We believe Trump Entertainment stock is worth $8.40 versus its current $21.00 price, representing downside of 60%. At $21.00, the stock trades at 12.7x LTM EBITDA of $164 million.  Given the Company’s 100% exposure to a single market with negative organic cash flow growth characteristics, significant new supply entering Atlantic City and neighboring gaming markets in 2007 and 2008, executions risks inherent in its turnaround, and LTM leverage of 7.5x net debt to EBITDA, we believe Trump should be valued at a maximum of 7x 2007 EBITDA - in line with regional and small-cap gaming companies. 

 

The crux of our short thesis is that investors have (i) misjudged the attractiveness of gaming assets in Atlantic City as a whole, and (ii) they are not appropriately discounting execution risks related to the turnaround of Trump. 

 

We believe a modest improvement in earnings at Trump is a best case scenario because the company faces stiff headwinds in 2007, 2008, and 2009.  Competitive pressure in Atlantic City is intensifying and will cause negative organic EBITDA growth for most Atlantic City casinos in 2007.  The $200 millionBorgata expansion in June 2006 has already caused promotional spending to escalate and has resulted in year-over-year EBITDA declines for both Borgata and Harrah’s in Q3 2006.  In 2007, Borgata will spend an additional $400 million to launch a new hotel tower.  Harrahs has already committed to spend $550 million in improvements and a new hotel tower at Harrah’s AC in 2007 and 2008, and is expected to announce an additional $500 million of improvements on other properties in AC.  Pinnacle has entered the market through its acquisition of Sands, and will further add to competition in the medium term by investing $1.5 - $1.7 billion in a completely revamped property.  Morgan Stanley has announced plans to build a new casino, and there is speculation of Wynn entering the market through a development at Bader Field.  MGM is reportedly evaluating the use of vacant land adjacent to Borgata.  And of course, slots are being added in neighboring feeder markets like Pennsylvania.  There is ample data from Atlantic City to demonstrate that the market does not easily absorb new supply.  Trump will suffer as a result of the massive supply increase.

 

Trump’s hedge fund investor base has already priced in a quick and successful turnaround despite management’s emphasis that they are targeting improvements in margins in late 2007.   Equity analysts show unrealistic improvements in margins and EBITDA growth starting as early as 2H 2006, while Harrahs and Borgata struggle to grow EBITDA.

 

Any delays in the turnaround, negative surprises on earnings, or liquidity issues will cause Trump’s fickle investor base to lose patience.  Morgan Stanley and Franklin Resources own over 10 million shares out of a float of 29 million shares.  With an effective float of $360 million and average daily volume of only $4.5 million, we believe any hiccup in the performance of Trump could result in a run for the exits by Trump’s hedge fund shareholders.  This could help the stock achieve our price target very quickly. 

 

The table below shows Trump’s historical financials, valuation, and net leverage.  We estimate that the company will generate free cash flow of negative $80 million in 2006 and negative $110 million in 2007, implying that leverage will continue to grow.  The ‘catch-up’ capex investments should really be added into the company’s enterprise value when calculating multiples.

 

 

 

Most investors are misled by the illusion of ‘growth’ in Atlantic City.  Superficially, the numbers suggest that Atlantic City is a growing market.  The table below shows gross casino revenue grew at an average rate of 3.2% from 1997 to 2005.  More recent years suggest even more impressive growth of +7% in 2004 and +4% in 2005.

 

 

The problem with these figures is they do not distinguish between organic versus acquired growth.  The high-growth years are those in which significant new capacity was added in Atlantic City.  The table below shows that if you exclude the new or refreshed/expanded properties, the remaining incumbents experienced negative or modestly positive growth. 

 

 

Here is a more detailed look at individual operators’ growth rates from 2000 to 2005:

 

 

The overall industry excluding Borgata had a CAGR of -2% over the six year period.  Gross Operating Profits (a close proxy for EBITDA – defined by the NJ Casino Control Commission as Net Revenue – COGS – SG&A – Doubtful accounts, excluding D&A) declined an average of 1% over the same period, with only a handful of casinos showing positive Gross Operating Profit growth over this period. 

