Description

Mohegan Gaming & Entertainment - Low risk, mid-teens IRR over the next 12-24 months

Mohegan Gaming & Entertainment, the operating company for the Mohegan Tribe’s regional casino portfolio, has short duration, 3x levered, senior secured bonds trading at a 11% YTM, with upside from an early refinancing driving a potential 18% YTC. While we are not relative value investors, we note that much of the HY gaming space currently trades at 6-8% YTW, implying the outlook for these bonds is significantly worse, which is a misperception.

The senior secured bonds fit into several of Mercator Fund’s investment frameworks. First, Mohegan Gaming is a private company with public debt, where the access to information and management requires more effort than traditional public investors are used to. Additionally, we identified that the market has been slow to appreciate Mohegan’s upcoming key growth drivers that will result in a step-function change in economics and a shift in capital allocation mentality, as prior growth investments are harvested for cash, resulting in meaningful growth and deleveraging.

First, Mohegan has begun to disclose the profitability of its Connecticut digital business, powered by FanDuel, the market leader in the sector. This business’ inflection to profitability will provide a ~10% boost to Restricted Group (described below) EBITDA in 2023 and should continue to grow at a healthy double-digit rate over the medium term. Second, the company has unrestricted subsidiaries in Canada and South Korea, both of which will be distributing cash back to the Restricted Group in the next 12-18 months, resulting in further deleveraging.

We believe the market is mispricing the Mohegan bonds for several reasons. First, Mohegan has traded at a persistent discount to regional casino peers given peculiarities around creditor rights for a tribal bond. Second, there is concern around the profitability of the company’s flagship property in Connecticut once New York officially launches its three full-scale casinos around the NYC area. Lastly, there is recession risk generally weighing on anything consumer related. While we are not dismissive of these risks, we believe they are all manageable and see very low probability our bonds could be impaired. 

Our base case assumes that the company refinances our bond at maturity in early 2026, generating an 11% IRR. We expect the near-term IRR to be higher because the yield will compress as the company de-levers. Moreover, if credit market conditions improve over the next 12 months, the company has structured its recent refinancing of the subordinate debt such that the company would like to refinance the entire capital structure at that time, providing us with a potential IRR of 18%.

Business Overview

Mohegan launched in 1996, at first operating only the flagship Connecticut casino, Mohegan Sun, which represented a major source of revenue for the Mohegan Tribe. As new competition in Massachusetts and New York emerged, management sought to diversify operations in order to expand the company’s revenue base. Mohegan has subsequently expanded to own or manage casinos in Pennsylvania, Niagara Falls, Las Vegas, Atlantic City, and Washington State. Additionally, the business has an online sports betting/casino business in Connecticut, as well as ownership of a new casino and resort in South Korea that will open in the next 12 months.

Restricted Group

The company has designated certain subsidiaries that guarantee its publicly traded bonds as members of the Restricted Group. Cash generated by subsidiaries in the Restricted Group cannot be used by unrestricted subsidiaries, which enhances the safety of our bonds. The Restricted Group consists of: Mohegan Sun Connecticut (75% of Restricted Group EBITDA), Mohegan Pennsylvania (15%), Mohegan Digital (10%) and Mohegan Las Vegas (de minimis). Notably, Mohegan owns the land under the Pennsylvania property and could elect to do a sale-leaseback as part of a refinancing. The Pennsylvania property currently generates ~$55mn EBITDA. Based on recent sale-leaseback transactions, that would imply the potential to extract $300-350mn of cash.

