Description

MGM Mirage is the largest casino operator on the Las Vegas strip with 9 casinos, ranging from Bellagio and Mandalay Bay on the high end to Circus Circus and Excalibur on the low end.  In addition to its wholly opened properties, MGM has a 50% interest in the recently opened City Center, which it operates on behalf of its financial partner Dubai World.  MGM also has 50% JV interests in the MGM Macau and The Borgata in Atlantic City.  MGM also has relatively immaterial operations in Reno, Michigan and Mississippi.  MGM will have to divest of its Borgata stake in the next year or so because the New Jersey gaming regulator has deemed MGM's operating partner in Macau to be unsuitable (the partner is Pansy Ho, daughter of Stanley Ho, who is rumored to be connected to organized crime). 

MGM has a lot of leverage.

Shares Outstanding 441.2

Market Cap 5.2 bn

Net Debt 12.1 bn (corporate only, not JV level)

EV 17.3 bn

09 EBITDA and multiple 1.25/13.8x

Peak EBITDA and multiple 2.1/8.2x

Leverage 9.7x 09

While the risk of bankruptcy was permanently averted for MGM during the summer of 2009 (barring a severe and extended double dip recession), the company remains extremely overleveraged.  The combination of a high debt level and a sharp increase in Las Vegas hotel and casino capacity eliminates the possibility of any free cash flow generation for several years in the future.  MGM will spend the next two years dealing with various debt maturities and managing its bloated balance sheet.  There are a number of corporate transactions that the company has set high expectations for.  If any one of them goes less than smoothly, it could be a catalyst for a revaluation of the company more in line with its peers and more in line with its profit outlook.  Historical multiple ranges on Vegas assets are 9-12x, but should be valued on the low end now because of the structural issues related to capacity increases, as well as uncertainty over the long-term consumer spending outlook.  Additionally, the big growth curve is behind Vegas, as the city has done an excellent job over the last 20 years of attracting corporate and convention business, as well as building appeal for visitors who are not avid gamblers.  For these reasons, most sellside analysts when doing a sum of the parts for Wynn (WYNN) and Las Vegas Sands (LVS) apply only 9x to their Las Vegas strip assets (both WYNN and LVS now generate the majority of their EBITDA in Macau).  If you were to put 9x on MGM's consolidated EBITDA, the EV of the company would be less than the value of its debt.  Since WYNN and LVS have newer, higher end properties than the average property within the MGM portfolio (MGM has some great properties, but also some crappy ones), giving MGM the same multiple on the strip as WYNN and LVS seems generous.  Given that the value of the strip properties is at best a wash with the corporate debt, the real value of MGM is really the sum of its JV interests, which adds up to far less than the current quote.

Secular versus Cyclical?

A lot of high level portfolio managers with a bullish outlook on the US economy want to buy MGM because it looks attractive on a multiple of peak EBITDA (although I would argue that 8x EBITDA is a full valuation for a competitive, capital-intensive business with limited opportunity to expand the addressable market).  These investors want to buy MGM because it is the ultimate leveraged recovery play - it has operational leverage and it has as much financial leverage as almost any company of its size in the market.  It peaked at just shy of $100 in 2007 (when it was wildly overvalued and a fantastic short).  The problem with MGM as a recovery vehicle is that the market has changed since it generated its former peak EBITDA.  Capacity additions into a weak marketplace make the attainment of prior peak EBITDA levels unlikely.  People playing the recovery trade are underestimating the impact of supply growth.  Since MGM's peak EBITDA years of 2006-2007, the market has seen the opening of the LVS's Palazzo, WYNN's Encore, and City Center.  Both the Palazzo and Encore were EBITDA-neutral events for their owners, although admittedly a weak economy played a roll.  The jury is still out on City Center, which just opened 12/16/09. 

