The single best machine to measure trust is a human being. We haven't figured out a metric that works better than our own, sort of like, 'There's something fishy about you'... —Simon Sinek
MGM Resorts International (NYSE:MGM) has unwrapped its proposed REIT red herring. We now have a chance to glimpse at the basics of the deal before the actual registration offering reveals the pricing and quantity of the issue, and most crucial, its basis for valuing the deal. Red herrings often disguise more than they disclose, giving investors sort of a fish that stinks from the head down. This one doesn't - at least as currently outlined. It seems to us, it's made a valiant effort here to be candid, finessing past some of the normal pitfalls of standard REITs.
Some aspects of this S-11 showed a bit of fancy footwork. But overall, we found nothing fishy in its financial engineering plan.
We've teased out from the babble and legalese of the deal a few highlights that impart some sense of the strategic direction of MGM's thinking.
It's something of a fish out of water from standard REIT structures, which we think, on balance, could auger well for the shares.
The opening asset base
The deal will transfer $10 billion of book value MGM casino property assets from the parent to the MGM Growth Properties, Inc. REIT. They include Mandalay Bay, The Mirage, New York New York, Luxor, Excalibur, The Park, Monte Carlo, MGM Grand Detroit, Beau Rivage and Gold Strike in Mississippi. The group gathers 24,466 hotel rooms on the strip under its corporate umbrella, a number representing 24% of all rooms on the Strip.
It furthermore will control 35% of all the privately owned convention space in Las Vegas as well. So far, so good.
Our take: The rent coverage estimate is based on historical MGM Grand corporate rent ratio as follows:
- 2013: 2.9x
- 2014: 3.2x
- 2015: 3.7x
The subsidiary will hold an initial 10-year triple net lease on all these properties yielding an opening rent revenue base of $550 million. Of that number, 90% or $495 million will be base rent plus a percentage of 10% or $55 million. A 2% escalator is built into the lease as well. Four 5-year renewals are also included.
Remember that all these properties included in the portfolio are legacy resorts. As such they are susceptible to potential downdrafts in a recession that could spur aggressive room discounting, lower occupancies, thinned out convention business and lower gaming spend per customer. We looked at the most recent thumping the Las Vegas strip took during the 2009 recession year.
Our conclusion: We think the rent coverage ratios could get skittish in a real bad recession. But we also feel under most scenarios - and they are just guesses - the portfolio can comfortably meet its rent obligations. Besides, since this is a parent company controlled REIT, MGM Grand, could in extremis, renegotiate leases. How such a move could play out legally with REIT holders is impossible to predict. But bear in mind both landlord and tenant here are essentially the same guys.
Buyers of the stock will need to understand that the boilerplate red herring risk alerts should be read carefully. They candidly stress the heavy dependence on the health of the Las Vegas Strip market that MGP's rent revenue base will face.
Expansion beyond the starting portfolio
The deal also gives MGP the right of first refusal to acquire two MGM properties currently in development: MGM National Harbor in Maryland, due to open at the end of this year and MGM Springfield Massachusetts, currently scheduled to open early 2018.
Our take: This is a two-scenario clause. On the one hand, it makes entirely good sense to first offer new MGM properties to your own creature REIT. On the other hand, we have a subtext potential REIT buyers need to consider. Could this clause be a disguised caveat emptor in that MGM is hedging its bets on its two new properties? The National Harbor development looks like a potential winner to us. It seems clear that if that property performs as well as we think it will, it won't ever see the light of day in MGP. It will stay comfortably nestled close to Bellagio and other MGM crown jewels inside the parent.
On the other hand, MGM Springfield is already facing headwinds. In our view, geographically, it was an ill-advised project to begin with. The two Connecticut tribal operators, whose Hartford/New Haven markets would be threatened by the MGM development, are working on a new casino project to be sited at the Connecticut/Massachusetts border to blunt that potential marketing attack.
Secondly, MGM has already announced a scale down and timing delay for that project citing various site related issues. We think there's a sub rosa aspect of second thoughts on the project going forward as well. MGM can't or won't pull out. But MGP could provide a face saving dumping place to which MGM Springfield can be transferred. In other words, it's a legacy property in waiting. The MGM Cotai project in Macau isn't in the picture at all.
The S-11 contains language that MGP expects to expand its reach into properties outside its family, particularly of interest is a reference to other casino companies, which could see lots of upside with MGP becoming their landlords. Furthermore, it suggests the REIT could seek out related non-gaming hospitality acquisitions as tenants. This one seems like throw-in language, as an attempt to build the case that MGP will really have a life of its own. MGM's corporate vision repeatedly stresses its strong non-gaming and entertainment performance, yet gaming represents 41% of all its revenue as of 2015.
Class A and Class B Shares
MGM will retain retaining a 51%+ majority interest in the REIT.
1. Ownership will be divided into Class A and Class B shares:
Class A: These shares will be offered to the public and traded on the NYSE.
Class B: These shares will be owned by MGM Resort Properties, Inc. and have effective control of the company.
2 No holder can own more than 9.8% in the value or number of any class of shares other than the holders of the Class B shares (MGM itself). This protective clause against potential activists or hostile market buccaneers reinforces the foundational premise of this REIT: This is ours and unlike other REITs, we aren't standard landlords.
Read it this way: We control whatever happens, under whatever circumstances and we are immunizing ourselves from potential mischief making from the outside. This we believe is a good thing in the sense that essentially slams the door on covetous activists and keeps the best interests of parent and offspring identified. So would be investors in the IPO need to bear in mind that in effect you are merely buying into a subsidiary of MGM. Don't expect spikes in the shares due to potential mammoth REIT acquirers coming into the picture if the shares get temptingly low. Or portfolio additions from other neither casino operators nor straight hotels - at least for the foreseeable. This deal at bottom is financial engineering undertaken under pressure to unlock shareholder value, no more, no less.
