Description
I recommend selling DJTCQ. Despite trading around $2.00, I believe this bankrupt hotel and casino operator concentrated in Atlantic City will be worth about $0.015 within 18 months.
99% of the value of DJTCQ is in 172 1-year warrants that each existing equity holder other than Trump will receive per share by the emergence date in late q1fy05 or early q2fy05, as suggested by dates stated in 8K filed 10/21/04 (p.8).
As I explain below, the current stock price implies a gargantuan premium for the warrants or call options that existing holders will receive. The current stock price implies that for a stock trading at $15, for example, a one year at the money call option with a $15 strike should cost $11.50.
Details of the Recap:
On 10/21/04, DJTCQ issued an 8K detailing a recapitalization (a pre-packaged bankruptcy) where the bondholders, most of whom recovered 93% of par, took a controlling stake in the company. Trump, the current majority owner (holding preferred and common shares equivalent to 14.4m shares), will invest $55m in the company and have a 25% stake worth about $120m. His previous 56% stake was worth $50m.
Per the 8K, after the recap, existing equity holders (other than Trump) will have their 20 million shares represent 0.05% of the company. If 20m represents 0.05% of total shares, then 100% of total shares is 40 billion. In other words, post-recap DJTCQ will have 40 BILLION shares outstanding.
With 40 billion shares out and the current stock price of $2.00, one might think that DJTC will have a market cap of about $80 billion. This interpretation ignores, however, the one-year term warrants that will be issued to existing equity holders.
The 20m non-Trump shares will have the right to purchase 8.6% of the 40bn shares, or about 3.4bn shares at $0.0145.
To do the math exactly, take the 19.94m shares of DJTCQ not owned by Trump (Trump is being treated differently) and divide by 0.05%, which equals 39.89bn shares. Shareholders will be given warrants (same as call options) to purchase 8.6% of 39.89, or 3.426bn shares, for one year after emergence at a $0.01455 strike. In other words, the 19.94m non-Trump shares will be given one-year call options to purchase 3.426bn shares, eg each non-Trump share will be given one-year call options to purchase 172 shares (take 3.426bn and divide by 19.94m to get 172). Though these call options will be given for free by the bondholders to the existing equity holders, exercising them would require $50m payment by existing equity holders to the bondholders (not the company).
The 8K says that the non-Trump existing equity holders will be able to purchase the 3.426bn at the same price as Trump and the bondholders, who will be buying the shares at $0.01455 with 40bn shares out. To derive the $0.01455 price, take the $580m market cap and divide by 40bn shares.
Therefore, the strike price of the call options will equal $0.01455 with 40bn shares out. This strike price can be confirmed by taking the $50m payment required for exercise and dividing by 3.426bn shares.
In sum, the plan implies existing non-Trump equity holders will be given 172 one-year call options (formally called a warrant with one year term beginning by June 30, 2005 at the latest) with a strike price of $.01455 (assuming 40bn shares).
Therefore, the value of an existing equity holders’ share, e.g. the value of one share of DJTCQ stock, is the sum of the value of a DJTCQ diluted share (e.g. diluted by the recap) plus the value of the 172 warrants (given for free by the bondholders to the equity holders) per share.
So what is the value of each of these pieces?
The first piece, namely a single post-dilution DJTCQ stock excluding the warrants will be worth $.01455. This value can be derived by taking the $582m market stated in the 8K detailing the recap, and dividing it by 40 billion shares.
The second piece, the value of the warrants, has two parts: time value and intrinsic value.
The Time Value of the Warrants:
If one knows the strike of a call option, one can derive the time value by using comparables.
As I have explained, the warrants will have a strike price of $0.01455.
Therefore, the warrants will be at the money if the stock trades where the 8K suggests it should trade, namely $0.01455, again the $582m market cap divided by 40bn shares.
