By Chad Mollman
Although Caesars Entertainment (CZR) appears to be reasonably valued, we view an investment as speculative and we have a negative outlook. The company has no economic moat and faces intensifying competition in the regional domestic casino industry, it has no meaningful exposure to the attractive Asia casino market, and it carries an excessive amount of debt on the balance sheet.
Caesars Faces Intensifying Competition in the U.S.
We have a negative long-term outlook for the U.S. casino industry and view the market as mature, saturated, and highly cyclical. In contrast to large gaming peers Las Vegas Sands (LVS), Wynn Resorts (WYNN), and MGM Resorts International (MGM), which generate a significant percentage of their revenue and cash flow from Asia, Caesars derives more than 95% of revenue and cash flow from the U.S. market. Until the beginning of the 1990s, a restrictive casino licensing environment in the United States provided casino operators with a substantial barrier to entry, and the regional commercial casino market grew at a compound annual rate of more than 24% from 1990 to 2007, as regional casinos that opened outside Las Vegas and Atlantic City capitalized on consumers' desire to gamble within driving distance of their homes. Caesars (then named Harrah's) took a lead in exploiting the growth opportunity and benefited from many years of industry conditions in which demand outstripped supply. During the industry's expansion phase, competition was often limited when the company first opened a casino in a new market. During the 1990s and early 2000s, it was not unusual for regional casino operators to generate returns on invested capital in excess of 15%.
Over the course of the past two decades, though, there has been a proliferation of casino licenses, with the U.S. now having more than 900 commercial or Indian-owned gaming facilities in more than 30 states, and commercial casinos in more than 20 states. The "Starbucking" of the American casino industry has created a competitive environment in which Caesars lacks an economic moat, in our view, as evidenced by the company generating returns on invested capital that averaged 2% the past several years.
With state governments under significant pressure to raise tax revenue to reduce state budget deficits, and new casinos an attractive source of tax revenue, we do not expect the intensifying competition in the industry to mitigate anytime soon. Ohio opened its first commercial casino in 2012, with Massachusetts recently passing legislation legalizing commercial casinos, and we expect other large states, such as Texas and Florida, to eventually legalize commercial casinos. Intensifying competition led Caesars' regional casinos, which generate approximately 60% of sales, to experience revenue declines of 4.2% in 2010, 4.8% in 2011, and 2.7% for the first nine months of 2012.
Las Vegas (34% of 2011 sales) is the sole region in which Caesars does not face intensifying competition. Following an approximately 15% increase in hotel rooms on the Las Vegas Strip in 2007-10 that led to depressed room rates for the company and a more than 25% decline in revenue for the company's Las Vegas operations, Caesars has benefited from a modest recovery in the Las Vegas market. Revenue for the company's Las Vegas casinos is on track to reach $3 billion in 2012, a more than 13% increase from trough revenue of $2.7 billion in 2009. The financial crisis ground all large casino projects in Las Vegas to a halt, and our current outlook is for no new large casinos to open on the Las Vegas Strip the next several years. Absent a recession, we expect the stabilization in the number of gaming positions and hotel rooms on the Strip to bode well for Caesars to increase hotel room rates and revenue per gaming position in the next several years. However, the recovery in the Las Vegas market slowed considerably in 2012, with Caesars increasing revenue there by only 1.8% for the first nine months of 2012, following 6.3% growth in 2011. Our current base-case outlook is for the company to increase revenue in Las Vegas by only 1.5% in 2013, with downside risk of revenue contracting in the event of a recession.
Caesars Has Almost No Presence in the Attractive Asia Gaming Market
We view the Asia casino market as significantly more attractive than the U.S. market because of stronger growth prospects (a 30%-plus compound annual growth rate the past five years), a more restrictive licensing environment, and significantly higher returns on invested capital, with many Asian casino operators generating ROICs of 20% or more in contrast to single-digit ROICs typical for domestic casino operators.
