This article is written in response to Vince Martin's "Caesars' Short Case Clearer, Simpler - And Stronger."
Martin's argument that "…the bear case remains startlingly simple; Caesars' assets are simply worth substantially less than its debt" is based on fundamental analysis of the company's perceived worth. Martin went on to write "Governor Christie's actions [legalizing online gambling in New Jersey] today don't change that fact; moving the interactive division to a minority-floated spin-off won't either. The only thing that has changed is the stock price; its recent move up simply makes a short sale more attractive." That was written on Thursday, after the price of Caesars (NASDAQ:CZR) had advanced 18% -- the day that Christie announced he would support a 10-year online gambling trial. Shares closed Thursday above $10 on the news. Keep in mind Martin first recommended CZR as a possible short candidate when it was trading at $8. The next day after the article was published, Caesars advanced $3.84, or 38%, to 13.91.
There are several points of Martin's original analysis that are based on faulty assumptions, in addition to the faults of fundamental analysis used entirely by itself. In addition, the composition of CZR stock makes it a poor short candidate to begin with, especially at the time his articles were published. The purpose of this article is to detail why Caesars should never have been considered as a short trade and to explain why fundamental analysis alone cannot be relied on to time and evaluate trades.
Let's look at the financials of Caesars Corporation. Caesars Corporation holds $21B in debt with equity of only $1B at the time of Mr. Martin's first short recommendation. That is debt of roughly $158.50 per share after subtracting for cash on hand. That is an absolutely enormous level of debt for a company to hold. It is no surprise then, that CZR has a relatively high beta of 2.5, since we know that the more debt a company carries, the more sensitive its share price is to changes in its profits or loss. The great thing about $158.50 in debt per share, however, is that as an investor I can wager a small amount of money, and not only potentially get an astronomical return, but furthermore, I am not held personally liable for any of this debt. Therefore, Caesars presents an attractive risk/reward opportunity from the long side given proper money management principles.
Now let's examine the composition of CZR stock. CZR stock has a float of 37.4M shares out of 125.3M shares outstanding. Roughly speaking, only 30% of all CZR stock is out on the public market. The vast remainder of the nonpublic float is held by Apollo Management subsidiary Hamlet Holdings. The problem with this is that the thinner the float, the more susceptible the stock is to wild gyrations, and the harder and more expensive the shares are to borrow. But that is only the beginning. A thin float can be potentially ruinous to the short investor for the simple reason that in the event of a positive catalyst, as occurred last week, shorts get squeezed with no daylight in sight. I am certain that a significant portion of the 64% two-day rise in CZR can be attributable to short-covering on behalf of short traders who were forced into covering. A small float exacerbates supply/demand imbalances, especially on the short side since these are initiated on margin.
If a highly-leveraged, thinly floated company was not enough to scare away even the most stubborn of bears in Caesars, then perhaps consider the short ratio and short float prior to Thursday. Of the 37.4M float, roughly 6.7M or 18% of the float was shorted. This is not an unusually high percentage of shares short, except when compared to the short ratio. Because CZR stock has a thin float, and therefore low daily volume turnover, the short ratio is a relatively high 12.5. The higher the short ratio, the greater the potential for upside movement; this is especially true if there is a positive catalyst.
The combination of a highly leveraged, high beta company in conjunction with a thin float and an already high level of short interest in the stock should have been a major warning sign for Mr. Martin to avoid short bets on CZR as a trading vehicle. This is to say nothing of the fact that the US gambling companies are not only breaking out of a trading range, but have shown Relative Strength to the broader S&P to the tune of about 30% since mid-August. Not to mention the fact that CZR had already completed a 70% decline from $15.74 to $4.52 since April 2012, and perhaps had indicated that the bear side was long in the tooth. CZR had recently broken out of a downtrend at the time of the "more attractive" short. By the time Caesars was considered as a short, the smart money was already counting their profits…
Dow Jones US Gambling Index Relative Strength
Listed below are some comments Mr. Martin made regarding the fundamental valuation and expectations of Caesars:
But Monday's rise was, simply put, asinine: the spin-off of Caesars Interactive (known as CIE) had been widely expected.
Indeed, the reason the spin-off was so predictable was because it was the only chance for Caesars' equity holders -- largely private equity companies who executed a doomed leveraged buyout in early 2008, among them famed, and struggling, hedge fund manager John Paulson -- to get any value out of the company.
Yet Caesars' enterprise value -- excluding the units to be spun off -- is somewhere in the range of 10x an EBITDA figure that, amazingly, gives the company credit for cost savings initiatives that have yet to be implemented.
A large part of the problem with Martin's analysis is that it was based on the fundamental value of Caesars at the present moment of his writing. For better or worse, the market prices assets with future expectations in mind. The fact that a spin-off was widely expected, the company's actions were predictable, and the price has discounted savings that are not currently in effect (but were expected) should have no bearing on the trade. In fact, it is because many of these factors were either expected or assigned a high probability of occurring that a short trade in Caesars makes even less sense. Trying to initiate a short trade by tying the value of EBITDA to an industry average is what is truly asinine, especially given the circumstances of Caesars and the known fact that short trades are highly speculative in nature.
And based on the sum of its parts, the spin-off's projected value appears to be even less than I projected in December, when I recommended a short with the stock trading below $8 per share.
The crux of the fault lies in valuing the entire company based on the one entity that is CIE. There is of course some value held by the Caesars name, existing operations, financing, and production currently in place, though of course pinpointing the actual dollar amount is a difficult task. But it is just this unknown that perhaps made Caesar a more interesting long than a short, an unknown that was backed by the technicals.
But there's not substantial room for additional growth beyond an unexpected federal legalization bill (which will include state-level opt-in or opt-out provisions) or a similarly surprising acceleration of the state-by-state legalization process, which has seen only Nevada, Delaware, and now New Jersey legalize online gambling.
The statement above goes to show that not only can the unexpected by expected, but that factors unknowable can be expected to come into play at any point. Did Mr. Martin take into account that Christie could legalize online gambling in New Jersey? I'm not sure, and I'm not sure that the public could have realistically assessed the possibility, but it is possible a select few did know for certain. And if they did know, then maybe they began buying some shares of Caesars. Or maybe the market itself began to come to this realization on its own, and savvy investors snapped up some Caesars given this perhaps unlikely though potentially highly profitable outcome. And all of sudden the downtrend trend in CZR is broken, and an accumulation pattern takes hold, and demand takes over supply in the price charts. This is Technical Analysis; this is food for thought.
Beware of "startlingly simple" cases for initiating positions, as these rarely are as simple as they seem on the surface. In addition to the fundamental case for or against a position, one should always examine the investment vehicle itself as well as the technicals. Despite what Mr. Martin saw as compelling cases for the bear side in CZR, had he inspected the vehicle and technicals he would have seen an unfavorable risk/reward on the bear side, with the potential for a nasty move to the upside. Look at the chart. If it appears as though the supply/demand balance is changing, perhaps there is a reason - a reason unknown to the general public. The time to short CZR would have been shortly after the IPO around 15, and not after it had already lost more than two-thirds of its value. In this case I have demonstrated why CZR was a poor short vehicle at the time, and why the timing itself was simply not conducive. As always, remember that the use of Technical Analysis provides statistics of probability and should never be construed as predictive ability or market foresight, nor taken as a statement of certainty.