The time value of the warrant: The time value of the warrant can be quantified by looking at similar one-year call options that are at the money. The comparables that have LEAPS are CZR, HET, MBG, MGG, and STN. One can also extrapolate the value of LEAPS of DJTCQ’s small cap comps, which do not have LEAPS. This extrapolation can be done by deriving a ratio that equals the Jan 2006 calls divided by May or June 2005 calls and applying that ratio to the price of June or March 2005 leaps of DJTC’s small cap comps: AGY, ASCA, AXR, BYD, and ISLE.
This analysis suggests that a call option at the money with a one-year term will be 10% of the strike price. Thus, 10% of $0.01455, or $0.001455, is the time value per warrant. Given that each share gets 172 warrants, take $0.001455 times 172, which is about $0.26 value per DJTCQ share. This value will equal $0.00 by June 2006 as time value decays.
The intrinsic value:
As I explain below, I do not think that these warrants will have intrinsic value because I expect EBITDA to continue declining in 2005-6, which will make even a $14.55 stock price unlikely.
A preview of my argument: In the 8k detailing the recap, the company arrives at a $14.55 fair value by using EBITDA of $240-$260 and placing a 7.6x-8.4x EBITDA multiple. I think these assumptions are wrong because EBITDA in 2004 will likely be below $240 based on trends in first 9 months and will decline further in 2005-6 due to increased competition. Moreover, as it declines, so will the multiple, probably to 6-7x. If DJTCQ gets a 7x EBITDA multiple and EBITDA declines to near $200m, the post-reorg $14.55 stock will be worth $0.
The reasons for my bearish view are:
1. the continued EBITDA decline,
2. the high current debt level going higher
3. the multiples of comps are lower
4. the distortion of EBITDA (explained below) that overstates EBITDA relative to comps,
5. on a free cash flow to equity basis, DJTCQ is even more expensive absolutely and relatively than on an EBITDA basis. Moreover, FCF basis is the appropriate metric because it cannot be distorted and thus is comparable across the industry. EBITDA is severely distorted by capitalization of expenses.
6. the concentration of 90%+ of EBITDA in Atlantic City and resulting extraordinary vulnerability to new competition nearby,
7. the lack of future EBITDA visibility, eg management (as evidenced by 8K) cannot predict profitability even in near-term and they do not give guidance.
8. the dilapidated properties, which will take 18-24 months to renovate
9. and management’s poor track-record.
DJTCQ’s comps (excluding outlier STN) trade at 6-8.5x Enterprise Value/EBITDA. These comps are growing EBITDA 10-20% while DJTCQ’s EBITDA has declined 2 years straight. These comps also have far less risk from new competition because they have more diversified hotel/casino portfolios. DJTCQ’s concentration in Atlantic City (more than 90% of EBITDA comes from Atlantic City) leaves it very vulnerable to recent legalization of slots in PA and increased competition in New York.
The best-in-class hotel and casino operations such as HET, MBG, MGM, and CZR, trade at 8-9x 2004 EBITDA and 7.3-8.4x 2005 EBITDA. (Station Casinos trades at 15.7x 2004 EBITDA and 12x 2005 EBITDA and 10x 2006 EBITDA. Per UBS report on STN valuation dated 12/1/04, STN’s owned casino operations receive a 9x 2005 EBITDA multiple; the rest of value comes from undeveloped land and managing casino contracts, the latter being a very small part of DJTCQ EBITDA. Massive insider-selling suggest STN is overvalued). DJTCQ however does not operate as a best-in-class operator as it faces much heavier competition, especially from PA, due to less diversification in its property portfolio and has generated lower returns to shareholders.
According to DJTCQ management, 40% of the customers of Atlantic City come from Pennsylvania and 15% from New York. These developments are discussed in DJTCQ’s 10Qs and 10Ks.
According to an article entitled “A.C. Casinos set sights on Pennsylvania” in the New Jersey Star-Ledger on June 25, 2004:
“Several Atlantic City casino operators are getting ready to jump in on the action in Pennsylvania, where legislation could allow an initial 37,000 slot machines at venues throughout the Keystone State -- with more to come.
