Caesars' Short Case Clearer, Simpler -- And Stronger

| About: Caesars Entertainment (CZR)
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The catch for shorting the stock is timing; if Christie does sign the New Jersey bill, CZR will definitely see a sharp rise.

So I wrote in December in arguing for the short sale of Caesars Entertainment (NASDAQ:CZR). (SA Pro access is needed to view the full article.) Indeed, it has come to pass today, as New Jersey Governor Chris Christie has issued a conditional veto of an online gambling bill that clearly allows for a new bill to be written that will pass the state legislature, be signed by Christie, and legalize a full suite of online gambling products in New Jersey. Caesars' presence in Atlantic City, where it owns four different casinos, is thought to give the company a leg up in the state; hence, the 18% gain in Thursday's trading.

The news from the Garden State is actually the second big boost to Caesars stock this week; the first came on Monday, when the company announced a potential restructuring in an 8-K filing. The stock rose over 11 percent as the company announced "it was pursuing a strategic transaction" in which its interactive unit, along with a $1.1 billion note, its Planet Hollywood casino in Las Vegas and its ownership stake in a casino project in Baltimore, would be spun off into a new concern named Caesars Growth Venture Partners (known as CGVP).

The rise on Thursday, while larger than many (myself included) had expected, makes some sense. Christie was expected by many industry insiders to veto the bill outright, while others expected the governor to allow only online poker, as opposed to other casino games such as blackjack and roulette. 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. It is readily apparent that Caesars' current land-based operations are worth significantly less than the company's over $20 billion in debt (most of it the remnants of the LBO). Based on preliminary Q4 results included in the 8-K that announced the planned creation of CGVP, 2012 adjusted EBITDA will be $1.863 billion (at the midpoint of Q4 guidance for $325-$365 million). Yet Caesars' enterprise value -- counting its $17 billion in net debt (which excludes the $1.1 billion destined for CGVP) -- is over $18 billion. Note that US regional operator Ameristar Casinos (NASDAQ:ASCA) was acquired by Pinnacle Entertainment for 7.6x trailing EBITDA, and that Caesars' former property in St. Louis was sold to Penn National Gaming (NASDAQ:PENN) for 8.3x EBITDA. 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. It's also worth pointing out that Q4 (excluding St. Louis, whose sale closed in the fourth quarter) is guided to see slight decreases year-over-year in both revenue and adjusted EBITDA. On a full-year basis for 2012 (again excluding St. Louis), both figures look set to increase by just a percentage point or two, if at all. And, of course, the idea of using EBITDA when the company's interest expense will exceed $2 billion this year -- versus less than $8 billion in revenue excluding St. Louis -- is questionable in and of itself.

Again, the only equity value in Caesars largely appears to be the proposed CGVP spinoff. 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 Planet Hollywood casino was acquired by Caesars (then known as Harrah's Entertainment) in 2010. In its most recent 10-K, Caesars noted that it had finalized valuation of the property during 2011; excluding the assumption of long-term debt attached to the property, the net value of Planet Hollywood was pegged at exactly $500 million. Given that property-level EBITDA across the Las Vegas region was flat in the first nine months of 2012 versus the year prior (excluding the modest effects of Caesars' construction activities on the center of the Las Vegas Strip), it seems unlikely that valuation would have changed much. Las Vegas Property EBITDA for 2012 looks set to come in at about $800 million across nine properties, meaning PH's share could conceivably be in the $80-$100 million range for the year. On that basis, the casino could be worth as much as $700 million at the high end.

The Baltimore project has yet to be completed, but two key variables already may impact its revenue potential. In November, Maryland legalized table games in the state, and also allowed for a sixth casino in Prince George's county, near Washington D.C. A study by consulting firm PricewaterhouseCoopers estimated that the addition of the sixth casino would cost the Baltimore project some $63 to $65 million in annual revenue, as potential visitors from Washington, D.C. and northern Virginia are lost to the new, closer location. However, the firm also estimated an annual gain of $74 million in additional revenue from the legalization of table games. Given the fact that the license for the sixth casino is yet to be awarded -- Penn National and MGM Resorts International (NYSE:MGM) are the two competitors -- the Baltimore room, which is scheduled to open in mid-2014, should have a two-to three-year head-start. It will, however, be competing immediately with Maryland Live!, which is already up and running in suburban Hanover, about 20 minutes from Caesars Baltimore's proposed downtown location.