The Mohegan Digital business is the one asset within the Restricted Group with real growth potential. In 2021, Connecticut came to an agreement with the tribes to introduce online sports betting and casino in the state, with DraftKings chosen as the partner for Foxwoods while Mohegan partnered with FanDuel, the #1 operator in the industry. The evidence from other states that have legalized online casino (NJ, PA, MI) is that although physical casino revenues are roughly flat compared to pre-COVID levels, overall gambling revenue in those states is showing significant double-digit growth. While in some states that may result in a long-term disadvantage for certain regional casinos without strong online brands, Mohegan is advantageously positioned due to the regulated duopoly market structure in Connecticut. The tribes governing Mohegan and Foxwoods have long-term agreements with the state to be the sole gaming operators. The early evidence in Connecticut is consistent with what we have observed in other states: the combined EBITDA of Mohegan Sun CT and Mohegan Digital is up ~20% in the last twelve months vs. pre-COVID levels and continues to grow, with digital revenues up 50%+ while the physical business remains stable.

Unrestricted Subsidiaries

Outside the Restricted Group are the managed operations of Niagara Falls, Resorts World Atlantic City, and ilani Resort in Washington State. Cumulatively, these subsidiaries generate ~$95mn of EBITDA, more than enough to self-fund operations, and certain unrestricted subsidiaries return cash back into the Restricted Group.

One upcoming negative as it relates to the unrestricted subsidiaries is that the tribe that owns the ilani Resort has decided to terminate its management agreement with Mohegan and operate the casino itself starting in mid-2024. On Mohegan’s 1Q23 earnings call, the COO stated that the cash distributions from ilani are roughly $25mn/year to the Restricted Group. In the near term, partially offsetting this drag will be cash distributions to the Restricted Group from the Niagara subsidiary ($54mn LTM EBITDA) beginning this quarter. We expect that initial distributions from Niagara will total $10-15mn/year given restrictions related to that subsidiary’s siloed debt.

Going forward, the most important unrestricted subsidiary will be Inspire Korea, the new integrated resort Mohegan is launching by year-end adjacent to Incheon International Airport. The cumulative investment in the project will total approximately $1.6-1.7bn. While management has not explicitly given an ROI target, they point out that in terms of the number of hotel rooms, table games, slot machines, etc., the project looks quite similar in profile to the flagship Mohegan Sun property which generates >$250mn EBITDA. Management expects that once Korea is fully launched and meeting the covenants in its siloed debt agreements (est. 2Q-3Q 2024), the subsidiary will begin to make cash distributions back to the Restricted Group. Given the scale of the project, we believe that a successful Korea launch could be a meaningful deleveraging event. That said, the bonds are attractive in our view even in the absence of any material cash distributions from Korea given the low leverage and highly profitable nature of the Restricted Group.

Perceived Risks

Tribal Discount

Mohegan’s bonds have often traded at a 1-3% higher yield than regional gaming peers, though in recent months this spread has widened significantly. We believe this discount results from the following:

1. It is unclear whether the tribe would be considered a debtor under the US bankruptcy code, making any creditor dispute likely to be resolved through a consensual restructuring rather than in court.
2. Tribes have sovereign immunity, representing another impediment to taking them to court.
3. Even if the tribe were to appear in bankruptcy court, federal law dictates that a tribe must be the sole proprietor of any permitted gaming operations, meaning that creditors cannot take any equity in a restructuring. 

The company has attempted to appease creditors by granting limited waivers of sovereign immunity as it relates to its outstanding debt. In addition, it has created a structure whereby Mohegan Gaming leases the gaming floor of the CT casino from the tribe, such that in a restructuring it could pass that lease on to creditors and avoid the issues with the sole proprietor requirement above. The company has also committed to attempting to enter proceedings first in NY bankruptcy court, followed by the CT bankruptcy court, and finally with an independent arbitrator. 

In the end, this might remain an overhang until the bond is refinanced. While there are precedent examples of creditors that were negatively impacted by tribal restructurings, we take comfort that Mohegan has a 20+ year history in the public credit markets, including through the Global Financial Crisis (GFC), and its creditors have always been made whole. Even in 2012 when the credit markets were effectively closed due to the chilling effect of the Foxwoods restructuring, the company was able to launch a bond exchange in which bondholders received a premium to par to extend maturities; ultimately those new bonds were refinanced within 18 months.