The Las Vegas strip is overbuilt with too much capacity in both hotel rooms and food and beverage, especially at the high end.  One needs to remember that about half of Las Vegas visitors arrive by car, and the majority of them are coming from California.  Peak EBITDA occurred in 2006-2007, the same time that much of Southern California was using their house as an ATM.  The big spenders driven by the "cash out and refi" aren't coming back.  Capacity growth will also constrain RevPAR growth.  After 20-25% RevPAR declines in 2009, the bulls are looking for easy compares to start leading to a flattening out of RevPAR, paving the way for a steep EBITDA recovery curve beginning 2011. But room rates have been slipping since City Center opened.  Week to week City Center rates are going down as you book closer in, and City Center is failing to command a premium.  Offers from Wynn and LVS are also accelerating.  It's not hard to get a luxury room for $129 midweek these days.  In addition, airline capacity has come out, making it hard to really ramp up visitation.  While MGM and to a lesser extent LVS have asserted the convention business is coming back, Steve Wynn said the opposite on his company's Q4 call.  Las Vegas does offer tremendous value to conventioneers relative to other higher-priced cities, so at aggressive rates, it makes sense volume will return.  It remains to be seen at what room rate the business comes back though.  On the leisure side, concern remains that City Center will cannibalize all the high-end Vegas properties, including MGM's crown jewel, the Bellagio.  Owning 50% of property that will cannibalize your 100% owned properties was never a great idea.

For those that think I may be too harsh on the outlook for the Las Vegas strip, I would direct you to look for recent comments by Gary Loveman, the CEO of Harrah's, also a major Las Vegas strip operator (now private, following its LBO by Apollo).  He has basically said Las Vegas will be a great market - in 5 years.  Five years is a long time to wait when leveraged at almost 10x EBITDA.  Steve Wynn has also made similarly bearish statements about Las Vegas, although his remarks have clearly been made with political motivations.

Recent Events

The run in MGM from $9 in late 2009 to just under $12 now was based on optimism over MGM getting their bank debt deal refinanced (it is maturing in fall 2011) and the beginning of the IPO process for MGM Macau.  The debt deal got done, as most likely will the IPO but people are likely too optimistic regarding the valuation and proceeds on the IPO.  MGM is guiding investors to assume a 17-18x EBITDA multiple for their Macau IPO, which is the valuation level currently given to the recent IPOs of Wynn Macau and Sands China.  It does not however make sense to the use the same multiple for MGM Macau as for Sands China and Wynn Macau because you are comparing the #6 of 6 players to player #s 1 and 2.  Also, LVS has two big openings coming in 2011 and WYNN has one in 2010...this means their Macau operations are growing, whereas MGM is at risk of shrinking in the face of supply growth from other better located and better operated competitors.  Other potential hurdles for the MGM Macau IPO are the potential tightening actions in China, which could cool Macau growth from currently unsustainable levels, as could the always present risk of Chinese government regulation changes that impact Macau in the form of Visa restrictions (China has a history of turning on and off the spigot of Chinese tourists into Macau on a whim).  On the bank debt side, there was a small increase to the interest rate (100 bp) which was largely ignored, but given the company is basically FCF neutral here at best, any rate change is material to cash flow.

