By Howard Jay Klein
Turn out the lights
The party's over
They say that
All good things must end
Call it tonight
The party's over
And tomorrow starts
The same old thing again
We've been fans of MGM Resorts International (NYSE:MGM) for nearly all of last year. We've seen the shares, even in the low $20s, as being undervalued, given the company's dominant share of the slowly, but surely recovering Las Vegas market. Pooled around the $20s, we saw a case for the shares to be valued much higher, as much as $35.
However, we always tempered our bullish view about what we perceived as a fuzzy corporate strategy going forward that was not aimed at unlocking the value we saw in the asset base. We were not alone. A small New York based hedge fund challenged management to consider a REIT conversion early last year. MGM then rejected the idea and brought out big asset evaluation guns to shoot down the assumptions of their challenge.
But MGM did react. First, it announced a Profit Growth Plan initiative to improve EBITDA. We found that response tepid because it was a) Something of an admission that operating margins, even in an improving Vegas environment, were not that stellar, and b) That it was little more than a cost slashing effort disguised as a big strategic initiative. In management, cost controls are daily bread, not the cake of special initiatives.
Then after having had rejected the REIT idea, MGM did a volte face, and embraced the idea when in October it announced that it would indeed move on the REIT front by forming a spin-off public company to be called MGM Growth Properties, Inc. In general, we never thought REITs were a smart direction for gaming companies and several analysts supported our view at the time.
However, as the structure MGM proposed goes, we thought the plan, which would keep 70% of the REIT equity lodged in the parent, better than anything we've seen. MGP had the fundamentally sound goal of unloading $4 billion of the company's $12 billion-plus in debt on buyers of a new IPO. This was clearly a caveat emptor issuance. However, the MGM properties to be included in the proposed deal perked our skeptical inclination that the company was defector offing a diverse portfolio of good to so-so properties while keeping the glittering gems close to home.
The IPO will contain: Mandalay Bay, The Mirage, Monte Carlo, New York, New York, Luxor, Excalibur, The Park in Las Vegas. Plus regional properties MGM Detroit, and the Beau Rivage and Gold Strike in Mississippi. It will retain full ownership of MGM Grand, Bellagio, Circus Circus, CityCenter, certain unimproved tracts of land and its two new development properties in Massachusetts and Maryland. The REIT properties will control 24,000 rooms.
During last week's earnings call, CEO James J. Murren told analysts that the company was moving ahead with the SEC and IRS, hoping to finish the transaction by the end of Q1. In our view, if a market correction continues and in fact worsens by then, a severe pricing problem with the IPO might arise, unlocking far less shareholder value than what had originally been envisioned. And that might cause a further delay in the IPO and send more confusing signals to the market, which in turn could hammer the new issue below fair valuations.
Our concern here is will the emerging, combined trading price of MGM and MGM Growth Properties, Inc. at issuance unlock sufficient shareholder value to have made the entire enterprise moot? At this writing, MGM sits at $18 a share. During its 52-week trading range, it had reached a high of $24. That's what the market had valued the company portfolio and its earnings engine in Toto.
Its Q4 earnings call last week further dashed market expectations. Revenue was down 8.1% to $2.19 billion and the net loss had more than doubled to $781.5 million to -($1.38) a share. The terrible performance was principally due to a $1.5 billion write down of MGM China, the 51% owned company operation in Macau. The market had expected a plus 8 cents a share number.
The Macau property underperformed its market peers on revenue, EBITDA and a stunning 57% decline in VIP drop, far worse than expected. Domestically, MGM did much better. Despite a 5% fall in Q4 gaming revenue, overall revenue was up 2%; with rooms leading the way with a sparkling 10% increase. Also the company saw improvement in its 50% owned City Center resort, led by a strong table games hold at Aria. Yet in his comments, CEO James J. Murren agreed with his Macau competitors Steve Wynn and Sheldon Adelson that the Macau market there was "stabilizing" and agreed that he thought the worst was over.
