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Hedge fund manager, special situations, small-cap, micro-cap
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When it comes to shorting a stock my method is quite simple: I identify a fragile company and make a bet on its eventual collapse. Now, I do not believe in making predictions. I am not trying to predict the exact date when a particular company will go bankrupt or when its stock price will crash. I am also not trying to predict which remote event will cause this crash. Predicting these things is impossible. I only know one thing for certain, what is fragile will eventually break; and, luckily, we can easily tell what is fragile.

In this article I will talk about a company called Caesars Entertainment (CZR). Caesars has all the attributes of a fragile stock - it is grossly overvalued, has a terrible balance sheet and deteriorating free cash flow. I believe these things make this stock the perfect short candidate.

Mountain of Debt Creates Significant Investment Risk

Caesars has one of the worst balance sheets I have ever seen. In fact, it seems as if the only thing this company is good at is taking on more debt. There is simply no margin of safety built in. Even a small setback could cause massive problems for the company and force it to declare bankruptcy.

According to the most recent 10-Q (March 31, 2013), the company had just under $2.1 billion in cash, plus an additional $367 million in restricted cash (comprised of current and non-current portions). However, the majority of the company's assets consisted of property and equipment of $15.7 billion (57 percent of total assets) and intangible assets of $7.1 billion (26 percent of total assets).

It really does not take much analysis to realize that Caesars is a highly leveraged company. For example, it has total debt of $21.3 billion, which makes up more than three fourths of total liabilities. Things get even worse when we take a look at the off-balance sheet obligations. The company has operating leases which should be capitalized and treated as debt. As of March 2013, these capitalized operating leases totaled approximately $1.6 billion. Additionally, the company has another $1.5 billion in other obligations and commitments that are also kept off-the-balance sheet. These include things such as purchase order obligations, construction commitments, payments to tribes and various other obligations and commitments.

Perhaps things would not be so bad if Caesars was cash flow positive, however, as we are about to see, this is not the case. The company has been posting enormous losses, which has forced it to add more debt to its balance sheet (making it even more fragile).

Deteriorating Free Cash Flow

The casino business is very capital intensive, so it should come as no surprise that Caesars is not a very profitable company. As can be clearly seen in the table below, the company has burned through billions in cash over the last few years:


(Click to enlarge)

Sources: 2012 10-K and March 2013 10-Q

Free cash flow has been negative every year and is continuing to deteriorate. Over the last twelve months alone the company burned through more than $775 million in cash. In order for the company to make up for these enormous losses, it will be forced to take on additional debt (increasing risk) and sell additional stock (causing further dilution).

Ridiculous Valuation Makes This a Scary Investment

Caesars currently has a market capitalization of about $1.9 billion and an enterprise value of $22.7 billion (including capitalized operating leases). The company is burning through hundreds of million in cash every year, and there are signs that these enormous losses will continue in the future. Since the company could obviously go bankrupt within the next few years, the only way it can be valued is to see what it could be sold for in liquidation.

At the end of March 2013, Caesars had a negative book value of $560 million (including non-controlling interests). However, the company's true book value is far worse than that. For example, the company has $7.1 billion in intangible assets (about half of it goodwill), so the tangible book value is negative $7.6 billion. But things get worse still! As I mentioned earlier, most of the company's assets are made up of property and equipment - approximately $15.7 billion. However, in liquidation these assets certainly would not go for this amount. Actually, if they could be sold for 50 percent of this amount it would be a miracle. In reality, Caesars true tangible book value deficit exceeds $15 billion. Investors holding shares in this company will end up getting nothing, because the company cannot even pay its bondholders.

Betting Against the House

As should be painfully obvious by now, Caesars is a worthless company that will almost certainly go bankrupt within a few years. In my opinion, even holding the company's bonds is risky. In truth, the only safe investment is put options. I would not directly short this stock because 11 million shares have already been sold short (30 percent of float), which could make it risky if there is good news that forces shorts to cover (causing the share price to rise). However, over the long term I believe that investors will be rewarded if they place bets against this stock (preferably using options). It will only take one small setback for the company to cause a massive crash in its stock price and cause those option premiums to go through the roof.

Source: Betting Against Caesars Entertainment