“Corporate culture matters. How it chooses to treat its people impacts everything - for better or worse…” Simon Simek
Depending on who you believe, Eldorado Resorts, Inc. (NASDAQ:ERI) is either inching closer to finalizing a deal to merge with Caesars Entertainment Corp. (NASDAQ:CZR) by month’s end, or still mulling whether to up its offer. We know that $10.50 a share was put on the table, perhaps $11. At best that put a 15% premium over the CZR trade. Clearly, that number did not work for the CZR board or more importantly, Carl Icahn, now holding 28.5% of the stock including swaps.
We know for certain from our own sources that ERI is well past the tire-kicking stage. It has done as deep a dive as it and its bankers can do on the CZR numbers and valuations. Whether it elects to up a bid that will get the thumbs up from Icahn or not largely depends on several factors. Will other serious buyers emerge with bids? (Golden Nugget’s Tillman Fertitta’s bid in the $12.50 to $13 range had been rejected by the CZR board last fall). ERI’s CEO Tom Reeg is no stranger to deal-making in the space having bought MTR Gaming, Isle of Capri and Tropicana (from Carl Icahn). Reeg has told the CZR board he wants to see first how $500m in cost savings could be achieved, before he lays down another offer.
Above: The Atlantic City Tropicana, doing well in a market that's half the size of what it was in 2006. Source: ERI
Since the parties continue to talk, we assume that a case was either made or is in the making to produce a feasible scenario for a $500m savings as a predicate for a deal. Then there is the classic Icahn path of waiting it out, building up valuation by improving operations and then selling at a fat premium.
These deals have brought this once iconic Reno-based family enterprise to a status as a major player in the US regional gaming space with 26 casinos in 13 states. We have every expectation that even if the CZR deal tanks, ERI is still worth a very hard look now going its own merry way. We have been fans of the stock and its management for a long time.
A quick history:
On September 20, 2016, we posted an ERI article on SA. That day the stock traded at $14.25. Our thesis was this: A great gaming family management DNA in the controlling Carrano family that was eventually joined by a savvy, aggressive CEO in Reeg would auger well for going long on the stock.
On September 15, 2017, we guided bullish on ERI again in another SA article. That day the stock was trading at $24.60, up 70% from our call the year before. We put a PT of $35 on the stock and guided readers to stay long; there was still runway ahead.
Since then we have continued very bullish on ERI as it absorbed its acquisitions efficiently, monitored its debt profile well and produced accretive EBITDA over 5 quarters since 1Q18.
Price at writing: $51.75
We also like how the company has expanded geographically with properties added in Las Vegas as well as Pennsylvania. This gave a Nevada fortress position and a strong new East Coast foothold between ERI’s southern, western and Midwestern properties acquired when it bought Isle of Capri.
Sports betting deal with William Hill
ERI made one of the better sports betting expansion deals with giant William Hill’s US subsidiary, William Hill Plc: (OTCPK:WIMHY). In exchange for partnering on sports betting action in 11 of its 13 states, it will receive a 20% equity interest in that company, plus another 1.3% of the giant UK parent. So it’s not merely a standard revenue share but in fact, enables ERI to profit not only from a share of sports betting revenue from its properties, but the potential upside in the Hill US shares should they appreciate going forward. The deal includes both online and brick and mortar betting sites.
Below: The William Hill deal includes a generous 20% equity stake for ERI in the US subsidiary and a 1.3% piece of the giant UK parent. Source: ERI
This shows us a level of deal-making creativity that bodes well for ERI as sports betting legalizations begin to proliferate. Right now, we’re at 10 states that are legal. Our forecast is that within the next five years that number will go to between 17 and 20 states where sports betting will be legal.
Price at writing today: $51.75, up more than 4X from our original 2016 call. This is entirely due to what we continue to believe is a superior management focus on the ABCs of running a profitable gaming company. Expanding a founding family’s DNA of customer service is an easier said than done proposition. An expansion in size and scope tends to thin out a core, hands-on management culture. What replaces it unfortunately, is an overdependence on systems and the kind of hubris that often accompanies it as was the case with CZR under the old regime.
Does ERI still have a runway if the CZR deal tanks?
With coverage on ERI dominated by the possibilities in the CZR deal, we thought it was time to consider the company if no deal were made. What if ERI saw an Icahn target price, which we believe lies somewhere between $14.50 and $16 at this point as too much of a stretch and walked away?
The bull case continues in our view despite a few key factors which could be seen as bearish at the current trade.
ERI is pricey compared to its closest peers:
Its P/E (ttm) is 42.76 against an EPS (ttm) of $1.22. The stock is up near 7% on the merger rumors.