However, the company's decision to postpone its Macau Cotai opening a quarter is far more telling than would first appear. MGM is committed to the tune of $3 billion already. Yet competitors Wynn and Las Vegas Sands are moving full steam ahead, clearly eager to convert massive chunks of debt into operating EBITDA as soon as possible. So this presses the question of what is the strategic rationale that MGM is still hacking its way through toward both domestically and in Macau.
With continued strong performance, mostly coming out of Las Vegas non-gaming revenue streams linked to the promise of even more growth when its new 20,000 seat arena opens this year, we see a different company. It's an MGM that envisions itself in the larger context of the resort/ hotel entertainment business. In his remarks, CEO Murren repeatedly compares Las Vegas to New York, Houston, Chicago and Orlando as tourist/convention destinations, a rather poor analogy when you consider that none of these other destinations offer integrated gaming resorts. Murren also recently cited the exorbitant daily parking fees commanded by hotels and entertainment zones in those cities as likewise a business model for Las Vegas, albeit his proposed fees would debut at a much more affordable scale. As we've observed before, more power to him if this pioneering effort to charge for parking works. He'll be entitled to the thanks of his competitors for his daring cross of that Rubicon.
If on the other hand there is strong resistance to that policy by overnight tourists from the key feeder western states, it telegraphs a question mark about MGM's total business model worth exploring for investors.
It's a model we believe is based on these assumptions:
1.That Las Vegas will continue its recovery from recession woes with hefty increases in total visitation, averaged up room rates, gaming revenues inching back to 2007 levels and new skill-based slots aimed at building casino revenue from the millennial demo. As controller of the town's largest room inventory and most diverse entertainment offerings, MGM should be presumed to most benefit from those developments. Yet, we are still bothered by the what-ifs that could intrude:
a) If we do fall into recession this year, will a decline in visitation, gaming revenues and hotel rates leave MGM over-dependent on Las Vegas at a time when its peer competitors may be benefiting from reasonable upward climb in Macau? It could offset a possible Vegas slowdown for Wynn (NASDAQ:WYNN) or Las Vegas Sands (NYSE:LVS). It is the ironic reverse of this trend that in the past has buoyed analyst support for MGM shares.
b) The debut of its two new east coast entries in Springfield, Massachusetts and National Harbor, Maryland will become immediate contributors to EBITDA, further reducing MGM's dependence on Macau. We're on record as having based some of our previous enthusiasm for MGM shares in the low $20s on our expectation that its National Harbor development was excellently sited, well planned and executed. It's a clear winner in the waiting room.
However, offset against that plus, we remain bearish about the company's other new development in Springfield, Massachusetts, which we believe faces considerable headwinds from a beggar-thy-neighbor border tribal property aimed at blunting the new MGM efforts to steal market share from the core Hartford-New Haven. That area is now very much part of the core feeder group of the two Connecticut tribal properties. Furthermore, the slot parlor opened earlier this year by Penn National near Boston began well enough, but is slow into a post novelty monthly win average. The difference between it and the MGM development is that the Penn National property has no pretenses about being anything but a slot parlor with basic food amenities not a full stroke resort. And of course, hovering to pounce sometime in 2018 is the Wynn integrated resort, which could threaten to engulf the entire New England market with a mega glamorous product. MGM has already rescaled its Springfield plan downward, triggering the consternation of local officials there.
Does corporate strategy assume that by Q1 2017 the Macau market will have risen from the ashes sufficiently to provide a much more welcoming revenue base to the debut of the MGM Cotai project than it would appear to offer shorter term? This could well be the case, but there are headwinds there as well. By that time both Wynn Palace and Sands Parisian will have both opened and wolfed down a chunk of the recovery upside. Given that possibility, could late-to-the-party MGM then have a $3 billion question mark on its hands?
If it does not share in a Macau recovery, the company could face increased pressure on its debt load and possibility be forced to consider leaving the jurisdiction entirely by selling or spinning off MGM China?