In one of the greatest strategic blunders in the history of the casino industry, in the mid-2000s, Caesars CEO Gary Loveman rejected Wynn Resorts CEO Steve Wynn's offer to sublicense to Caesars a gaming license in the Macau market, with Loveman deeming the $900 million subconcession fee as excessively high. Wynn instead granted the sublicense to Melco Crown (MPEL), which has since built two large casinos in China, and currently has a market capitalization of nearly $11 billion. Recognizing the lost opportunity, Loveman subsequently paid $578 million to acquire a golf course in Macau, believing that ownership of land would position Caesars to receive a casino license there. The Macau government's policy, though, has been to only grant land concessions to build new casinos to the existing six license operators, and we do not expect any near-term changes. In our view, Caesars is unlikely to receive a license to operate a casino in Macau in this decade.
Caesars also failed in a bid for a casino license in Singapore, which is on track to surpass the Las Vegas Strip as the world's second-largest gaming market this year, behind Macau. The Singapore market is a duopoly, with two casinos and gaming regulations that do not allow for a third casino until 2017. In our view, Caesars is not particularly well-positioned to receive a casino license in Singapore or other Asian countries that may legalize casino gambling, such as Japan, as it lacks a proven record internationally in operating large integrated resorts that feature gambling, hotel, entertainment, retail, and convention operations. Las Vegas Sands, Genting, and Wynn Resorts, which have proven records of operating successful integrated resorts in international markets, are better positioned to receive licenses to operate casinos in new international markets, in our view. Caesars currently generates less than 5% of its revenue from international markets.
Mountain of Debt Creates Significant Investment Risk
Apollo's and TPG's leveraged buyout of Caesars in 2008 resulted in an excessive amount of debt on the balance sheet, and Caesars has made only minimal progress in paying down debt since the LBO was completed. Total debt stood at $20.8 billion as of September, and total debt/EBITDA is currently at approximately 11 times. Through the first nine months of 2012, the company had an EBITDA/cash interest coverage ratio of only 1.2 times. We expect the company to generate less than $150 million in free cash flow (cash flow from operations less capital expenditures) in 2013 and 2014, and we expect, absent large asset sales or a dilutive secondary common stock offering, the company to make only minimal progress in paying down debt in 2013 and 2014. On a positive note, management has done an excellent job of extending the maturities on almost all of its debt to 2015 and beyond. The company has a five-year Cash Flow Cushion (cash and cash generated divided by cash commitments) of only 41.6%. In our view, Caesars can survive a mild recession in the U.S., but a severe recession that causes EBITDA to decline 20% or more is likely to cause the company to be in violation of covenants and unable to make all interest expense payments, leading to a restructuring or potentially a Chapter 11 filing.
We View Caesars as a Speculative Investment With a Wide Range of Outcomes
Caesars currently has a market capitalization of about $930 million, relative to more than $20.7 billion in debt; just a 5% increase in the enterprise value for the company would lead to a more than doubling of the market capitalization. While we have a negative outlook for the company and think there is the potential for the stock to decline further if the economy goes into a recession, we think a short position (as of November, 16.7% of the company's float was held by short sellers) could move against investors.
Potential positive catalysts for the stock include a significant improvement in economic conditions, leading to a significant improvement in free cash flow and the company deleveraging, and passage of online gaming legislation. In our upside financial model, in which we project revenue to grow at a 5.1% annual rate (compared with 3% in our base case) for our forecast period of 2012-21, with the company generating meaningful free cash flow, our fair value estimate is $37 per share, relative to our fair value estimate of $8 per share in our base case. An additional potential catalyst for the stock is legalization of online poker at the state or federal level. While we do not foresee any legislation being passed at the federal level in 2013, several states have legislation pending to legalize online poker, and while we think that passage of state legislation would not lead to a material increase in revenue and EBITDA for the company, we think there is the potential for state legislation to lead to increased speculation for the passage of federal legislation, leading to a rise in the stock price.