Pennsylvania could soon have more slot machines than New Jersey, slicing anywhere from 5 percent to 10 percent from Atlantic City's $4.5 billion gambling market, analysts said. At the same time, New York racetracks are gearing up to open their own slot parlors, and Native American casinos are being proposed in the Catskills.
"It's definitely going to be negative," Susquehanna Financial Group analyst Eric Hausler said of the Pennsylvania legislation. "It's hard to quantify now because we don't yet know the nature and scale and when they'll be online.
"But the pressure is going to be on Atlantic City, and the operators are going to have to position themselves away from their reliance on slot customers."
The proposed legislation in Pennsylvania calls for 3,000 video slot machines at 12 venues, a mixture of racetracks and stand-alone slot parlors, with the potential to go up to 5,000 machines at each, said Jim Cawley, chief of staff for Pennsylvania State Sen. Tommy Tomlinson. In addition, two resorts would be allowed 500 slots each.
Philadelphia alone eventually will be a $1-2bn market with 15,000 slots. Harrisburg, very near Atlantic City, will probably have 3000-3500 slots. The Taj, Marina, and Plaza (the 3 in Atlantic City) have about 10,000 slots total as of September 30, 2004 and these accounted for 77% of total revenue net of promotional allowances in first 9 months of FY04. The public players that will install slots in PA include CZR/HET, PENN, MECA, and ISLE. There are also private players such as the Centaur group.
Why the $2.00 stock price is ridiculous:
If one shorts 1000 DJTCQ today at $2.00 and there is a 1000:1 reverse split, one will be short 1 share at $2000. As I have explained the value of each share without warrants before a reverse split is $0.01455. After a 1000:1 reverse split, the value is $14.55. By being short one share of DJTCQ, one is also short 172 warrants or call options with a strike of $14.55, assuming a 1000:1 reverse split. The value of these 172 warrants is $2000-$14.55 or $1985.45 or about $11.54 per warrant. Given that the strike is $14.55, the stock after emergence would have to trade to a little over $26 (assuming a 1000:1 reverse) for one to break-even.
At $26, DJTCQ would have an EV of about $2.5bn because net debt now is a little over $1.4bn. In 2004, DJTCQ EBITDA should be $240m, so DJTCQ is trading at about 11x 2004E EBITDA. Moreover, debt will rise in 2005 because of $300-$500m in renovations funded via debt. These renovations will take 18-24 months and they will begin in early to mid 2005, so no EBITDA benefit until late 2006/early 2007. In fact, 2005 EBITDA should drop from 2004 EBITDA because the DJTCQ Atlantic City properties will lose more share to existing players like the Borgata, who have been expanding rather than underspending in capex (as has DJTCQ) and thus look/feel better than DJTCQ’s properties. The Borgata and Tropicana are expanding their casinos and hotel room numbers.
2006 could be even worse than 2005 because by early 2006 much of the new competition from Pennsylvania will be operational and 2007 will see large expansion of slots in PA as probably only half the slots out of all possible slots will be installed in 2006.
Therefore, I think 2005 EBITDA will be down relative to 2004 because of expansion by existing players and the absence of the benefit of renovations. My research suggests 2006 will decline by at least 10% to near $200m because of PA competition.
If one believes that 2006 EBITDA will approach $200m, the current EV of $2.5bn/2006 EBITDA will approach 12.5x. The EV will likely be greater than $2.5bn, however, given DJTCQ’s raising $300-$500m new debt to renovate its properties.
One might argue that I am not counting the benefit of spending this debt. If one assumes $500m of debt spent over 2005-6, of which $150m will be repaid via cash flow from operations between 2005-6, debt will increase by $350m to $1.75bn by 2006 end.
The incremental EBITDA generated by this capex is unclear but to stress-test my argument, let’s say its $100m, such that capex generates a 20% EBITDA return. Then at 2006 end, the EV would be $2.8bn (using $2.00 current stock price to get a bit over $1bn market cap).
Even if one takes my 2006E EBITDA of $200m and adds $100m to get a 2007 EBITDA of $300m, one is currently paying over 9x 2007 EBITDA with the stock at $2.00.