At the same time, it also means you're putting your money on MGM management end to end. The performance of the portfolio will be largely a creature of how well the parent continues to operate. We believe MGM's management is no better or worse than some of its peers. It can be somewhat bureaucratically clumsy at times. There are vibes at every property among employees that moan and groan about certain cost cutting measures. But in the context of the casino business as I experience it first hand - that's an attitude pretty much echoed through the ranks of many other MGM peers.
For 2015, parent MGM did $9.2 billion in revenue, producing $2.2 billion in EBITDA, showing a $1 billion consolidated net loss. Its key indicators were all up in Las Vegas including occupancy, RevPAR, dining, entertainment, etc.
However, its leverage remains an issue, which presumably, the formation of the REIT could have a practical value in providing a way for the parent to significantly refinance high cost debt. (Total long-term debt currently stands at $12.3b). Maturities are manageable, but high-cost debt and maturities do need attention sooner rather than later. The MGP REIT will enable that process by presenting a better total interest coverage story to would-be lenders.
Let's assume MGP can produce a solid performance on dividend distribution close to or exceeding what an actual proforma could show. Add that to the core performance of the parent, and ask this: Would the combined share prices of both companies exceed its present trading range in the low 20s and produce the much desired unlocking of shareholder value in its fine asset base? And of course, will its final pro forma make the case for a continue dividend number that competes with its REIT peers?
We are no fans of REITs for casinos per se. We'd have much preferred to see MGM take an alternate course tightly focused on improving margins (a cost cutting program is already in place), selling off selected regional and Vegas legacy properties to reduce leverage and put savings into capex for its best performing properties.
However, in comparing the MGM parent controlled REIT structure to a standard REIT, such as the one most recently formed by Gaming & Leisure Properties, Inc. (NASDAQ:GLPI), we think MGP is better. It avoids potential management conflicts, it identifies the interests of the landlord more closely with the interests of the tenants and holds the promise-repeat-the promise not the certainty of unlocking shareholder value to a far greater degree.
The operating entities of both Penn and Pinnacle are among the best regional US gaming companies. However, the GLPI REIT now trades at around $29.81 against a 52-week range of $24.24 to $38.30. The stock has basically sloshed. Its dividend is $2.24 throwing off a 7.59% yield, which is fine and probably secure. Penn National trades at $14.99, and Pinnacle at $32.74. The test here will be to see what the Pinnacle shares will move to after the last regulatory body gives the sale to GLPI the nod and the market makes its judgment on the expanded base.
So clearly, it's a dividend play edge to edge. MGP will become among the top 5 publicly traded hotel REITs in the US, with a lot more flexibility in its combined management goals and long term, reduced potential for conflicts.
The JOBS Act rationale
Finally, in a bit of investment banker/legal twist and turn, the MGP red herring says it has filed for status under Section 107 of the JOBS Act, which was a 2012 law created to encourage "emerging growth companies." What the act primarily did was excuse such companies from various disclosure requirements provided their total revenues were below $1 billion. The presumption here was that the law was to be an igniter of such things as crowd funding by Internet. Or to speed formation of limited investor pools by bypassing the need for auditor-approved numbers in registrations. Congress presumably wished to grease the wheels under start ups to more quickly enable faster capital formation and result in many more jobs.
MGP is not an Internet seller of virtual goldfish bowls or a new app for home delivery of toilet paper. How it qualifies as an emerging growth company takes the imagination of George Lucas.
So all I can see in this JOBS Act twist is that under it, MGP can get its numbers out to investors faster, trim down disclosure and control the speed of the process of transfer. The red herring does indicate that the JOBS twist could be ushered out the door if the raise/value exceeds $1 billion by the time of the registration of the IPO. This seems to me to be easily the case but reading the red herring it's kind of fuzzy on the point.
Overall, the company is shooting for the completion including IRS approvals by the end of this year.
We believe that part of the reason for the JOBS Act twist could be that MGM wants to open investment in its asset base to a new class of investors. It wouldn't surprise us if indeed, the company does have a program in mind to offer MGP shares over the internet as do many JOBS Act start ups. But as the red herring acknowledges, there is clearly a strong probability that the offering will surpass the $1 billion threshold.
By designating JOBS Act businesses as "emerging growth companies," Congress might have had the image of start-ups comprised of a few bearded kids sitting around a garage clicking away at their computers between sips of Red Bull. Suddenly, the head nerd, shoots to his feet, yelling "Whoo! We got it!" And then races directly to his nearest VC slapping together a high speed JOBS Act public issue.
That doesn't sound like MGP to me? Does it to you?
MGM shares now
From early last year, we'd been bullish on the shares largely because we liked the MGM Vegas asset base, the National Harbor project and most of all, the enlarged Macau footprint coming on stream when GGR there is back on a positive track. We saw a potential upside to $35. However, since early last year, we turned more bearish concerned management wasn't moving aggressively enough to reduce leverage, or improving margins or spinning off borderline legacy properties that did not fit its overall strategy. So we downgraded the stock in several steps to a hold around $20 to $22 until we got a clearer look at its planned REIT conversion.
Now that we have a sense of management's MGP thinking, MGM looks like a $25 stock to us moving toward the REIT. After the IPO is priced and debuts, we may revisit the trade. Overall, our response to the limited info in the red herring leans positive for the shares. It could tick up as we near the registration date.
Howard Jay Klein is a 25+ year C-level casino industry executive who has run his own consulting business in that sector for the last ten years. He is the author of Mastering the Art of Casino Management and publisher of "The House Edge" premium site on Seeking Alpha.
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.