Lakes Entertainment LACO
January 08, 2011 - 5:21pm EST by
pfq783
2011 2012
Price: 2.92 EPS $0.00 $0.00
Shares Out. (in M): 26 P/E 0.0x 0.0x
Market Cap (in $M): 77 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 57 TEV/EBIT 0.0x 0.0x

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Description

 

LACO is an opportunity to participate in greenfield casino developments in Ohio at a fraction of liquidation value with a few lottery tickets on Indian casinos in California that are worth multiples of the stock price if realized.

Ohio Casinos

In November 2009, the Ohio Constitution was amended through statewide referendum to permit gaming in Ohio and allow one casino in each major city:  Cleveland (2.5mm gaming age), Cincinnati (2.4mm gaming age), Columbus (1.8mm gaming age), Toledo (1mm gaming age).  Also embedded in the Constitution was a very casino-friendly 33% flat tax rate.  The initiative was lead by Penn Gaming and Rock Ventures, an entity owned by Dan Gilbert of Cleveland Cavalier fame.  LACO received the right to contribute 10% of the equity capital needed to develop each casino in return for supporting and helping fund the legislation.  Penn Gaming has the right to develop Toledo and Columbus, while Rock Ventures got Cleveland and Cincinnati. 

LACO sold their 10% right back to PENN for $25mm in July and intends to use these proceeds + cash on hand to fund its share of Rock's Cleveland and Cincinnati projects.  A few weeks ago, Rock Ventures finalized a JV with Caesar's (formerly Harrah's) to operate and help develop the projects.  Terms of the JV, management contract, and projections were not disclosed, but we know Rock Ventures will own the "majority" of the JV and Harrah's has contributed Cleveland's Thistledown racetrack, which it purchased for $43mm out of BK earlier this year, to the JV.  LACO has clarified that their 10% right extends only to the equity capital required from Rock Ventures, not the JV, so on a lookthrough basis LACO will be diluted by Caesar's to somewhere between 5 - 9% of the equity in each casino.

LACO partnered with Quest Media in 2008 to push the ballot initiative forward and will cede 18.5% of distributions after $500k minimums once LACO has recouped all cash spent on the initiative.  LACO paid the $500k to Quest related to the PENN sale and still has millions of cash to recoup, but to keep things simple and help bake in the margin of safety I'll assume they give up 18.5% of all OH casino value to Quest. 

Ohio Value to LACO

So what is OH worth to LACO?  Rock and PENN have been playing their cards close to the vest about the upside here, but we can triangulate with a few data points.

Simple/crude approach:  LACO sold 2.8mm gaming age population (1.8mm Columbus + 1mm Toledo) for $25mm = $8.93 per gaming age population.  Apply same metric to 4.9mm gaming age (2.5mm Cleveland + 2.4mm Cincinnati) and you get $44mm ($1.67 per share).

Ok, let's us real numbers approach:  PENN's Charlestown casino in WV is comparably large to the OH sites with 4500 - 5000 slot machines, also located in a market without a ton of competition, the largest casino in the region, and the weekly gaming commission reports lets us calculate gaming win / slot at the property.  $265 in 2007, $240 in 2008, $230 in 2009, $233 in 2010 so let's go with $230 win per machine.  Each OH site is capped at 5000 machines.  Rock Ventures has plenty of land to hold 5k machines, and certainly plenty of market to fill 5k seats (especially Cleveland), but pencil in 3500 machines at each site to be conservative.  (sanity check:  PENN's Lawrenceburg, IN casino is 30 minutes from the Cincinnati market and has 3200 machines + 90 tables)  7k total machines at $230 win/day is $588mm topline revenue, further ignoring F&B revenue which usually runs 15% of property revenue.  Charlestown ran historically low EBITDA margins of 28.0% during the recession years in a 57% tax jurisdiction.  Ohio's 33% tax is 24 points lower, so tacking on 20 points of margin for better tax rate less 10 points of margin for assumed management fees to Caesar's (LACO is trying to develop and manage a smaller casino at 13% of EBITDA at the highest split threshold ) gets us to 43% margin, or $253mm EBITDA.  