Lastly, this company clearly has plans to expand its operations based on the NYC bid and South Korea project. It will require access to the capital markets and Mohegan will risk losing that access by harming creditors.

New York Downstate Casinos

Given the Mohegan Sun CT casino is still the primary EBITDA generator for the business, the upcoming licensing of three downstate casinos in NY is a potential risk.  With the senior secured bonds maturing in early 2026, it’s highly unlikely any full-scale casinos will be licensed and built by the time the bonds go current, meaning we will more than likely be refinanced before any impact is felt. That said, even if these new casinos launch inside our investment horizon, we believe the impact to Mohegan EBITDA will be limited.

To start, the company has already experienced a similar event in 2019 when Wynn opened their Encore Boston casino in Massachusetts. The Encore was only open for two quarters prior to COVID, but in those quarters, Mohegan Sun’s revenue decreased 7% and EBITDA by 10%. Historical filings from the company showed that prior to Encore opening, Massachusetts and New York customers each represented ~20% of revenue.  The New York percentage has decreased since COVID reopening as Mohegan has largely halted its bus service from NYC to CT given the low-margin profile of customers that used the bus service. Even so, if we assume that the impact of downstate NY casinos is roughly similar to the Boston impact, the resulting 10% hit to CT EBITDA would still leave us with a bond that is only 3.5x net levered, which is very safe.

Additionally, it is widely expected that Empire City and Resorts World will win two of the three licenses. These are existing casinos that offer slot machine play and are therefore already competitors to Mohegan Sun. Adding table games to the competitive set would be an incremental negative, but not the equivalent of a fully new competitor opening its doors nearby. Currently, it appears that a Hudson Yards casino (Related/Wynn) and a Long Island casino (Las Vegas Sands) are top contenders for the third license. For Mohegan, any casino built in Manhattan rather than a suburb would be incrementally positive given that visitation from rated players in Manhattan is quite low.

Another potential offset is that Mohegan has partnered with Soloviev Group to bid on an NYC license near the UN, whereby Mohegan would manage the property. While the company has not disclosed the terms of the arrangement, we trust that management remains prudent with respect to capital allocation and note that management has historically created financing structures outside the Restricted Group for expansion projects (e.g., South Korea). If Mohegan happens to be the winning bid, we view that as a long-term positive for the group. 

Recession Risk

To date, the casino business has held up very well despite inflation and recession concerns, but obviously a weakening consumer is an ever-present risk. Because the 2026 notes are only 3.1x net levered, we do not believe a short recession would undermine the company’s ability to refinance. While we do not expect a GFC scenario is about to unfold, it is worth noting that during that time revenues in regional casino markets were down just mid-single-digits (vs. Las Vegas Strip down nearly -20%) before beginning a slow recovery. In such a scenario, ignoring the fact that digital revenues are still in hyper-growth mode, Mohegan’s EBITDA would be down -10-15% and leverage through our bonds would only be 3.6x net. 

Early Refinance Optionality

In December 2022, Mohegan came to an agreement with Chatham Asset Management, owner of the vast majority of the company’s $500mn 7.875% unsecured 2024 notes, to exchange those notes for new 13.25% unsecured 2027 notes. The call schedule for these notes was designed such that Mohegan can call the notes at par at any point prior to June 2024, and thereafter the call price would increase to 113.25 through June 2025 and 106.625 through June 2026.

If the credit markets have improved by mid-2024, management has indicated that the company would call the 2027 unsecured notes at par, as well as our 2026 notes at 102, to issue new prepayable debt that would ladder maturities. If called at 102 in June 2024, the 2026 secured notes would generate a 18% YTC. While we don’t assume this will happen in our base case, it offers meaningful upside to an already attractive 11% YTM.

Catalyst

-Early refi
-Unrestricted subsidiaries returning capital (Korea opening)
-Continued strong performance (including strong Fanduel results)
-Debt repurchase