Description

Caesars Entertainment (CZR or CEC) is a mispriced special situation following the closing of the bankruptcy restructuring of its subsidiary CEOC (along with its emergence from bankruptcy) and the merger of Caesars Acquisition Corp. (CACQ) and CZR/CEOC.  I believe the mispricing is caused by several temporary issues, and two underappreciated longer-term dynamics.

Following the completion of the restructuring, the litigation risk from former CEOC creditors has been removed, and CZR now has more flexibility to pursue growth opportunities (both M&A and greenfield development).  CZR trades at a discount to its closest comps, but more significantly, it is discounted without giving any credit to the two underappreciated longer-term dynamics which lead to an even lower effective valuation pro forma for transactions that are either agreed upon (i.e., the three Call Right Properties) or likely to occur (i.e., other properties discussed below on the roadmap of VICI Properties shown during VICI’s roadshow).

CZR is in the process of transitioning to a more asset-light model, with less casino ownership and higher operating leverage, which should improve CZR’s multiple.  CZR is shifting its casino asset base from owned and operated casinos towards operating casinos sold to the VICI REIT (and potentially other REITs) and leased back, and CZR is poised to unlock value for shareholders.

Temporary Issues Causing CZR Mispricing

The initial overhang and selling pressure from former CEOC creditors selling CZR stock.  

--CEOC creditors—not natural long term CZR holders—ended up with ≈416 million shares (excluding the convert), which represent 69% of the non-Sponsor shares currently outstanding.  There were only 149 million CZR shares outstanding prior to the merger/restructuring, 88 million of which were owned by the Sponsors (TPG/Apollo, etc.), so it was not possible for creditors to short out their full CZR exposure prior to the merger.  ≈40 million CZR shares were short on the Effective Date (65% of the non-Sponsor CZR shares outstanding prior to the merger/restructuring).

--It took from closing (Oct. 6, 2017) to late November for CZR to trade enough shares for the creditors to potentially get liquid (if you assume all sales were from the creditors, which is unlikely: some other shareholders were also selling during that time period), so there has been a large overhang pressuring the stock for most of the time since the closing of the merger/restructuring.

--In addition, on December 5, 2017, the TPG/Apollo Co-Invest Funds distributed 46.7 million shares pro rata to their members, which may have added some selling overhang.

Complexity of the situation is confusing some analysts.  For example:

Capital structure confusion

--The reconsolidated capital structure had been opaque prior to the restructuring, and although it was clarified and finalized with the restructuring, some confusion remains given that the latest 10Q does not reflect the post transaction structure (which closed Oct. 6, after the Q3 close).  The final equity capitalization structure is included at the end of this write up.

Longer-term Dynamics Causing CZR Mispricing (more detail for each is below)

1) (Most important) Underappreciated Real Estate Value:  a) The cash value embedded in CZR’s real estate, which is in the process of being monetized through sale-leaseback transactions with VICI Properties, and b) the ongoing opportunity to create incremental CZR equity value in M&A transactions using the proceeds from real estate sales, which have a multiple arbitrage that create incremental CZR equity value.

2) Latent pricing power in Las Vegas room rates

Brief Background on the CZR Merger/Restructuring

On January 15, 2015, CEOC filed for Chapter 11 Bankruptcy.  On October 6, 2017, CZR/CEOC and CAC completed a merger/restructuring in which CEOC converted its corporate structure into two companies—OpCo (New CEOC) and PropCo (VICI REIT).  

Certain domestic properties were contributed to VICI (initially 19 properties, including Caesars Palace), which is now wholly owned by former CEOC creditors.  New CEOC (a wholly owned subsidiary of New CEC) continues to own substantially all operations, gaming licenses, personal property and other related interests in the casinos, and leases the properties owned by VICI REIT.  CEC does not own any equity interests in VICI REIT.  The chart below represents the structure of New CEC after the completion of the merger/restructuring:

Full background on the merger/restructuring can be found in the proxy statement / prospectus from 6/23/17:

https://www.sec.gov/Archives/edgar/data/858339/000119312517211279/d303274d424b3.htm

More Detail on Longer-term Dynamics Causing CZR Mispricing:

1) Underappreciated Real Estate Value

--Call Right Properties = $1.3 billion of cash value for CZR

--Additional Properties on VICI’s near-term roadmap (which is included in the VICI roadshow and is pasted below) = $6.5 billion of cash value for CZR

--Total Value of properties on VICI’s near-term roadmap = $7.8 billion of cash value for CZR

Following the restructuring, CZR’s property structure is the following (with the modification that after this presentation was prepared, CZR and VICI completed a sale-leaseback of Harrah’s Las Vegas real estate):  

VICI and CZR have a Right of First Refusal Agreement which provides both VICI and CZR with ROFRs on future acquisitions of domestic gaming facilities located outside of Clark County, Nevada, or Greater Las Vegas, proposed to be owned or developed by Caesars or VICI.  They amended the ROFR Agreement to include a ROFR on a future sale-leaseback of the properties Caesars recently announced it is acquiring from Centaur Holdings, so after the Centaur acquisition has closed, CZR can also sell the Centaur real estate to VICI, which will create additional incremental equity value for CZR.  