Budgets haven't been released, but $400mm has been floated for Cincinnati and $600mm for Cleveland, for $1B total cost.  

Assuming 30 year straight line depreciation (conservative) for tax, we've got a $33mm annual tax shield.

Casino companies will tell you a rule of thumb for property maintenance capex runs ~$3mm per 1k slot machines, so $21mm of capex.

At 40% income tax rate, these projects should be conservatively generating $144mm of unlevered FCF (14% unlevered ROE).

Given Caesar's leverage, there is strong incentive to write the thinnest equity check possible.  A 30% equity check behind 45% secured at 6% and 25% unsecured at 9% is $50mm of interest expense, or $114mm of levered FCF (38% levered ROE).

LACO's 5-9% gross share of FCF is $5.7mm - $10.3mm, less ceding 18.5% to Quest nets $4.6 - $8.4mm.  At a conservative 10x FCF, the stakes are worth $46mm - $84mm vs. required equity contribution of $15mm - $27mm for a rough NPV of $31mm - $57mm.

Replace 3500 machine assumption with a realistic 5000 machine constitutional maximum and perform the same math:  $840mm revenue, $361mm EBITDA, $179mm levered FCF, nets $7.9mm - $13.1mm.   The stakes are worth $73mm - $131mm for a rough NPV of $58mm - $104mm

Indian Casino Development and Management Contracts

LACO contracts with tribes to navigate the gaming approval process, develop, finance construction, and then manage the casino for a limited term.  LACO advances costs and minimum payments to the tribes with the hope of being paid back with interest once operations are cash flowing.  LACO's advances and future management fees are subordinated to minimum payments to the Indian Tribe from the casino, secured fixture financing, and senior indebtedness for construction and funding of the project.  If everything goes according to plan, LACO sells the interest in their advances to investors at little or no discount and books the lucrative management fees going forward.  Typically by the end of the term, the Indian tribe has enough gaming expertise that it takes over operations.  Contracts are almost never renewed.

Four Winds casino / Pokagon band: 18 months left on this contract, all ~$100mm advances to the tribe were sold in 2007.  Management fees are not broken out by property, but I estimate $22mm of management fee revenue per year from this contract, or $33mm over the life.

Red Hawk casino / Shingle Springs band:  5 years left on this contract, ~$50mm of advances and ~$22mm of accrued interest outstanding as of Jan. 2010.  I estimate only ~$3mm of management fees are being booked each year, but these appear to be non-cash.  I don't think subordinated payments are currently being made on either the management contract or advances.  Shingle Springs Tribal Authority Bonds are trading at a discount, so for the sake of conservatism I assume zero cash flow from the management contract and only tax write-offs on the advances (see tax assets later).

Jamul Indians:  $38.9mm principal (+ $21mm accrued interest) to the Jamul tribe for development of a California casino.  California Transportation Authority is requiring traffic and other studies before permitting construction of road access onto the current 2-lane state highway for entry/exit from the property, which is the final approval before construction may begin.  I'll assume zero value here and only a tax write-off of principal advances.  But it would be a coup to develop the project.  Not only are advances + accrued a big number, LACO is contractually set to receive another $30mm of construction and development fees on a successful project (this would almost certainly be reduced somewhat, however).

Tax/Other assets

If LACO terminates development efforts or realizes losses on subordinated advances through default of an operating casino, LACO can write off the principal of these advances for tax (but not, I believe, interest accrued on these advances).

Jamul principal:  $38.9mm, tax write-off value:  $13.6mm

Shingle Springs principal:  $50mm, tax write-off value:  $17.5mm

Given the $25mm of income from sale of the PENN interest and future income from OH distributions or a sale of its OH interests, LACO will be able to utilize these write-offs.  Obviously the upside from Red Hawk not defaulting (management doesn't seem to think it will, but only bondholders see the casino's operating results and covenants) or getting Jamul off the ground are far more significant.

