By Howard Jay Klein
"The poker player learns that sometimes both science and common sense are wrong; that the bumble bee can fly; that perhaps, one should never trust an expert; that there's more things in Heaven, and Earth than are dreamt by those with an academic bent…"
David Mamet, playwright
In an IPO-starved market, MGM's REIT, MGM Growth Properties, LLC (NYSE:MGP) has debuted to a potentially full table of potentially hungry investors, many feeling lucky, ready to ante up now that MGM has started to deal. We've gone through the company's S-11 filing and found no surprises. The REIT is essentially a nifty piece of financial engineering, superior in concept to other hotel/gaming/REITs. Yet in our view, it doesn't go far enough in solving the fundamental longer-term strategic issues of MGM. We'd like to have seen moves to program sturdier action to deleverage the balance sheet, sell off regional assets, even lower its overly heavy Las Vegas asset portfolio (62%).
In effect, Las Vegas is to MGM (NYSE: MGM) what Macau is to Wynn (NASDAQ: WYNN). And reading through the S-11, it becomes clearer by the page that as Las Vegas goes, so goes MGM. Its regional casinos comprise 12% of its portfolio and current Macau property 26%. (This will change when its new Cotai project opens early in 2017). But two-thirds of the MGP future lies on the Las Vegas Strip - make no mistake about it.
We say this because while its regional casinos in Detroit and Mississippi are reasonably stable (Detroit has shown a little life lately while Mississippi languishes), their long-term growth potential remains minimal. They are currently about where they will be five years from now depending on macroeconomic factors. For a company whose stated strategic positioning is in lodging, retail, entertainment and gaming diversity aimed at Las Vegas tourists and conventioneers, it's tough to see where regional gaming properties really fit. However going forward, MGP may bring something to the regional party, as we will show later.
MGM's new development in Springfield, Massachusetts, due to open in 2018, will exacerbate the regional over-commitment into an area that from day one will be challenged by robust competition and questionable geography. Contrary-wise, its National Harbor development in Maryland, due to open at the end of this year, is a clear winner in the making. Yet, when all the shekels are gathered and counted, MGM's lifeblood is Las Vegas. And any hammer blows to the town possibly coming from an economic downturn could really shake up the assumptions of the MGP prospectus.
This is the Janus face of market jitters about the Macau downdraft that battered the shares of Las Vegas Sands (NYSE:LVS) and Wynn last year. Only until that storm began to subside in Q4 did analysts feel a bit better about Macau heavy shares. During the beating those shares were taking last year, many analysts cited MGM's strong Las Vegas presence vs. its 26% Macau dependency, as a better bet.
We didn't agree with that view but did and continue to like MGM's Vegas asset base. We believed that if the company moved to correct the distortions in its strategy, it was clearly a buy. There were stirrings that MGM would move in that direction and we liked the $20-ish shares at first to go to $35. Then when management announced its Profit Growth Plan, aimed at adding $300 million in EBITDA - we agreed it was fine. Yet, we didn't see that initiative as anything exciting enough to call a buy on the shares. Instead, we reduced our target to $30.
When the announcement came last August of the parent-controlled REIT, we again dropped our target to a hold. We wanted to see the mechanics and pricing of the deal before re-evaluating the shares. We aren't fans of gaming REITs at all, but did believe the MGP design was better than most when it was first announced.
Would-be investors in the MGP IPO above all need to feel highly confident that Las Vegas' recent recovery from its 2009 nadir will continue. If it doesn't, if the tourist/convention market takes a hit from a sagging economy, in the 2016-2018 FYs, MGP shares will wallow in the mid-teens or worse in our view.
Basics and Valuation
The company is offering 57,500,000 Class A common shares at $21, hoping to raise $1.207 billion. (The total includes a 5% of the issue reserved for insiders). The Class B shares will remain with the MGM parent controlling 51% of the subsidiary.
At the outset, the carve out portfolio will consist of: Mandalay Bay, The Mirage, New York New York, Luxor, Monte Carlo, Excalibur, The Park, MGM Detroit, Gold Strike and Beau Rivage (Mississippi).
The building boodle will contain 24,466 rooms, 2.5 million square feet of convention space, 100 retail outlets, 200 food and beverage outlets and 20 entertainment venues. All with a book value estimated at $10 billion.
Various analysts have valued MGM the parent at $27.00 a share using a 9.7x EV/FY16e EBITDA. On this basis, MGP deal looks to some observers to be worth $1.1 billion or $22 a share applying an 11.9x FY16e FFO. This tells us that fans of the REIT deal believe the properties in the portfolio are undervalued based principally on a cheerier outlook for Las Vegas going forward.