Penn National Gaming (NASDAQ: PENN) trades at a P/E (ttm) of 23.88 with an EPS (ttm) of $0.84.
Boyd Gaming Corp. (NYSE:BYD) 24.66 against an EPS (ttm) $1.04.
All these are good companies which go head to head in many regional markets. ERI Consensus PT: $56.75.
Furthermore, ERI posted an ROE of 11% in 2018, which fell below the general hospitality industry benchmark of 14%. Its debt to equity ratio is 3.80. This tells us that management is using debt generously to fund its growth. The hospitality industry average is not a fully analogous metric since it includes non-gaming hotel companies.
So if you are inclined to be turned off by this paradigm at a $52 entry point it is understandable. Stripped of the CZR possibility, would ERI tank back down into the mid to lower forties, or even less?
I tend to look at these kinds of companies from an industry-centric viewpoint, not just standard metrics. My view: There is still runway ahead, CZR or no CZR.
Our PT assuming the CZR deal does not happen is $63 based on what I see as the propulsion in the sector by its most aggressive acquirer.
The speed of consolidation in the US regional gaming space has been picking up momentum for the last three years. ERI, Penn National, Boyd Gaming as well as giant MGM Resorts International (NYSE:MGM) and recently, CZR itself which have bought two Indiana racinos. They have all been buying into markets to increase their national footprints. The combination of still cheap money, and the balkanized nature of regional gaming has pushed the scramble to scoop up smaller regional operators.
The sale of gaming realty to REITs is one of the safety values seen as casino operators take on debt to buy properties and then quickly move the realty into REITs. It’s not my favorite approach but it makes the process highly propulsive in de facto financing expansion and turning debt into EBITDA. Either way, I see ERI well-situated to move forward at a quickening pace of growth unfettered by foolish asset allocations. CZR, with more US casinos than anyone (37) was unable to overcome the debt burden taken on with its sale to private equity operators Apollo Global and TPG in 2006. Nor did its 55 million member database rescue it from the 2007/9 recession. CZR’s bankruptcy certainly resulted from its being too big not to fail when recession and crushing debt hit it simultaneously.
It was as much the result of bad management and asset allocation than macro events out of its control. Contrariwise, ERI has made good decisions on asset allocation that have brought a net plus to both their geographic footprint as well as accretive earnings. While we think the general quality of management at the major regional operators noted above is good, we like ERI best because it is less heavier invested in the Las Vegas locals market than is BYD, and far less invested in the racino construct as is Penn National. We see a pattern in CEO Reeg’s acquisitions: He is a big game hunter as is evidenced in his stepping up to the plate on a possible CZR deal as the most logical mover for the deal. MGM is already too big and spread out, Wynn (NASDAQ:WYNN) and Las Vegas Sands (NYSE:LVS) are clearly Asia future facing companies.
Wynn’s Boston property, about to open, may be its only move in the US east coast. LVS recently closed on the sale of its only US regional in Bethlehem, Pa to a tribal operator.
So here’s my bull case based on what we believe augers for the rationale for ERI even if the CZR deal tanks:
I believe that ERI will continue big game hunting to diversify its geographic portfolio. I have every expectation that the successful sequence of acquisition, absorption and imposition of a highly positive management culture, will result in more merger activity going forward. I see the company able to digest acquisitions, convert debt to EBITDA with a strong business model based on excellent customer service DNA. With $4.22bn in long-term debt and an acquisitive nature, some investors worry about its net margins, and its debt to equity ratios.
There is also concern about the pace at which it can generate enough FCF to continue to manage a reduction in its debt profile going forward being so aggressive an acquirer. There are never guarantees without question. But investors in the space understand that the casino business has been, is and will probably always be a heavy capex sector. But it is also a mighty generator of cash.
The takeaway: From the all-important line employee level I have experienced, all the way up to the board room, ERI has a healthy management profile from an industry-centric viewpoint. Mr. Market generally glides over these kinds of attributes, tending to look at earnings profiles, debt, macro trends in gaming, markets. All these are unquestionably useful in evaluating a decision whether to call a buy hold or sell on a given stock.
But not all metrics are created equal. The EV/EBITDA is the best for gaming stocks in our opinion. ERI’s is 11.71, around the lower end of where the S&P range sits between 11 and 14. But even this very good metric doesn’t alone provide the essence of the bull case I see on the company.
So with ERI my view is that you are betting on the metrics to some extent, but the confidence in your pick has to include a premium for the demonstrated acuity of ERI management.
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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.