Louisiana tax litigation

Louisiana Department of Revenue has sued LACO for past taxes and penalties related to management contracts from 1999 and 2001.  LACO has recorded a $17mm payable against the entire amount, and the parties are set for trial within the next couple months.  If the parties settle, we should hear something soon, but I assume LACO pays in full.

Miscellaneous assets / liabilities

LACO owes contract acquisition costs of ~ $1mm related to the Four Winds management contract and $8.0mm payable over the life of Red Hawk contract (net of a $2.4mm receivable to one of the parties).  I haven't been able to determine whether the $10.5mm is payable in the event of a default at Red Hawk, but for now I'll assume it is and update in a thread when I find out.  LACO also has $2.8mm coming in over the next 15 months related to a recent contract termination with the Iowa. 

Liquidation Value:

Cash on hand:                                                                                   $46.9mm

Taxes payable on PENN sale:                                                             -$9.0mm

Full reserve on LA tax matter:                                                           -$17.0mm

Net misc liability (undiscounted):                                                     -$6.2mm

After-tax write-off value of Red Hawk casino:                                      $17.5mm

After-tax write-off value of Jamul development:                                  $13.6mm

After-tax 18 mo. Four Winds cash flow (undiscounted):                      $19.8mm

NPV of OH stake:                                                                             $31mm - $104mm

Net liquidation value:                                                                        $96.6mm - $169.6mm

Diluted Shares:                                                                                 27.5mm

Liquidation Value per share:                                                          $3.51 - $6.17

Potential upside surprises: 

  • 1. Red Hawk doesn't default and LACO starts recovering their $72mm subordinated receivables and the management contracts starts cash flowing.
  • 2. California Transportation Board approves the traffic study and construction starts on a casino.
  • 3. Caesar's takes less than a 10% management fee from OH projects
  • 4. Louisiana tax dispute settled for less than the full reserve
  • 5. $10.5mm total contract acquisition costs related to Red Hawk don't need to be paid if the casino doesn't flow cash to LACO.
Potential risks:
1.  Management does something stupid with our assets.
2.  Management lets $12mm annual overhead erode shareholder value.

Catalyst

Projections released by Penn Gaming, Caesar's, or Rock Ventures for the Ohio development opportunities.
Settlement with State of Louisiana in advance of looming trial over $17mm of taxes + penalties.
Red Hawk casino doesn't default and subordinated advances and management payments resume to LACO.
California transportation department allows Jamul casino construction to move ahead.
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    Description

     

    LACO is an opportunity to participate in greenfield casino developments in Ohio at a fraction of liquidation value with a few lottery tickets on Indian casinos in California that are worth multiples of the stock price if realized.

    Ohio Casinos

    In November 2009, the Ohio Constitution was amended through statewide referendum to permit gaming in Ohio and allow one casino in each major city:  Cleveland (2.5mm gaming age), Cincinnati (2.4mm gaming age), Columbus (1.8mm gaming age), Toledo (1mm gaming age).  Also embedded in the Constitution was a very casino-friendly 33% flat tax rate.  The initiative was lead by Penn Gaming and Rock Ventures, an entity owned by Dan Gilbert of Cleveland Cavalier fame.  LACO received the right to contribute 10% of the equity capital needed to develop each casino in return for supporting and helping fund the legislation.  Penn Gaming has the right to develop Toledo and Columbus, while Rock Ventures got Cleveland and Cincinnati. 

    LACO sold their 10% right back to PENN for $25mm in July and intends to use these proceeds + cash on hand to fund its share of Rock's Cleveland and Cincinnati projects.  A few weeks ago, Rock Ventures finalized a JV with Caesar's (formerly Harrah's) to operate and help develop the projects.  Terms of the JV, management contract, and projections were not disclosed, but we know Rock Ventures will own the "majority" of the JV and Harrah's has contributed Cleveland's Thistledown racetrack, which it purchased for $43mm out of BK earlier this year, to the JV.  LACO has clarified that their 10% right extends only to the equity capital required from Rock Ventures, not the JV, so on a lookthrough basis LACO will be diluted by Caesar's to somewhere between 5 - 9% of the equity in each casino.