We agree that recent upsides in visitation, ADRs, RevPARs and overall gaming performance of Strip properties in general aren't necessarily Panglossian dream world views. But bear in mind, nor are they slam dunk givens.
1. MGM has forecasted RevPAR growth of +6% YoY for FY16 largely based on forward convention bookings. We think this could be a bit rich as we are getting more and more reports from our associates in Las Vegas of a possible softening of occupancy. Room occupancy was 89.1% in 2014 and finished 2015 at 89.8%. It's okay but kind of flattish.
We are also getting reports from on-the-ground executives and managerial level sources that the millennial partying propulsion that has done so much to prop up non-gaming Strip offerings is beginning to wane. We allow that these reports are anecdotal for certain. (Former party powerhouse property The Palms' deterioration of its customer base has put off many new patrons, our sources say. And it's currently for sale with no apparent takers at this moment).
Convention bookings are solid to be sure but they have an underside that is not widely understood by many investors. In my own experience in the business, I've learned that meeting and convention bookings may be a certainty, but their value can be drastically reduced by sudden adverse economic conditions.
A company can block rooms in advance assuming they will dispatch a delegation of 8 people who will share 4 rooms and 6 rooms for various executives (and or/spouses) and one suite for the top honcho. That booking is usually made anywhere from 6 months to one year in advance. Enter even Mr. Mild Recession. Company managements, suddenly shaken by business prospects going forward, can go anywhere from a corporate-wide cost trimming program to a complete slash and burn rampage. Sometimes they lose deposits rather than go against business headwinds.
In either event, the company convention contingent will take a hit. Instead of the bodies originally booked, memos go flying. Who is a must-go? Who is a no problem if he or she does not show? And what if the CEO or the VP marketing just does an overnight fly-in to shake all the key customer hands, host a dinner and be done with it? So while forward bookings are fine, in the end, it is the number of bodies who actually show up and what kind of spend accompanies them relative to forecasts.
2. The S-11 points out that Las Vegas supply is expected to be limited, i.e., not subject to the kind of explosive growth that will trigger oversupply problems and by extension, heavy room discounting. This on the surface is correct. Yet we must also keep in mind that the big 5,000 room Genting project is coming within two years and on top of that, the newly announced Wynn Paradise Park outdoor project also within that time line. That will add another 1,000 rooms. Neither of these is likely to trigger oversupply of course. Yet, the question is this, as it has always been in Las Vegas: Success breeds copycats. We saw this in the 2009 collapse with huge strip projects like the Echelon going down the tubes.
Our view is that "limited supply" has never been a phrase applied to the Las Vegas strip long term and that won't change. Supply, like cactus on the desert, will tend to spread.
3. Visitation: There were 42.3 million visitors to Las Vegas in 2015. Of these, 43% arrived by air, or roughly 18 million passengers. Deduct trips by local residents and/or visitors staying with families from this number. (Actual numbers are hard to quantify since such arrivals may include both visitors who stay with relatives as well as those staying at strip hotels. For our purposes, we can assume the 18 million as the foundational number of room occupants. Of these, 18% are self-identified conventioneers, or 3.24 million arrivees. The MGP portfolio contains approximately 24,000 rooms, a good ratio to arrivals to assure high occupancy. However, the question is begged: Where will the growth come from? The reverse side of the coin of "no new supply" is no dramatic new growth either unless, competitors build more capacity. Or does MGP go into more debt to finance tower expansions?
Our conclusion: MGP's S-11 numbers are okay but are boxed in, over-dependent on Las Vegas. The prospectus indicates that the company will have right of first refusal on all or any MGM properties later considered for carve out to MGP. You can be certain that the two immediate candidates will be the new development properties.
Our take: Springfield, opening against headwinds, will be an immediate candidate for the REIT, while National Harbor with its strong upside will remain nicely nestled among MGM's crown jewels NOT included in the REIT portfolio.
Peer group valuation
Looking at the sector that MGP will enter, we think the offering edges on the pricey. Gaming trades at a discount to most other major REIT categories. Expectation that gaming REITs will command higher valuations if the IPO gaming REIT trend continues goes against the grain of our own logic. We think the flaw in this assumption lies in the underlying harsh reality those casino hotels, no matter how diverse their amenities, are basically single purpose buildings. Unlike residential, commercial or industrial buildings, you simply can't convert their usages if adverse conditions threaten the flow of triple net lease payments.