As mentioned above, the state of New Jersey forced MGM's hand in making them choose whether to keep their Macau asset or their Atlantic City asset.  Unsurprisingly, MGM chose Macau, a market in hyper growth, over Atlantic City, a market in secular decline.  MGM will be putting its 50% stake in the Borgata in a trust for disposal.  The most likely buyer of the stake is Boyd Gaming, their current JV partner and the operator of the property.  Boyd is currently in the process of trying to buy the assets Station Casinos, their main competitor in the Las Vegas locals market, out of bankruptcy.  While both the Atlantic City and the Las Vegas locals markets are both performing horribly, one could argue that Las Vegas locals is in cyclical decline whereas Atlantic City is in secular decline.  Las Vegas locals refers to off-strip casinos in Las Vegas where local residents gamble.  Las Vegas is one of the worst, if not the worst, housing market in the country and has one of the highest unemployment rates as well.  While doubling down in that market may seem risky, Boyd would have a lot of synergies if it bought the Station properties, and one can make an argument that a cyclical recovery will come someday to Las Vegas locals.  The situation in Atlantic City is much worse.  The city has been in decline for years, and most of the properties there are dilapidated after years of underinvestment.  The Borgata is by far the best property in town and a beautiful property, but it's hard for even a beautiful mansion to hold its value in a neighborhood full of boarded up, foreclosed houses.  Atlantic City is also under attack from increased competition.  Pennsylvania recently approved the addition of table games to its casinos which were previously slot machine-only.  LVS opened a brand new casino in Bethlehem, PA last year - which is conveniently located to many of the markets that Atlantic City draws from.  WYNN recently announced their plans to open a casino in Philadelphia.  Maryland recently approved slot machines.  New York already has one of the highest revenue slot facilities in the country in Yonkers, and there are (forever delayed plans) to open a similarly sized but more easily accessible facility in Queens at the Aqueduct racetrack.  There is much speculation that New York will eventually approve table games for that facility.  All the increasing casino supply in the markets that Atlantic City draws from - Philadelphia, New York City, Northern and Southern NJ suburbs - makes Borgata a tough sell.  If Boyd can swing the purchase of both the Station assets and MGM's 50% stake in the Borgata (or if they lose out on Station), they will likely be the buyer.  But if they can't buy it for any reason, it will be a problem because there seem to be no strategic buyers interested and a financial buyer is going to demand a valuation much lower than the one MGM is talking about and that the sellside is using in their sum of the parts.  That valuation is about 7.5x EBITDA, but many regional casino operators are trading at 6-7x with better diversification and markets.  As the CFO of one regional casino operator recently said of the Borgata, "I'd buy it if they offered it to me at 1x." 

MGM needs the sale of the Borgata and the IPO of MGM Macau to go well or else they will yet again face funding gaps in paying off their debt.  Thus anything less than perfect execution on these transactions will be potential downside catalysts.

Other Financial Issues

It is worth mentioning that:

• MGM is at an unsustainably low capex level, and even with low capex, still generates zero cash.  MGM is spending less than $200 mm/year on capex, although depreciation is in the $700-800 mm range.  This seems unsustainably low, especially for a company that allows people to smoke cigarettes and drink alcohol in their facilities.   Given the nature of their business, it's hard to imagine that wear and tear has dropped off much.
• Leverage to increasing revenue on EBITDA may be overstated because some of their massive cost cuts are probably not sustainable...variable labor expense will creep back.
• MGM is talking about a recap of City Center - even though the company has not reported a full quarter of EBITDA yet.  This discussion is beyond premature.
• Dubai World has a bunch of debt coming due, and rumors are out there that they are shopping their City Center stake, which is their primary asset outside of Dubai.  MGM has right of first refusal on the Dubai World stake, and has indicated they would buy it if it comes for sale at a reasonable price and they can finance it.  Adding more debt to double exposure to an unseasoned property while the cyclical versus secular debate continues to rage on is a move that would add even more risk to MGM.

Risks to the Short

• Macau IPO goes better than anticipated
• US macro gets much better much faster than expected - V-shaped recovery lifts all boats
• This short is crowded - 18% of the float is short but it's more like 30% if you take out Kirk Kerkorian's and Dubai World's stakes (37% and 6%, respectively).  Stock trades like water though so the short interest ratio is only 3-4 days.

Valuation

• Macau worth $2.60 (12x EBITDA of $250 mm, net of $700 mm debt, 50% ownership)
• City Center worth $1.50 (9x 350 mm normalized EBITDA - generous, net of $1.8 bn debt, 50% ownership)
• Borgata worth 90c (7x 225 mm normalized EBITDA, net of 800 mm debt, 50% ownership)
• Vegas assets worth $0 post debt, give it $2 for option value
• $7.00 target

Catalyst

Catalysts

• IPO and Borgata sale get done on anything but best possible terms
• Vegas RevPAR disappoints throughout the year and MGM misses #s and EBITDA goes down and leverage goes up, raising questions of what happens with the balance sheet long-term
• Macau fever cools, people start recognizing the inherent risks of putting mid to high teen EBITDA multiples on a business that is wholly dependent on laws that change on a whim
• Dubai World dumps their 6% of MGM in the open market or a secondary (this would be good for a one day hit, but not more than that)