Futhermore, my assumptions above are aggressively beneficial to company. The $150m in cash flow from operations assumes no taxes and the company will be a tax payer. The $150m assumes $235m EBITDA in 2005 and $220m in 2006, both of which probably will be lower. For 2005, my aggressive estimate of free cash flow from operations is $83m, which is the $235m in EBITDA minus $112 in interest expense (8.5% on $1.2bn in debt and $150m new term notes at 7%, which is my guess). The capex will be funded out of debt, so the only other cash outflows will be $12m for capital lease obligations, $14m for CRDA, and $14m for interest on new debt raised via credit lines, I assumed $200m at 7%. 2006 is the same except for EBITDA declines to $220, so free cash flow that can be used to repay debt will be $68m.
If we compare DJTCQ to comps on a normalized free cash flow basis, it is even more expensive than on an EBITDA basis. Normalized free cash flow from 2005-2006 would be negative because the company has stated that it needs to spend $100-$120m annually in capex to not lose share. In the scenarios above, the capex is funded out of debt rather than from cash flow from operations.
Though I have used 20% EBITDA returns in my analysis of 2005-2007, the historical EBITDA return on every $1 of capex is closer to 13.5%. Moreover, a bondholder, in article entitled “Trump Still the Master of the Art of Bankruptcy” (dated Oct 21, 2004) states that “a new tower at the Taj, at a cost of around $200m could increase cashflow by $25 to $35m.” The bondholder suggests the incremental EBITDA return is 12.5% to 17.5%. 20% EBITDA return is also at the high-end of the industry.
Three other points supporting an EBITDA multiple near the low end of range:
EBITDA as derived by DJTC mgmt (per their news releases) is higher than the EBITDA derived by using their SEC filings by $5-7m in 2003 and 2004. The reason is that DJTC adds back non-cash CRDA write-downs as part of EBITDA whereas this is not added back in the SEC filings. Such write-downs are not added back in the SEC filings because the CRDA write-downs themselves are non-cash but equal an annual cash outflow that is essentially an expense. Giving DJTC the benefit of the doubt, I have used DJTC’s mgmt EBITDA definition in my analysis though in economic reality the CRDA write-downs should not be added back to EBITDA because they represent yearly cash outflows.
The guidance for 2004 EBITDA in the 8K is too high. In the 8K, the company, which usually gives no guidance, had to provide an EBITDA estimate for 2004 to justify the enterprise value the deal implied. The company guided to $240-$260. They will miss this guidance and likely hit $230 because last year EBITDA was $246 and they are down $11m relative to last year in the first 9 months. Missing guidance so badly, eg they issued this guidance well into the fourth quarter, indicates the lack of visibility.
Not all EBITDA is created equal; the real equalizer is Free Cash Flow to equity. DJTCQ and others distort their EBITDA by capitalizing CRDA and many of their leases, which raises EBITDA relative to treating CRDA as an expense and classifying all leases as operating leases. A capital lease hits the income statement in D&A and Interest expense whereas an operating lease hits the rental expense line, thus detracting from EBITDA in the latter but not the former. On a FCF basis, DJTCQ is even more expensive than on an EBITDA basis especially now as they pay taxes when they emerge due to change in control, eg NOL will be restricted.
Miscellaneous:
The warrants will expire by June 30, 2006, at the latest, eg one year ahead of the latest possible emergence date. These will likely be non-detachable warrants, so there will be two types of stock after emergence, those that have warrants and those that do not. That difference will last one year, when the warrants expire.
Conclusion:
Even if people look at 2007 EBITDA during 1HFY06 and expect $300m due to renovations and put a 9x on it, you get an EV of $2.7bn, which is less than the EV of $2.8bn at 2006 end that I projected above using aggressive assumptions beneficial to the company. I do not think investors will feel confident about 2007 because of the bad results in 2006 due to increased competition and because the company gives no guidance.
Risks: disclosure statement coming out Dec 15 with projections for next 5 years
Rise in consumer spending on gambling
Catalyst
people realizing the value implied by the stock
emergence from bankruptcy
continuation of bad results