 

What’s missing in the table above is that the casinos actually spent significant capex dollars on expansion projects.  In the table below, we look at how much of a boost the above casinos received from expansion projects.

 

 

The data shows that in the five years from 2000 to 2004, operators spent almost $2 billion in capex, representing 9% of net revenue.  Most operators tell investors that their maintenance level capex is 3%-4% of revenue.  In the analysis above, we assume that 4% of revenue is maintenance capex, with the balance spent on expansion capex projects.  This implies that the industry as a whole spent approximately $1.1 billion in expansion projects between 2000 and 2004.  Most operators suggest they are able to generate 15%-20% EBITDA returns on expansion projects.  Analysts often use these ROIC assumptions when modeling cash flows of casino developers.  We assume that these returns are exaggerated, and conservatively assume only 10% EBITDA ROIC.  When we strip out the implied expansion project EBITDA contribution from each casino’s 2005 EBITDA, we find that only 2 casinos had positive cash flow growth in the period from 2000 to 2005.  Industry cash flow declined at 3% per year on an organic basis.  If we had assumed 15% ROIC, organic cash flow growth would be -4.4% per year.

 

On an aggregate basis, Atlantic City operators generated $5.5 billion in Gross Operating Profits but spent $2 billion in maintenance and expansion capex projects between 2000 and 2004.  If you assume another $1.5 billion in taxes (35% tax rate on $5.5 billion less approximately $1 billion in depreciation), it implies the operators generated $4.0 billion in unlevered operating cash flow, but spent 50% of this to simply maintain stagnant cash flows.  The underlying dynamic that we observe in Atlantic City is that operators must continuously upgrade and improve properties in response to one another, and the capex spent is not accretive to either the industry or individual operators.  Operating cash flow simply declines less rapidly if you keep upgrading.  To understand this dynamic at even more granular level, we offer 2 specific examples:  Harrah’s and Aztar.

 

 

The table below lays out the EBITDA and capex spent by two of Harrah’s Atlantic City properties, Harrahs AC and Showboat.  On the surface, EBITDA growth looks quite strong at an average of +6% from 2001 to 2005 for both properties.  In the same period, the overall market grew almost 4% per year, so it makes sense that with operating leverage, Harrah’s EBITDA growth would be 6%.

 

 

 

However, Harrah’s spent significant amount in expansion capex to post these numbers.  The company spent almost $500 million in expansion projects at the 2 casinos in the period from 2001 to 2005.  We assume only 15% EBITDA ROIC for Harrah’s expansion projects in Atlantic City which implies the growth in EBITDA from 2001 to 2005 for the 2 casinos is entirely due to expansion projects.  If we strip out the $72 million contribution from the expansions, we find that EBITDA actually declined 1% per year over the 5 years.  If you listen to Harrah’s Q3 2006 analyst call, these properties continue to struggle.

 

 

The table below shows the results of Aztar’s expansion of its Tropicana property in Atlantic City. 

 

As the analysis shows, the Tropicana’s reported EBITDA declined modestly between 2001 and 2005.  However, between 2002 and 2004 Aztar spent $267 million to add a new hotel tower, a retail mall, and additional parking.  The project suffered a delay in opening from early 2004 to late 2004 because of a construction accident that occurred in October 2003.  The accident likely impacted earnings somewhat in 2003 and 2004.  However, in its first full year of operations in 2005 – well after the construction accident – the Tropicana’s EBITDA was only $119 million.  Further adjusting this number for the theoretical 15% EBITDA ROIC from the $267 million investment suggests $40 million of ‘acquired’ EBITDA.  Adjusting 2005 EBITDA for the ‘acquired’ EBITDA suggests an 11% annual decline in EBITDA over the five year period.