VICI and CZR also have a Call Right Agreement that specifies the following:

--VICI has a Call Right (for up to five years) to purchase and leaseback three properties from CZR: Harrah’s Atlantic City, Harrah’s Laughlin, and Harrah’s New Orleans.

--The agreed cash purchase price is 10x the initial annual rent for each property.

--The initial rent for each property will be determined based on a rent-to-EBITDAR ratio of 1.00-to-1.67 (i.e., rent ≈60% of LTM EBITDAR for each property at the time of call option exercise).

The three properties on which VICI has a call option represented $130 million of total rent (as of the 6/28/16 CEOC Disclosure Statement, pg. 393; the VICI roadshow in January 2018 still assumes $130 million rent for these three properties), and will be acquired for 10x annual rent: $1.3 billion if rent remained flat since that time.  VICI Pro Forma EV/EBITDA (LTM Adjusted) is 15.3x ($10.9 billion EV (pro forma for HLV acquisition, $1 billion equity private placement, and IPO at midpoint of filing range); $711 million LTM adjusted EBITDA), so they should see rapid accretion from buying the rent from these three call properties (which will drop straight to EBITDA for VICI) at 10x.

In addition to the three Call Right properties, VICI states in its prospectus about the rest of CZR’s owned U.S. casinos: “We may seek to purchase additional Caesars properties, similar to our recent acquisition of Harrah’s Las Vegas. Additional owned properties of Caesars include:”

1. Octavius Tower (Las Vegas)

2. Paris Las Vegas

3. Bally’s Las Vegas

4. The Cromwell (Las Vegas)

5. Flamingo Las Vegas

6. The LINQ Hotel & Casino (Las Vegas)

7. Planet Hollywood (Las Vegas)

8. Rio Hotel and Casino (Las Vegas)

9. Harrah’s Philadelphia (Philadelphia, PA)

10. Horseshoe Baltimore (Baltimore, MD) (JV in which CZR holds ≈40.9% interest)

CZR does not disclose property level EBITDAR in its quarterly or annual reporting, but EBITDAR for the next CZR properties on VICI’s shopping list can be imputed from the TEVs and Multiples in the tables on pages 311 and 312 in the proxy statement / prospectus from 6/23/17:

https://www.sec.gov/Archives/edgar/data/858339/000119312517211279/d303274d424b3.htm

VICI bought Harrah’s Las Vegas for 13x rent (7.7% Cap Rate), which is on the low end as a multiple / high end for Cap Rate based on recent comparable single asset real estate transactions (from the VICI roadshow):

Even though 13x rent is on the low end of multiples for recent comps, if we assume the remaining CZR properties are purchased at 13x rent and based on the terms in the PropCo Call Agreement (rent-to-EBITDAR ratio of 1.00-to-1.67), the cash value to CZR of these properties represents $6.5 billion. Together with the $1.3 billion cash from the three Call Right properties, the properties represent $7.8 billion: 44% of the current enterprise value of CZR (net of the rent finance obligation to VICI).  A lower cap rate (and higher multiple) more in line with the comps above would generate even more cash for CZR.

In addition, CZR’s 9 owned international casinos offer an additional source of liquidity in a similar fashion, potentially of similar size, but the financials for those casinos have not been disclosed, so the magnitude is uncertain.

The following table shows CZR’s TEV / EBITDAR multiples for the following:

--LTM

--2018E

--Pro Forma for the Centaur Holdings (not including the planned introduction of table games) and Harrah’s Las Vegas transactions

--Pro Forma also including sale-leasebacks with VICI of the properties described above

--Pro Forma also including sale-leasebacks of the properties described above and 9 the international owned properties (assuming those properties represent similar financial size as the properties described above).

CZR valuation and multiples (assuming conversion of the convertible notes, which are in the money) are the following.  Each scenario increases the discount at which CZR is trading relative to its closest comps:

Note: CZR deconsolidated financial results for Horseshoe Baltimore in Q3’17, and CZR’s 40.9% stake in Horseshoe Baltimore is now accounted for as an equity method investment, so it needs to be valued separately.  The average of the value estimates by Moelis for CZR’s Horseshoe Baltimore stake (in the merger proxy statement / prospectus) was $88 million.