    LACO partnered with Quest Media in 2008 to push the ballot initiative forward and will cede 18.5% of distributions after $500k minimums once LACO has recouped all cash spent on the initiative.  LACO paid the $500k to Quest related to the PENN sale and still has millions of cash to recoup, but to keep things simple and help bake in the margin of safety I'll assume they give up 18.5% of all OH casino value to Quest. 

    Ohio Value to LACO

    So what is OH worth to LACO?  Rock and PENN have been playing their cards close to the vest about the upside here, but we can triangulate with a few data points.

    Simple/crude approach:  LACO sold 2.8mm gaming age population (1.8mm Columbus + 1mm Toledo) for $25mm = $8.93 per gaming age population.  Apply same metric to 4.9mm gaming age (2.5mm Cleveland + 2.4mm Cincinnati) and you get $44mm ($1.67 per share).

    Ok, let's us real numbers approach:  PENN's Charlestown casino in WV is comparably large to the OH sites with 4500 - 5000 slot machines, also located in a market without a ton of competition, the largest casino in the region, and the weekly gaming commission reports lets us calculate gaming win / slot at the property.  $265 in 2007, $240 in 2008, $230 in 2009, $233 in 2010 so let's go with $230 win per machine.  Each OH site is capped at 5000 machines.  Rock Ventures has plenty of land to hold 5k machines, and certainly plenty of market to fill 5k seats (especially Cleveland), but pencil in 3500 machines at each site to be conservative.  (sanity check:  PENN's Lawrenceburg, IN casino is 30 minutes from the Cincinnati market and has 3200 machines + 90 tables)  7k total machines at $230 win/day is $588mm topline revenue, further ignoring F&B revenue which usually runs 15% of property revenue.  Charlestown ran historically low EBITDA margins of 28.0% during the recession years in a 57% tax jurisdiction.  Ohio's 33% tax is 24 points lower, so tacking on 20 points of margin for better tax rate less 10 points of margin for assumed management fees to Caesar's (LACO is trying to develop and manage a smaller casino at 13% of EBITDA at the highest split threshold ) gets us to 43% margin, or $253mm EBITDA.  

    Budgets haven't been released, but $400mm has been floated for Cincinnati and $600mm for Cleveland, for $1B total cost.  

    Assuming 30 year straight line depreciation (conservative) for tax, we've got a $33mm annual tax shield.

    Casino companies will tell you a rule of thumb for property maintenance capex runs ~$3mm per 1k slot machines, so $21mm of capex.

    At 40% income tax rate, these projects should be conservatively generating $144mm of unlevered FCF (14% unlevered ROE).

    Given Caesar's leverage, there is strong incentive to write the thinnest equity check possible.  A 30% equity check behind 45% secured at 6% and 25% unsecured at 9% is $50mm of interest expense, or $114mm of levered FCF (38% levered ROE).

    LACO's 5-9% gross share of FCF is $5.7mm - $10.3mm, less ceding 18.5% to Quest nets $4.6 - $8.4mm.  At a conservative 10x FCF, the stakes are worth $46mm - $84mm vs. required equity contribution of $15mm - $27mm for a rough NPV of $31mm - $57mm.

    Replace 3500 machine assumption with a realistic 5000 machine constitutional maximum and perform the same math:  $840mm revenue, $361mm EBITDA, $179mm levered FCF, nets $7.9mm - $13.1mm.   The stakes are worth $73mm - $131mm for a rough NPV of $58mm - $104mm

    Indian Casino Development and Management Contracts

    LACO contracts with tribes to navigate the gaming approval process, develop, finance construction, and then manage the casino for a limited term.  LACO advances costs and minimum payments to the tribes with the hope of being paid back with interest once operations are cash flowing.  LACO's advances and future management fees are subordinated to minimum payments to the Indian Tribe from the casino, secured fixture financing, and senior indebtedness for construction and funding of the project.  If everything goes according to plan, LACO sells the interest in their advances to investors at little or no discount and books the lucrative management fees going forward.  Typically by the end of the term, the Indian tribe has enough gaming expertise that it takes over operations.  Contracts are almost never renewed.

