Betting on Casinos, Part I

One of my friends sent me a Barron's article on Caesars' stock from last week and suggested that it would be a good topic to discuss. It is indeed a good topic because it involves a farrago of issues such as equity valuation, a complex capital structure and an alleged distress situation.

"Caesars (ticker: CZR), which has been gearing up for legalization, has one of the leading brands in its World Series of Poker. Yet the shares look overpriced because the debt-laden company has little going for it besides a future in online poker. Its current market value of about $2 billion assumes legalization of online poker at state and federal levels and significant profits from what is likely to be a very competitive business." Barron's

The company only issued 1% of its outstanding stock in it's IPO, and Barron's claims that volatility in stock price and the alacrity with which shares were scooped up is due to a scarcity of supply. 

Importantly, the company is encumbered by so much debt that any equity value would be elusory. 

"There appears to be little or no equity value in Caesars' core business given the ugly financials. Yet the IPO prospectus shows Caesars carved out its online business, including the World Series of Poker, into a separate unit unencumbered by debt. This means Caesars equity holders should get all the online profits; hence the investor focus." Barron's

There are two issues that I have with betting on the online gaming business for Caesars: 

1) Just because the online gaming business is in a separate unit that is unencumbered by debt does not mean that its proceeds cannot be used to pay for the debt that has a parent guarantee. 

2) I'm not sure if online gaming is as lucrative as the gaming industry would have us believe. 

I'm going to discuss the first issue in this post and the second issue in the next post. For starters, here's the organization structure according to Caesars' website in a presentation dated December 4, 2013:

Notice that the public shareholders hold shares in the Parent company, Caesars Entertainment Corp. The online gaming portion is held in a separate entity called Caesars Interactive Entertainment, as the Barron's article stated. 

"Caesars Interactive Entertainment, Inc. ("CIE"), which is a majority owned subsidiary of CGP LLC, operates an online gaming business providing for certain real money games in Nevada, New Jersey, and the United Kingdom; "play for fun" offerings in other jurisdictions; and social games on Facebook and other social media websites and mobile application platforms, such as Slotomania. CIE also owns the World Series of Poker ("WSOP") tournaments and brand, and licenses trademarks for a variety of products and businesses related to this brand." CZR 2013 10K 

So let's break down the debt level at various subsidiaries. According to the Prospectus Supplement for CZR Stock, CEOC has $15.8 billion of debt, CERP has $4.6 billion of debt and CGP has $721k of debt. Total debt on CZR's balance sheet, therefore, is a little over $19 billion. CGP has an additional $1.1 billion of debt that is associated with a recent acquisition of four properties from the Parent. 

Even though CIE does not have any debt outstanding, that does not mean that all of its earnings go to public shareholders. The reason is that the shares are issued at the Parent level or Caesars Entertainment Corporation (CZR). Moreover, of the $19 billion of debt listed on the balance sheet, at least $15 billion of that is stated in the prospectus as Guaranteed by the Parent or Guaranteed by the Parent and certain other subsidiaries. What that implies is, in the case of a bankruptcy, at least $15 billion of debt is still considered an unsecured obligation by the parent and is still ahead of the equity claims. 

Now that we know that there really is a substantial amount of debt ahead of the equity, the shares can be valued on the likelihood of the Parent being unable to meet its debtors' obligations. 

There is some real concern of Caesars being able to meet its debt obligations. Caesars' latest sale of four casinos to CGP has raised some eyebrows. 

"Caesars Entertainment Corp. (CZR)’s $2.2 billion property sale to an affiliate raises the chances the world’s most-indebted casino operator will force a restructuring of its bonds at a loss to investors.

By selling four casinos to Caesars Growth Partners LLC, the unprofitable company will receive proceeds that Chief Executive Officer Gary Loveman said will help pay down loans. That may help the company persuade those lenders to amend its credit agreements, allowing it to restructure high-cost bonds on more attractive terms, according to CreditSights Inc.

This week’s transaction means the operating unit “will have far fewer assets in Las Vegas where the market is improving -- it will be left with Atlantic City assets where the market continues to basically tank,” Kim Noland, an analyst at Gimme Credit LLC, said in an e-mail. Anticipated future steps will include a distressed-debt exchange and possibly the removal of the parent guarantee." Bloomberg

And the bondholders aren't sitting idly by. Second-lien bondholders of Caesars Entertainment Operating Co., such as Canyon Capital Advisors, Oaktree Capital Management and Appaloosa Management (which, full disclosure, is my former employer), have sent a letter to Caesars Entertainment Corp that alleges that its operating unit is insolvent and that some of its intercompany transactions constitute fraudulent transfers. 

"Still, if the second-lien bondholder group formally litigated and succeeded in court, the lenders could simply get their money back, which wouldn't be a very rewarding result.

In a worst-case scenario, however, CEOC could file for bankruptcy, in which case the new lenders' claims could be subject to a stay and could be invalidated." The Deal Pipeline

If the bondholders are right and CEOC is insolvent, files for bankruptcy or restructures, CZR could be on the hook for making its guaranteed debt as close to whole as possible. Thus, the equity value could be diminutive considering the $15 billion of debt that is guaranteed by the parent is issued by CEOC.

The other obstacle for the stock could be CGP which wholly owns CIE, the unit with the online gaming business. CGP also has a substantial amount of debt associated with it, $770 million of which is on the balance sheet and $1.1 is billion associated with acquisition of the above properties. That debt is an unsecured obligation of CGP, so if CGP has to restructure, any equity that would have been generated from CIE would also be diminished. 

Thus, I think pricing CZR stock is less of an exercise in valuing the online business and much more of an exercise in valuing CZR's subsidaries that have issued bonds with Parent guarantees.