Caesars On The Lows With Balance Sheet Support From VICI

About: Caesars Entertainment (CZR), Includes: BYD, GLPI, LVS, MGM, PENN, TPCA, VICI, WYNN
by: Mike Winston

Why Caesars not buying back debt with operating cash flow?

VICI, an independent public REIT focused on CZR, has the right to cause sale leasebacks and stuff CZR with cash.

Stock down 46% y/y looks interesting here.

Caesars is down 46% Y/Y and the company is levered 5.5x so small changes in enterprise value can have a large impact on the stock price. In bankruptcy, the company's operations were streamlined by TPG and Apollo and Caesar’s picked up $800mm of incremental same store EBITDA. The company runs at EBITDAR margins about 400-500bp better than those of both MGM and WYNN. CZR is profitable on both a cash and book basis, has a billion and a half dollars of cash and no sizable debt due until 2023.

What's interesting here is that we have a lot of leverage and a big free cash flow yield. Traditionally, that free cash yield would be misleading because all the dollars would be headed toward debt repayment. Here though, a related REIT structure has the right to stuff CZR with cash in sale leaseback deals, and so Caesars can actually use its free cash yield to do leverage neutral or accretive deals (or even buy back stock). I mean, who the heck buys back stock with 5.5x Net Debt/EBITDA? Caesars.

By way of reminder, CZR operates 47 properties (7 in Vegas owned and 9 operated) in 13 states and 5 countries with 39,000 hotel rooms. Overall revenue is divided evenly between gaming and non-gaming. The company is better than half way through a $350mm Las Vegas room renovation that will update 90% (15k) of the rooms across its seven owned properties -- accounting for ~58% of EBITDA. In a show of discipline, CZR is giving the Flamingo (on strip) its first renovation in 20 years, but not upgrading the somewhat beleaguered off-strip Rio Hotel Casino. The room updates are supposed to drive ADR up about $20-$30/night, and will be completed at the same time (2020) a new $375mm CZR convention center opens. Convention customers tend to generate about $135-$150 of incremental food and beverage revenue - so bringing the rooms up to par to attract convention attendees - and then opening a new convention center - helps the business maintain its market share where it lags vs MGM rev par today. The convention center is expected to add $50-$70mm of incremental run rate EBITDA.

TPG and Apollo architected an OpCo/PropCo strategy that now has two independent companies – one a REIT called VICI (VICI) that owns only CZR properties and the other CZR – which still owns properties and occasionally does a sale leaseback with VICI. This is similar to PENN/GLPI, a gaming company and relate REIT. If CZR requires liquidity during hard times or wants to fund an acquisition it may sell a property and lease it back to VICI (provided VICI is game). The existence of this one tenant REIT alters Caesar's ability to access liquidity - and gives us a lot more confidence around the sustainability of their capital structure. For example, CZR acquired Centaur Holdings for $1.7bn this past year, funded primarily with proceeds from the sale leaseback to VICI of Harrah’s Las Vegas. Sale leasebacks may also act as a more tax efficient means of financing v debt - given the new limits on the deductibility of interest. To be fair, the company does pay a price in the form or higher fixed rent payments (~$727mm '18E total rental payments), but better to have the balance sheet cushion.

The company is targeting 4.5x lease adjusted net debt to EBITDAR by 2021 (from 5.53x '18E today) and has $439mm remaining on its share buyback program. So far they have bought back $311mm of stock this year. They have also committed not to buy anything unless it reduces overall leverage or is at least leverage neutral. The CFO has said publicly that he doesn't think buying debt on the open market is a good use of cash, so expect net delevering to come from cash build or increased EBITDAR (or VICI sale leasebacks - more below).

It's a weird thing for a CFO to swear off buying back debt when CZR has at least a turn of leverage to reduce. When it was created by TPG and Apollo, VICI received five year call options to acquire Harrah’s New Orleans, Harrah’s Laughlin, and Harrah’s Atlantic City, respectively. The purchase price of each property is supposed to be 10x the initial property lease rent (10% cap rate), calculated as 1.67x LTM EBITDAR. VICI is apparently saving these for a rainy day for the moment. VICI also has a put/call agreement in place for the Eastside Convention Center, ROFRs on the gaming elements of Centaur Holdings and any domestic gaming facilities located outside of Greater Las Vegas. The point is, at any time during the next five years VICI is likely to stuff CZR with cash by acquiring one or more properties and leasing them back. In that light, CZR could use these cash windfalls to delever - rather than assigning cash flow from the business to delever (i.e. this explains the CFO's aversion to paying down debt with cash flows from operations).