    Four Winds casino / Pokagon band: 18 months left on this contract, all ~$100mm advances to the tribe were sold in 2007.  Management fees are not broken out by property, but I estimate $22mm of management fee revenue per year from this contract, or $33mm over the life.

    Red Hawk casino / Shingle Springs band:  5 years left on this contract, ~$50mm of advances and ~$22mm of accrued interest outstanding as of Jan. 2010.  I estimate only ~$3mm of management fees are being booked each year, but these appear to be non-cash.  I don't think subordinated payments are currently being made on either the management contract or advances.  Shingle Springs Tribal Authority Bonds are trading at a discount, so for the sake of conservatism I assume zero cash flow from the management contract and only tax write-offs on the advances (see tax assets later).

    Jamul Indians:  $38.9mm principal (+ $21mm accrued interest) to the Jamul tribe for development of a California casino.  California Transportation Authority is requiring traffic and other studies before permitting construction of road access onto the current 2-lane state highway for entry/exit from the property, which is the final approval before construction may begin.  I'll assume zero value here and only a tax write-off of principal advances.  But it would be a coup to develop the project.  Not only are advances + accrued a big number, LACO is contractually set to receive another $30mm of construction and development fees on a successful project (this would almost certainly be reduced somewhat, however).

    Tax/Other assets

    If LACO terminates development efforts or realizes losses on subordinated advances through default of an operating casino, LACO can write off the principal of these advances for tax (but not, I believe, interest accrued on these advances).

    Jamul principal:  $38.9mm, tax write-off value:  $13.6mm

    Shingle Springs principal:  $50mm, tax write-off value:  $17.5mm

    Given the $25mm of income from sale of the PENN interest and future income from OH distributions or a sale of its OH interests, LACO will be able to utilize these write-offs.  Obviously the upside from Red Hawk not defaulting (management doesn't seem to think it will, but only bondholders see the casino's operating results and covenants) or getting Jamul off the ground are far more significant.

    Louisiana tax litigation

    Louisiana Department of Revenue has sued LACO for past taxes and penalties related to management contracts from 1999 and 2001.  LACO has recorded a $17mm payable against the entire amount, and the parties are set for trial within the next couple months.  If the parties settle, we should hear something soon, but I assume LACO pays in full.

    Miscellaneous assets / liabilities

    LACO owes contract acquisition costs of ~ $1mm related to the Four Winds management contract and $8.0mm payable over the life of Red Hawk contract (net of a $2.4mm receivable to one of the parties).  I haven't been able to determine whether the $10.5mm is payable in the event of a default at Red Hawk, but for now I'll assume it is and update in a thread when I find out.  LACO also has $2.8mm coming in over the next 15 months related to a recent contract termination with the Iowa. 

    Liquidation Value:

    Cash on hand:                                                                                   $46.9mm

    Taxes payable on PENN sale:                                                             -$9.0mm

    Full reserve on LA tax matter:                                                           -$17.0mm

    Net misc liability (undiscounted):                                                     -$6.2mm

    After-tax write-off value of Red Hawk casino:                                      $17.5mm

    After-tax write-off value of Jamul development:                                  $13.6mm

    After-tax 18 mo. Four Winds cash flow (undiscounted):                      $19.8mm

    NPV of OH stake:                                                                             $31mm - $104mm

    Net liquidation value:                                                                        $96.6mm - $169.6mm

    Diluted Shares:                                                                                 27.5mm

    Liquidation Value per share:                                                          $3.51 - $6.17

    Potential upside surprises: 

    Potential risks:
    1.  Management does something stupid with our assets.
    2.  Management lets $12mm annual overhead erode shareholder value.

    Catalyst

    Projections released by Penn Gaming, Caesar's, or Rock Ventures for the Ohio development opportunities.
    Settlement with State of Louisiana in advance of looming trial over $17mm of taxes + penalties.
    Red Hawk casino doesn't default and subordinated advances and management payments resume to LACO.
    California transportation department allows Jamul casino construction to move ahead.
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