By Howard Jay Klein
"Come, Watson, come! The game is afoot. Not a word! Into your clothes and come…"Sherlock Holmes
The endgame of the Caesars (NASDAQ:CZR) bankruptcy is in process. Management and junior note holders are locked in a mediation process ordered by the presiding federal judge Benjamin Goldgar. There's no telling if the parties can find a deal formula that drops the juniors' lawsuits at this point. It is clear that resolution is closer than farther given the long agonizing process that began over 15 months ago.
Meanwhile that part of Caesars not inside the bankruptcy is now run by its new CEO, Mark Frissora, formerly of Hertz. With his listening tour and learning curve presumably behind him since he took the helm last July, he has tightened cost controls and attempted to put a positive face on the rump operation's results.
The rump company's Q4 earnings release showed a 8.7% increase in revenue against a $76 million loss, dramatically down from the pre-bankruptcy billions in prior earnings reports. However, to be charitable the performance numbers are to some extent window-dressed happy talk. The 600-pound gorilla in the room remains the court appointed examiner's report issued on March 16 that comes down hard on Caesars management and its private equity owners Apollo Global and TPG. His conclusions, though not binding, clearly supports the junior noteholder contention that management acted improperly in its asset shuffle that created a good Caesars and a bad Caesars. The offload was an effort he implied, to preserve equity for Apollo Global and TPG at the expense of the junior holders. This clearly strengthened the juniors hand in any litigation going forward.
The report sets a $3.5 to $5.1 billion potential liability to Caesars. That's money it does not have, nor is likely to be able to raise, thus setting the stage for a possible total Chapter 7 court ordered bankruptcy and liquidation.
Adding an element of soap opera into this basket of snakes was a revelation last week that an advisor hired by Caesars to assess valuation of its proposed deal confessed she had an affair with a Caesars corporate lawyer. This prompted the presiding judge to order any further investigation on behalf of Caesars by her successor firm to be shut down.
Against all this Caesars has promised to restructure its original offer and presumably put on the table a sweetened deal for the juniors. If accepted it would end further legal wrangling and cut off the possibility of a Chapter 7 filing.
Meanwhile is there money to be made as this legal mini-series comes closer to some resolution?
A quick look at the status quo. Bear in mind the pretense of business as usual for the rump company is entirely based on the belief by management that somewhere nearby a non-liquidation solution will be found to satisfy the juniors and enable the company to go forward with its restructuring.
The rump company:
Price at writing: $6.59
One-year target: $9.00 (assumes no change in portfolio or operations from that which recently reported Q4 2015 results).
52-week range: $3.30-$12.48
EPS (TTM): 40.26 (Note: it's a number shorn of all the baddies in the original company's operating statement. Essentially meaningless.)
The takeaway: Caesars margin and yoy earnings improvements were achieved on room rate and revpar increases of its Las Vegas strip properties with upside trickles and dribbles from its other portfolio components. There also had be some cost cutting and efficiencies management claims is linked to one of those fancy Sigma management programs put in place by the new CEO. The history of those kind of initiatives is spotty. Some large companies have done well deploying it while others have scoffed at it as just another imposition of programmatic management babble on operations.
Our conclusion: There is nothing in Caesars' current operating performance that could in our view support an upward rise in the shares entirely based on results of the rump company. This is a tangle of titanic proportions - "Titanic" may indeed be the correct adjective to employ here. And until we see what Caesars' new offer looks like we strongly recommend a hold for investors already committed and a stay clear signal for anyone sniffing out a possible buck to be made in situ on a fast flip or options.
With that in mind, we sussed out three possible scenarios that could play out with smart entry points to either buys, sells, shorts or hold commitments by investors.
Scenario One: Mediation works, a deal is struck
Naturally it's in the best interests of everyone to stop the clock ticking on the costly legal mess and its consequent continual drain on resources for all involved. Moved by that stark reality, and tough prodding by the judges in the Chicago and New York cases, here's what needs to happen:
1. One way or another, in one form or another, the senior lenders presently held whole in the current deal will have to take some kind of hit in order to provide the cash to beef up the recovery boodle for the juniors. The likelihood of this seems remote on the surface. Yet the seniors must recognize that a reasonable slim down of their deal bodes far better for them than a possible Chapter 7 liquidation. They must likewise realize they are dealing with an empty pocketed debtor at this point. Borrowing an estimated $3.5 to $5.1 billion to satisfy what the examiner's report has concluded is the amount the juniors were dealt out of is a non-starter. So let's assume the seniors are forced to agree to something of a haircut resembling one's instructions to his barber that begins "Just a trim Joe, just a trim. I'm in a hurry…"
2. The Junior lenders who have already spent a ton of money on lawyers and banking fees won't go away cheap. They've been on record demanding 60% of the Caesars equity - a figure they know they won't smell, certainly not in a liquidation. Thus far there's $1.8 billion for them sitting on the table. Since they stand behind the seniors in any liquidation their chance to get anywhere near the $5 billion the Davis report said was the recovery number also sleeps with the fishes. We've talked with our own circle of gaming people both in the legal and financial worlds and their consensus is that the juniors would be looking to a recovery that included legal costs and a number they believe would come closer to the mark over $2 billion, most of which would have to be pried loose from the seniors. Caesars also could issue all holders new securities, possibly debentures. Beginning with a nice coupon, the conversion covenant could be dated to trigger an option for common a year after the issuance is priced to build in a believable upside.
And the current REIT spin off could be made to walk the plank and be pitched over the side, at least until a restructured company with a coherent vision going forward proved its valuations on the properties woven into the REIT were reasonable. And of course, its capacity to meet triple net lease obligations is realistic.