The promised yield of a $1.43 per share distribution estimated in the S-11 for year one representing around 80% of the midpoint of the estimated price range and cash flow, is not terrible but really, gun to the head, is no great shakes. We've factored in our own realities, largely out of what we believe to be a possible - not probable - but possible Las Vegas slowdown if a recession hits the macro economy.
Neither its pricing nor potential yield do we see the valuation of MGP settling into a range higher than $14 and $16 a share once the initial hoo-hah from a market hungry for IPOs fades. That's based on our valuation of the carved out properties in the offering and the prospects of the Las Vegas strip at this time. Clearly, this IPO is reasonable financial engineering. But that's all it is.
Now the good news
What we do like about MGP is the post-IPO heavy breathing period as a buy. We believe MGP could have several acquisition targets in its target range, either or both of which would considerably heighten our enthusiasm for the shares going forward.
They are possible acquisitions just too tempting and obvious not to mention at this point as color on this IPO.
1. MGM is already in partnership with Boyd Gaming (NYSE: BYD) in its 50% ownership of the AC market leader Borgata. That property not only leads what's left of AC in brick and mortar gaming but also is number one in its online gaming site legal in the State of New Jersey.
While there is something of a threat to Borgata's valuation by the statewide referendum in New Jersey to authorize two new casinos outside AC, at locations across the Hudson from Manhattan, we believe that property will continue to do well. Furthermore, if the referendum passes, the Boyd/MGM partnership would be in a centrally powerful position to bid for one of the two new licenses.
At this writing, our sources tell us the vote could go either way. Finally, if New Jersey fires this shot across the bow of New York, take it to the bank that the Empire State's governor Andrew Cuomo will be on the phone with the likes of Las Vegas Sands, Genting and Steve Wynn within minutes asking if they'd be interested in a casino in the city of 8 million. And he'll assure tell them he'll get his legislature moving on amending the current NY casino law to accelerate the 7-year moratorium on a casino in any of the city's 5 boroughs ASAP.
So a move on Boyd by either a) Buying the company and throwing its entire portfolio into MGP. Or b) buying out Boyd's half of Borgata, with shares in an MGP that will include either Borgata or Boyd's total regional portfolio.
The other deal we envision is MGP acquiring Isle of Capri casinos (NASDQ: ISLE) currently in the very tempting range of $14-$15 a share. This would give more thrust and strategic meaning to MGP's regional presence, offer lots of cost efficiencies and relatively short money. Yet another could be the bottom fish acquisition of some of Caesars' (NASDAQ:CZR) legacy regional properties to give MGP a solid national presence.
These are just a few possible deals that come immediately to mind outside the MGM family. Add in the Springfield development (essentially an off-load) and you begin to see the formation of a gaming REIT with a valuation that could easily come close, if not surpass Gaming & Leisure Properties, Inc. (NASDAQ: GLPI) as the leader in the sector.
On this basis, we see a valuation for MGP that could double from the offer price within 18 months.
The takeaway for now:
We don't see MGP as a buy now if the price settles anywhere from the low-to-mid $20s due to REIT-inclined IPO investors in the institutional space. The valuation to us does not take serious enough heft until we see a stronger, sustained bounce on the Las Vegas strip of gaming and non-gaming revenues.
That's a pass.
Ante up if you are a short-term trader. We believe the built-in demand for IPOs from well established corporate issuers and general positive sentiment about improving numbers in Las Vegas will generate some early enthusiasm for the shares. That could be worth a nice short-term buy or options play. The downside risk isn't great. Management engineered an Erector set that won't collapse at the touch like the ones you built as a kid. So there could be a nice 4 to 6 point move you could grab and run for the hills when reality starts to bite by Q2 or Q3.
Fold if your religion just forbids you from buying any REIT. While there are many aspects of this one that is superior to most of its ilk, it's still a REIT. Investors still worry a lot about the impact of a rise in FED rates, concern about owning a chunk of a company in which Class A shares sit in a minority position. Also consider this. The MGP prospectus includes a clause that mandates no entity will be permitted to own more than 9.8% of the shares in number or percentage. This protective device against mischief-makers also tells you that MGM has no intention of leaving MGP vulnerable to the wiles of activist investors.
In the end, this isn't a poker game among friends. It's you against house rules stacked to defend and protect the dealer.
Let the games begin.
Howard Jay Klein is a 25-year c level executive veteran of the casino industry and a consultant. He is the author of Mastering the Art of Casino Management and the publisher of The House Edge, premium site on Seeing Alpha. His own gaming portfolio sits in a blind trust for his children and grandchildren to avoid possible conflicts of interest with consulting clients.
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.