The VICI roadshow highlights the advantages VICI’s independence and governance offers them as a bidder for casino real estate relative to potential competitive bidders who own casinos (e.g., MGP), which send a key message to any gaming operator that decides to pursue a sale-leaseback of casino real estate to a gaming REIT:

--VICI will not be a competitor of theirs, and information about their ongoing operations will not be in the hands of a competitor.  In the words of the VICI CEO: “If you were McDonald’s, you wouldn’t want Burger King as your landlord.”

--Independence: there is 0% Tenant (i.e., CZR) ownership of the VICI REIT

--Governance: there is 0% REIT / Tenant Board of Directors overlap

This dynamic should enhance VICI’s access to capital, which they can then use to acquire additional CZR real estate..

2) Arbitrage Opportunity for the REIT Structure to Create Incremental CZR Equity Value in M&A Transactions

The cash generated by the casino sales described above can be used for future M&A.  Casino real estate sale-leaseback transactions can create incremental equity value for CZR due partly to multiple arbitrage, as Eric Hession (CFO) described during the May 18, 2017 CZR Analyst day:

Acquiring properties for 7-9x EBITDA, funded largely by selling real estate to the VICI REIT (although 11.5-12.5x rent is used in the example above, Harrah's Las Vegas real estate was recently sold to VICI for 13x rent), which in combination with synergies leads to a very low effective EBITDA purchase multiple for an acquired property, which in turn will create incremental equity value for CZR when the incremental EBITDA is capitalized at CZR's multiple.  CZR is undervalued prior to realizing the benefits of incremental equity value from transactions of this type.

In the first actual example of a transaction of this type, CZR announced that they are acquiring Centaur for an 8.3x implied EBITDA multiple (in year two inclusive of expected synergies); assuming introduction of table games to these properties (pending regulatory approval), the effective purchase price multiple would be less than 7x at that time:

http://investor.caesars.com/news-releases/news-release-details/caesars-entertainment-acquire-centaur-holdings-llc-17-billion

CZR will fund most of the transaction with the sale of Harrah's Las Vegas real estate (which CZR sold to VICI for 13x rent), so the remaining Harrah's Las Vegas EBITDA capitalized at the current CZR multiple will create incremental equity value for CZR.  

http://investor.caesars.com/news-releases/news-release-details/caesars-entertainment-announces-completion-harrahs-las-vegas

Transaction Summary for Centaur Holdings and Harrah’s Las Vegas is the following:

VICI highlighted during its roadshow that the limit on the deductibility of interest in the tax reform, may make casinos prefer real estate sale-leasebacks rather than debt to raise capital, since there is no limit on the deductibility of rent.  The new tax law also allows for a 20% deduction on income from REITs.  CZR will also be a beneficiary of the tax law change to allow accelerated depreciation of cap ex (which is ongoing).

2) Latent Pricing Power in Las Vegas Room Rates

The Las Vegas ADR Premium is well below late cycle peaks:

This lack of price premium gives CZR powerful potential future pricing power, which could lead to meaningful EBITDAR growth even with flat occupancy.  In combination with the high Las Vegas occupancy rates and the fact that few lodging or gaming real estate developments of significance are expected to open along the Strip over the next several years, there is latent pricing power for Las Vegas ADR:

Non-gaming revenue has continued to grow as a percent of the total, and Caesars has more room to grow in this regard than others:

Free call options included in a stake in CZR:

--Additional visitation resulting from to move of the Raiders to Las Vegas with a new stadium, and the potential of a basketball franchise in Las Vegas with the proposed Las Vegas Sands-Madison Square Garden joint venture arena: http://m.lasvegassun.com/news/2018/jan/25/sands-joined-by-madison-square-garden-to-unveil-ar/

--Continued growth of e-sports and e-gaming, where CZR will participate and benefit.

The final equity capitalization structure is the following:

CZR Financial Information:

VICI Prospectus: https://www.sec.gov/Archives/edgar/data/1705696/000119312518011685/d496153ds11a.htm

Catalyst

--End of the overhang and forced selling by former CEOC creditors

--Equity brokers have been resuming coverage, and more will do so.  CZR shares had been orphaned by equity analysts, but coverage has recently been initiated by numerous brokers

--A larger public float

--Broader group of investors that can own the stock, including those prohibited from owning due to having a subsidiary in bankruptcy

--Refinancing of existing debt improving FCF generation, which will support faster deleveraging.  Refinancings have already reduced their cost of capital and reduced combined annual interest expense by more than >$290 million.  

--Potential addition to indices (e.g., S&P 500)

--ADR growth due to ongoing renovations and latent pricing power for room rates.

--Execution of additional sale-leaseback transactions of remaining CZR properties, which will generate cash that can be used for accretive acquisitions

--Execution of additional M&A

--Incremental equity value from sale-leaseback transactions and M&A funded by those transactions.