The emergent company: The post deal entity would need to swallow responsibility for more debt than the current $10 deal slashes. They'd need to make the case that they could generate the cash flow to service more debt and not be so impaired so as to face another bankruptcy going forward.
3. The three-card Monte shuffle of subsidiaries would end. All spun-off entities could be refolded into the parent to build a credible equity base the lenders could believe in. On that basis they could see real value in a debenture or other new security linked to the company's future performance.
It's far too early to judge whether Caesars' new CEO can succeed in recreating a once great gaming company. Thus far he appears to be wedded to some of the initiatives that worked some of the time for him at Hertz. He's not a gaming guy - but could become one. With that question hanging we need to value the potential performance of a newly restructured Caesars unencumbered with the immense debt overhang yet one that would appear manageable.
The outlook for Las Vegas: We think it's inching positive though we're not among those observers who are already proclaiming the arrival of a new Strip nirvana. However we do believe the Vegas arrow - save a disastrous new recession - is pointing north. And that augers well for Caesars.
US Regionals: Regional casinos are a mixed bag. We've reviewed Caesars' regional portfolio against gaming and occupancy numbers market by market and see a worse-case flat scenario, with some jurisdictions pointing slightly north. We believe that a new Caesars vision must include the possibility of a sale or spin off of some of these regional properties. Such an initiative would reduce leverage, clear bad acquisitions from the portfolio, and remove the threat of new jurisdictional challenges (ex: Horseshoe Baltimore soon to face MGM's National Harbor). Yet even if that contingency is not pursued, we continue to believe the regional properties can survive well enough to carry their own weight.
On this basis: We think the product of a smart mediation along the lines suggested in this scenario tells us the company stock could settle into a range that would make it an attractive buy in the $12 to $18 range from the get-go.
Scenario Two: Mediation Fails: The company is liquidated in a Chapter 7 filing
There are two blinker signs investors need to watch for assuming mediation fails, i.e, that the juniors have rejected any new Caesars restructuring deal:
1. The parties decide to roll the dice and go to trial. In this instance, the sell signal is on red alert. Reading summaries of the Davis report I've imagined Caesars management and its private equity principals on the stand being questioned by barracuda litigators. I know a lot of these guys and I can comfortably forecast lots of twitching behinds and hamada, hamada, hamadas, twisting and turning around their answers.
The pattern of three-card Monte shuffling was clear before the report was issued and the report confirmed some of the worst accusations of the juniors. Not a pretty prospect for Caesars managers, Apollo Global or TPG to explain under withering cross examination. So chances are even if the cases go to trial, there would be a settlement before that circus hit town. My guess: The settlement would be very similar to a deal that should have been arrived at by mediation.
But we have petitioners here with very deep pockets. They aren't wont to be pioneers, i.e. early settlers. My guess is that while they'd prefer not to go to trial as well, they do believe (according to friends in the business who know these guys ) that they hold the winning hand in any trial given the preponderance of evidence. Yet anyone ever predicting the outcome of any trial is dancing on very creaky floorboards.
Chapter 7 filing:
Our takeaway: If it's announced that the case will go to trial Caesars is a good play on buying the calls for a fast win and walk strategy. If a Chapter 7 filing occurs, the company as we know it disappears. In its place we'll see a bidding war among potential buyers from both here and abroad. The question remains: Is there enough recovery in a liquidation to promise the juniors more than they can get from mediation or arbitration? The answer? Probably not according to everyone we spoke to in the business. All buyers almost by definition will be bargain hunting. That obviously won't apply to crown jewels like Caesars Palace and a handful of other top performers in the portfolio. Yet all told we see a less than acceptable recovery number for creditors when the last gavel bangs down.
The signal: If you believe in the reality of a Chapter 7 filing and you hold the shares now, sell or buy the puts fast before the roaring tide comes in and drowns the equity base.
Scenario 3: A plague on both your houses: The judge mandates arbitration.
Arbitration in bankruptcy cases has a complex history. Judges can mandate it and many cases where it was appealed were upheld. The case here is difficult because any arbitration clauses that may be operative here presumably would be those found in the bond indentures. And those can be very tricky. The four New York cases have been reassigned to a new judge due to the imminent retirement of its current overseer. He is Judge Jed Rakoff, who is noted for his comparatively fast track decision sequencing on the notorious Madoff Ponzi scheme cases. "This is a guy with zero patience for the lawyers dueling with endless motions," a top shelf Wall Street attorney friend told me. "Rakoff will fry these guys if they try to slow down the process. His presence probably presages a much quicker potential order to arbitrate if it lies in the cards."
We put the question of a potential final resolution by arbitration to an industry colleague who has followed the case since it began over 15 months ago. "I don't see much difference between the result of a mediation and arbitration deal. Everyone gives more than they wanted to, everyone gets less than they'd settle for. There would be one difference: the result of arbitration has force and walking wounded. Mediation has grumbling, bandaged warriors but a peace treaty."
Our takeaway: If Judge Rakoff loses patience within the next 90 days, he won't hesitate to use any such arbitration clauses that may exist anywhere in this litigation. And if he does the likelihood is that the final deal would not bode well for the shares short term and probably cost the seniors anyway.
Conclusion: If mediation produces a new Caesars, a far more coherent collection of assets, reduced debt that is manageable, we see any resultant exchange of debt for equity in the process as a positive. In that case, depending on final valuations, we see the new issues, if there are ones, as a strong buy. Stay tuned it will be worth it if you can spot the trends in the legal circus.
About the author: Howard Jay Klein is a 25+ year c-level casino executive and currently a consultant to casino operators. He is the author of Mastering the Art of Casino Management and the publisher of the premium marketplace site on Seeking Alpha:
The House Edge.
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.