-dining restaurants, cruise lines, amusement parks and gaming), which has traded at 11x EBITDA, collectively, over the past 10 years. ⁽²⁾

Due to a wide dispersion in cash flow conversion from EBITDA within the gaming sector, we primarily focus on a normalized FCF-based valuation methodology. Given our conviction that the risk of competitive disruption to CZR’s business is low, and thus the opportunity to continuing deploying capital at attractive rates of return is high, particularly within Las Vegas and Digital, we believe the business is worthy of a mid-teen multiple. At 15x, which would be 3x below the average commanded by gaming peers over the past decade, the equity would be worth $150 per share by the end of 2024 (+200% upside).

If we cut our 2024 earnings estimate by 25%, which would imply a GFC-like impact to the P&L that appears highly improbable, the business would still generate of over $1.5bn of normalized unlevered FCF, supporting an equity valuation of $65 per share before considering value from Digital. Thus, at current valuation, we think the equity offers an enormous margin of safety and a highly asymmetric risk-reward profile.  We think the gap between the trading price and our estimate of intrinsic value could begin to converge as the market appreciates the durability of CZR’s earnings power through a cycle, its prospects for accelerating FCF growth, and scope to deleverage the balance sheet.

Management Team

Our capital is invested alongside one of the most skilled operators and wealth creators in gaming: Tom Reeg.

As background, Reeg became the CEO of CZR after Eldorado Resorts, a regional gaming company where he was previously CEO, acquired the former in a transaction orchestrated by Carl Icahn. Icahn hand-picked Reeg because of his exceptional track record of value creation at Eldorado as the ideal suitor to turn around the legendary gaming company. Reeg’s operating prowess is reflected in a 30x appreciation in the share price under his leadership since joining the company from 2014 to October 2021 (prior to the 60% sell-off). Importantly, we believe Reeg employs an operating mindset of a private business owner, with a focus on maximizing long-term free cash flow per share. As the owner of over 700,000 shares when fully vested, Reeg is highly financially motivated to deliver against this objective for the benefit of shareholders.  

Risks

1) Economic recession weakens operating results and leads to multiple compression; 2) inflation remains elevated, which could weaken cash flow given exposure to variable rate debt and CPI-based leases; 3) deleveraging cadence is slowed in parallel with weaker operating results; 4) Las Vegas convention and international visitation is slow to recover; 5) Digital fails to generate attractive returns on capital

Contact

Jordan Fox

jf@scpinvestment.com

Footnotes

⁽¹⁾ $4.2bn of total EBITDAR multiplied by 50% = $2.1bn. Divide by a lease coverage ratio of 1.3x = $1.6bn of PropCo rent. Apply a gaming REIT multiple of 17x (6% cap rate) and CZR’s real estate is worth $27.5bn. Minus $12bn of traditional net debt and this yields an equity value of $15.5bn, or $73 per share (+50% upside).

⁽²⁾ Hospitality peers include NCLH, RCL, CCL, SIX, SEA, FUN, CAKE, TXRH, DRI, WYNN, LVS, MGM, PENN, BOYD

Disclaimer:

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