They are also investing to take share in sports betting and in their unrelated smart phone app so they can push notifications to customers and interact more directly with them. If you've walked through Caesars in Las Vegas as I did this past month you would have noticed a certain percentage of people milling about the property staring at their cellphones on unrelated tasks instead of directing attention toward the table games and slots. CZR means to greet customers where they live (i.e. on their smart phones), especially when geo-location data suggests a customer is on-property.

Valuation Multiples

Last: $7.00
S/O: 833.7
Market Cap: $5,836
Debt Ex-convert*: $8,008
Leases capitalized at 8x: $6,264 (the company makes this assumption as does the rest of the street)
Total Debt: $14,272
Cash: $1,563
Net Debt: $12,709
TEV: $18,545
LTM Adj. EBITDAR ($600+$623+$518+$505) = $2,246
2018E Adj. EBITDAR: $2,300
Net Debt/LTM Adj. EBITDA: $12,709/$2,246 = 5.65x
Net Debt/2018E Adj. EBITDA: $12,709/$2,300 = 5.5x
TEV/LTM Adj. EBITDA: $18,545/$2,246 = 8.26x
TEV/2018E Adj. EBITDA: $18,545/$2,300 = 8.1x
'18E FCF $565mm $5,836/$565 = 10.3x FCF [or the company's normalized measure of $720mm implies 8.1x or 12.3% yield]
*The converts are callable in 2020 and the company filed an S-4 in June in preparation to tender for them early - the conversion price is $7.19 so they are technically below that level now and we could pull them from the share count and put them back into debt - but the company itself is presenting them as shares not debt - and the company will ultimately determine their classification.

The market cap is $5.8bn, one turn of EBITDA is $2.3bn. So at 6.7x instead of say 7.7x the stock is $3.24 and at 5.7x instead of 6.7x it nearly disappears in the presence of 5.53x turns of Net Debt/EBITDA. These kind of price moves would imply something far more dire than a slight miss on the quarter. For this reason, while prepared for another leg down, I think the risk reward now favors the upside. Recall the stock was $12-$14 in January 2018.

Recent Negative Developments

In the most recent quarter CZR announced that the CEO would depart in Feb ’19 at the end of his contract, there will no longer be quarterly rev par guidance, and Las Vegas revenues missed on unfavorable casino results. There are plenty of skilled gaming CEOs who would like the job, CZR has consistently outperformed Las Vegas rev par by 300bp over the past ten quarters and casino revenues do occasionally vary. For some reason in each of the past three years 3Q has shown weak gaming results. To reflect the softer Las Vegas result in the quarter, the company took down the midpoint of guidance 2% -- that inadvertently put guidance right in line with the midpoint of where consensus was before the earnings announcement. Much ado about nothing - but Mr. Market must respond. For more about the puts and takes in the quarter go here: CZR 3Q18 Investor Presentation.


CZR has the best margins in Las Vegas and maintained a premium product through a multi-year bankruptcy; for example CZR has consistently outperformed Las Vegas rev par by 300bp over the past ten quarters.

RevPAR Growth 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18
LV Strip Ex-CZR 7% 3% 9% 4% 7% -3% 0% -8% -5% 2%
Caesars 7% 6% 11% 7% 10% 0% 3% -3% -2% 4%
∆ bps - 311 249 309 254 280 298 527 347 113
Average spread of ~300 bps between Caesars & the Las Vegas Strip

It is now thoughtfully spending (i.e. Flamingo not Rio) to refresh its rooms and build new convention space in the Vegas market where it makes 58% of EBITDAR. Although 5.5x leverage is nothing to take lightly, the presence of VICI materially reduces the possibility that CZR could be caught short of funds and explains why the CFO doesn't feel compelled to use cash from operations to delever. Because a related REIT structure is stuffing the company with cash from time to time, CZR can actually use its free cash flow yield to do leverage neutral or accretive deals (or even buy back $311mm of stock YTD). At less than 8x for a major national gaming company, a double digit free cash flow yield to equity and a stock down 50% for the year, I like the risk reward.

We should have a new CEO in 1Q19 who may clarify the story - as well as a quarterly report.

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