Description

Thesis: Red Rock Resorts (RRR) is a US regional Casino operator that is currently in the midst of an over-budget renovation at its Palms asset in Las Vegas. The company has an over-levered balance sheet at 5.2x ND/EBITDA and is over-valued on consensus EBITDA numbers that are overly optimistic. I believe RRR will get low-teen returns on redevelopment capex at best and at a cycle average multiple of 8x EBITDA this could be stock that trades in the high-teens.

Background: RRR owns 20 casinos that target the Las Vegas Regionals market. The most famous properties would be the namesake Red Rock Resort, the Palms, and the Palace Station. The company also has management contract for the Graton Resort & Casino in California. All told, RRR has 22,251 slots, 450 tables and 4,516 hotel rooms across the 21 properties.

The company has been around in one form or another and run by the same family for a number of decades. The assets company initially went public in 1993 as Station Casino and was taken private as part of a management-led LBO in 2007 at 16x LTM EBITDA using 6.5x turns of debt. 2 years later the company filed for Chapter 11 in the summer of 2009.

**Note that technically RRR is a holding company that has a 59% equity interest in the Station Holdco operating company. Brothers Frank and Lorenzo Fertitta own the remaining 41% through exchangeable super-voting Class B shares

Current day: RRR’s most recent public market incarnation came about from an April 2016 IPO at $19.50/sh. The month following the IPO RRR announced that it was acquiring the Palms for $312m, or 8.8x post-synergy EBITDA of $35m. With 1,250 slots, 48 tables and 710 hotel rooms this implies the Palms could achieve $21.4k EBITDA/playing spot (assuming 8 spots per table, which is standard in the gaming industry).

Since coming public the company has undertook 2 major renovations: Palace Station & The Palms. At Palace Station, RRR has already spent $179m on a $191m project that will see the site go from 1,268 slots and 38 tables to 1,800 slots and 43 tables.  This represents a roughly 36% increase in gaming capacity. This project was completed this quarter (4Q18)

At the Palms, RRR is undergoing a 3 Phase expansion that media reports peg as “the most expensive reno in Las Vegas history.” The project will add 16 tables and 300 slots (representing a 26% increase in playing spots), a Hotel renovation, the addition of a night club, a pool club, and several new dining concepts. The project was originally expected to cost $610m and be completed by mid-2019, but with 3Q18 results RRR said the expansion will now cost $690m and will be done by 3Q19. To date, $318m has been spent. With less than half of capex spent, I believe there is further risk of capex creep as cost increases tend to happen at the end stages of a project.

What does the future look like: In the first 3 qtrs of 2018 RRR generated $374m EBITDA, implying full-year run-rate of ~$500m. Management has called out the Palms & Station Casino reno as being a $10-15m annual drag on EBITDA, so call run-rate unaffected EBITDA $515m.

The question becomes, how much incremental EBITDA can the redevelopments & renovations generate? Currently, consensus estimates are looking for 2020 EBITDA of $632m. Put into context, the redevelopments will only see company-wide playing capacity increase by less than 5% (1k new playing spots).

In my opinion, consensus calling for $117m of incremental EBITDA on $880m of capex seems high. While redevelopment in the casino industry typically average mid-teens (and good operators can get +20%), I wouldn’t classify RRR as best-in-class operators. Palms has never delivered the base EBITDA that management called for. LTM pre-IPO RRR’s Las Vegas business was doing $418m EBITDA. They called out $35m of EBITDA with synergies when buying the Palms, and in the following 12 months Las Vegas EBITDA only grew to $433m. Considering Las Vegas Locals GGR (measured as Clark County ex-Strip) was up over 6% in that timeframe, the 3.5% growth in EBITDA including an acquisition that was supposed to increase Las Vegas EBITDA by 8% alone is disappointing. Also, this is the same management team that did an LBO at the height of the credit bubble and went bankrupt 2 years later.

What is RRR worth: Even if I’m wrong and RRR is able to hit Street numbers I still think RRR is a short because the stock would still be expensive. On $632m of 2020 EBITDA RRR would be trading at 9.5x EV/EBITDA. The chart below shows US Regional Casino comps on EV/EBITDA NTM basis. As you can see, over the past 10 years (through the cycle), Regional casinos have traded in a wide range of 6-11x EBITDA, and have averaged 7.5x. So at 9.5x Street 2020 numbers, RRR is effectively already trading near the high end of the range on what I think are aggressive EBITDA assumptions.

As a valuation check I decided to look at what casino assets have been trading at in M&A transactions. Going back 2.5yrs there has been $12bn spent on 14 deals. The range of purchase prices paid was 8-12x EBITDA, while the mean was 9.1x and the median 8.8x. So again, RRR would be trading above what assets have been going for in M&A markets.

The table below shows sensitives to various redevelopment IRR’s and valuation multiples. Personally, I think that once the redevelopments are done RRR will be closer to a $600m EBITDA business. As you can see from the table, unless you assume peak multiples and best-in-class project IRR’s, there is material downside for RRR’s share price.

Conclusion: I’m not sure owning an expensive and over-levered casino company 10 years into an economic recovery is the best risk-return proposition. I think there are a number of ways you can win on the RRR short. 1) Execution issues on redevelopment and further capex creep and return deterioration, 2) street numbers come down, 3) leverage issues, and 4) economic growth stalls out

Catalyst

Monthly GGR numbers, Sector M&A, Updates on capex programs.