 

These 2 examples illustrate that Harrah’s and Aztar’s ‘expansion’ capex projects were more like ‘maintenance’ capex projects.  Harrah’s – considered one of the best and most experienced operators in the industry - had to spend 35% of its EBITDA from 2001 to 2005 in new projects to grow its overall EBITDA modestly.  Aztar had to spend almost 50% of EBITDA between 2001 and 2005 to simply keep EBITDA flat over the 5 year period. 

 

Aztar and Harrahs were both impacted by the opening of Borgata in summer 2003.  Borgata took market share away from Aztar and Harrah’s and essentially negated the impacted of the two companies own investment projects. 

 

The industry analysis and 2 case studies have very negative implications for Trump stock.   Proponents of Trump stock like VIC member Mark81 expect EBITDA for Trump to almost double from current levels to $320 million in 2009.  Baseline EBITDA is expected to grow to $270 million, as the company dramatically improves EBITDA margins from 16.5% in 2005 to 24% in 2009.  The $250 million hotel tower project at Trump’s Taj Mahal property is expected to generate a 20% EBITDA return on investment, suggesting an additional $50 million of EBITDA.

 

The problem with this is that it models Trump in isolation from historical industry realities and from $3 billion of upcoming investments – more supply in a compressed time-frame than we have ever seen in AC - by high-quality competitors Borgata, Harrahs, Caesars, and Pinnacle.  Note that this represents known capex so far.  We also know that Morgan Stanley will be constructing a new casino in AC in the next 2 years, Bader Field could be up for development, and of course neighboring markets like Pennsylvania will take share from Atlantic City.  We have shown empirically that individual operators experienced negative cash flow growth rates in the past 5 years, and were very negatively impacted by more modest competitor investments.  The $3 billion of investment in the next 2-3 years dwarfs what we have seen in the last 5 years, and will quickly render Trump assets obsolete. 

 

We believe that Trump’s experience will more likely resemble Aztar and Harrahs in 2001 - 2005.  Significant dollars will be spent on new hotel construction and other expansion capex projects, but this spending will resemble ‘maintenance’ capex as it did for Harrahs and Aztar.  In isolation, perhaps Jim Perry and his talented management team could improve margins and EBITDA, but historical data suggests no casino should be modeled in isolation from additional capacity coming into the market. 

 

Trump, because it has historically been starved of capex, essentially has a large, latent capex liability associated with it and must invest significantly in its properties to get them up to a similar standard to competitor properties.  A simple visit to Atlantic City demonstrates the stark differences in quality of these properties. 

 

 

We believe that Trump Entertainment provides a unique opportunity to capitalize on investor misperception of a competitive, capital-intensive industry with negative organic growth.  Investors are currently mesmerized by the idea that overall investment spending in 2007 and beyond will benefit Trump and Atlantic City as a whole.  We have empirically shown that Atlantic City has not demonstrated these characteristics.  It is over 2 years since Borgata opened and competitors have not seen improved organic cash flow growth as a spillover effect from Borgata.  The industry struggles to digest even a minor expansion at Borgata (see Boyd and Harrah’s Q3 2006 results).

 

When competition in 2H 2006 and beyond impacts Trump’s financials, the timeframe for the turnaround gets pushed back as a result of competition, and liquidity problems become more significant (Trump recently re-negotiated the definition of EBITDA for its covenants),  Trump will revert to its historical valuation.  Historically, regional gaming assets and Atlantic City assets have traded at 5x – 7x EBITDA.  The best performing assets like Borgata probably deserve a premium multiple.  A 7x EBITDA valuation assuming (a not so conservative) $225 million of EBITDA in 2007 implies a stock price of $8.40.  A more generous multiple of 8x 2007 EBITDA would imply a stock price of $13.80 – still far below the current price.  Note that a company like Harrahs with a highly diversified revenue mix, relatively low leverage, and talented management team, traded below 9x 2007 EBITDA before the private equity bid.  Trump deserves a discounted valuation to Harrahs.  Other investors have chosen to ascribe additional value to the hotel tower and potential new projects in Pennsylvania.  We do not believe those projects are significant sources of value because they require significant funding, compete with larger competitor projects, or have a relatively low probability of success.