In terms of valuation, it's worth noting that Caesars Baltimore is estimated to cost some $400 million, setting a likely floor on its current valuation. But Caesars itself does not own the entire project; according to the most recent 10-Q, its ownership stake in the Baltimore joint venture is 52 percent. With Planet Hollywood being worth in the neighborhood of $500-$700 million, (and likely skewing closer to the lower end of the range), and CGVP owning barely half of the Baltimore JV (plus undisclosed annual management fees), it seems likely that the two land-based assets, plus the company's social gaming arm (created through a roughly $180 million acquisition of Playtika in 2010 and 2011) have a value, at best, equal to that of the $1.1 billion in debt being assigned to the proposed spin-off. Something like $600 million for PH, $400 million for Baltimore, and $100 million for Playtika (whose value has surely declined, given the steep fall at Zynga (NASDAQ:ZNGA) and other social gaming companies) would cancel out CGVP's debt.

That leaves CIE to justify the roughly $1 billion in market capitalization currently placed on Caesars. Based on TV contracts, I calculated in December that CIE's World Series of Poker brand had a rough value of about $200 million. Can online gambling make up the remaining $800 million? It's unlikely. The WSOP brand is already used as a skin for 888 Holdings (OTCPK:EIHDF) in the UK, but has apparently had limited impact on 888's poker growth overseas. (The company mentioned a series of marketing initiatives and software investments in explaining its poker growth in its 2011 annual report, but ignored its partnership with Caesars. Despite that growth, 888 remains a distant fourth in worldwide market share.) Caesars will roll out online poker in Nevada, where it will be competing with seemingly every casino-related company in the country for a state-wide population of less than 3 million. New Jersey promises a far larger market -- it has 8.9 million potential customers, triple that of Nevada -- but it will also have a far more fearsome competitor in PokerStars. PokerStars -- which controls more than 60 percent of the worldwide online poker market through its namesake brand and recently acquired Full Tilt Poker -- is buying Atlantic City's Atlantic Club casino. And a re-write of the New Jersey bill removed a "bad actors" clause, allowing PokerStars to enter the online gambling market in the state.

Caesars may have a branding edge in more traditional "house games" such as roulette and blackjack, but again, it will be marketing to a population of just 9 million in those games. Atlantic City gambling revenue totaled just about $3 billion in 2012; even if online gambling adds 50 or 100 percent to that total, Caesars would have to take substantial market share to justify its current share price. It's also worth pointing out that Governor Christie's conditional veto included a demand to raise the gambling tax from 10 percent to 15 percent of winnings (this, of course, is in addition to more traditional forms of corporate taxation.)

In the bull case, Planet Hollywood and Baltimore may justify the new spin-off's debt, and Caesars Interactive may see enough success to justify the company's current market capitalization. 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.

Meanwhile, this bull case omits significant risks. It's worth noting that in its 8-K, Caesars' plans for CGVP clearly did not include a pure spin-off. "We anticipate that CEC would own a significant portion of CGVP's equity interests," Caesars wrote in the filing. This means that CGVP assets, though not directly encumbered by Caesars' debt, could still wind up affected by a restructuring at the parent company or a dilutive debt-equity conversion. Should Caesars maintain majority control of CGVP, there would also be serious questions about its management of the spin-off, given the clearly manipulated nature of Caesars' 2012 IPO and its clear favoritism toward its major investors.

All told, the bull case for CZR at this point relies purely on financial engineering and political will, neither of which investors should ever take for granted. Meanwhile, the bear case remains startlingly simple; Caesars' assets are simply worth substantially less than its debt. (This fact is supported by the company's book value per share of just 26 cents, which is likely to become a deficit once Q4 results are reported.) Governor Christie's actions 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.

Disclosure: I 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.