Conclusion: We can't read the company's mind nor do we pretend to. Our view is that quite simply by its moves and lack of moves to trim its portfolio, MGM's business model is this: We are a US operator of integrated resorts that offer entertainment, tourist and convention venues and as a shrinking amenity to the whole, gaming. We will be the major beneficiary of continued strong recovery in Las Vegas and be open to opportunities in other parts of the US. (Most recently, the company was first to raise its hand when stirrings of gaming legalization were heard from Georgia. They have since gone silent.)
The presumption of MGM Growth Properties is to unlock shareholder value of course whenever the IPO debuts. However, the subtext of that move clearly becomes an effort to offload $4 billion of company debt on a wider range of shareholders, relieve debt service pressure on the parent and rationalize its portfolio by keeping its keepers and producing a good return for its REIT holders. The problems and the opportunities for investors all lie in the combined pricing. With its current trade at $18 a share, how much makes sense for the REIT pricing? Of course, only MGM's bankers can make a stab at a number with fingers crossed. Their guess would be as good as any reasonably educated investor in REIT shares could make.
The larger question, is would a combined pricing seem to provide a strong valuation to shareholders of both the parent and the REIT? For the sake of discussion, let's assume that MGM trades pre-REIT IPO at $20. Would the company opt to bargain price the IPO to get that $4 billion in debt off the books ASAP in light of its Macau postponement? Would there be questions raised if Q1 earnings at the selected IPO properties were hit by recession? Would the market begin to question their ability to meet triple net lease rent requirements? It's a possibility, especially if by then the economy and the market continue to sag. Say $15 a share offering price backed up by a credible valuation by an investment bank is announced. That would produce a combined $35 price for both. Would that price plus the proposed dividend yield make made sense for investors?
On the other hand, suppose MGM foresaw a $20 price for its IPO, thus producing a $40 combined total for what is essentially the exact asset base as now commands $18 on the market? How would they value that? This would especially loom large if Vegas and the other jurisdictions involved in the asset transfer were facing the beginnings of a recession? Undoubtedly, a $4 billion reduction in debt obligations is a big positive for the MGM parent. But what's next?
What is the MGM of 2017/18/19 going to be? That is the question current and potential shareholders of the company need to evaluate when the IPO debuts, hopefully as presently announced sometime just before or soon after Q1 of this year.
Our takeaway: We have always liked MGM's Vegas asset base and continue to do so. We're not overwhelming by its Profit Growth Plan as a visionary strategy. Nor do we believe its REIT IPO actually solves long-term strategic problems and opportunities - but as we've said, it's a much better design than any other gaming REIT we've seen.
The underlying unspoken message we believe here is reactive, not visionary.
The Profit Growth Plan is fine, but aren't cost cutting and margin increases something every operator must do as a matter of course? And shuffling assets and debt off onto the shoulders of a presumably broader field of shareholders isn't very visionary either in our view. It's a good effort for what it is. But my view was that what the company really needed to excite the market and move its shares sharply north based on its fine asset base was demonstrate a vision of a company trimmed down to fewer, stronger Las Vegas properties, much lower levels of debt and a build-up of cash to enable it to pick and choose US acquisitions in stronger markets as the industry consolidates. It seems to us Boyd Gaming (NYSE:BYD) would be a natural merger partner given the two companies' present partnership in the highly successful Borgata in Atlantic City.
The danger of a Caesars scenario looms over all gaming companies who substitute financial engineering solutions for hard, visionary moves to build a coherent, fiscally sound enterprise that builds shareholder value based on hard, across-the-board results, asset value increases and above all, clarity of who they are and what they are to increase returns on conviction shareholders. MGM knows better, of course, but investors need a clearer sense of direction. This is a $9 billion company. Investors deserve clarity.
About the author: Howard Jay Klein is a 25+ year c-level executive veteran of the casino industry and now a consultant to that sector. Due to that potential conflict of interest, his own portfolio of gaming shares is held in a blind trust for his children and grandchildren. He is not a CFA, but his observations are presented to offer investors a 360-degree view of gaming operators, their managements, their assets and operations. He uses his own metrics but does employ some standard measures as well to provide context for SA readers. He is the author of Mastering the Art of Casino Management and the publisher of The House Edge premium site on SA.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.