Kent State University

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1 Kent State University Kerrisdale Capital Investment Case Study Caesars Entertainment Corporation Evan Gallagher Daniel Shuster Shervon Preston

2 Caesars Entertainment Corporation Equity Research Report Kent State University Highlights Competitive Landscape: Caesars lags behind its competitors in terms of profit margin, and lacks a physical presence in Macau, China, the largest gambling hub in the world. Bankruptcy Proceedings: Caesars primary revenue generating unit, Caesars Entertainment Operating Company is in the midst of a bankruptcy filing. The proposed restructuring plan calls for a decrease in the operating unit s debt, however there is significant controversy surrounding the shifting of assets between Caesars various entities. Negative Cash Flow: Caesars currently operates with negative free cash flow and will continue to do so well into This report is published for educational purposes only by students competing in the Kerrisdale Capital Investment Case Study for the Economist Ticker: CZR Current Price: $10.95 Recommendation: SELL Market Data 52 week High ($) $30 CZR Daily Adjusted Stock Price 52 week Low ($) Previous Close ($) Market Cap (Millions $) EPS (ttm) ($) , $25 $20 $15 $10 $5 $0 Company Overview Caesars Entertainment Corporation owns, operates, and maintains casino and resort properties across fourteen states and five countries. The company is headquartered in Las Vegas, Nevada. 1

3 Industry Overview Industry Overview Caesars Entertainment Corporation operates in the casinos and resorts industry. The industry is competitive, heavily regulated, and very sensitive to economic conditions. Commercial casino gaming takes a variety of forms, the most recognizable of which consists of what are called Las Vegas-style casinos. Other commercial gaming venues include excursion (mobile) and dockside (permanently moored) riverboats, card rooms, and racetrack casinos, commonly called racinos. Economic Slowdown The Casino industry is heavily depended on the level of disposable income available to the general consumer. The economic recession brought a fall in consumer discretionary spending which in turn caused the casino industry to suffer, and despite the general market recovery, the casino industry has yet to fully recover. The Las Vegas Strip was hit hard by the economic recession, and it continues to suffer. An increasing number of states have legalized gambling, which in turn has led to a decrease in traffic to Nevada, and this lower profits for some of the largest casinos. There are currently twenty-one states and two U.S. territories that allow commercial casinos in some form. Macau Macau, China is the world s largest gambling hub, which recently saw its first full year decline in revenue since the early 2000 s. China s high profile corruption crackdown is to blame, specifically that of Xi Jinping, the President of China, who s crusade against mobsters has deterred ultra-high net worth and VIP gamblers away from the gaming tables. These gamers account for two-thirds of Macau s casino receipts, and their absence has sent revenues down by 2.6%. The fate of the gaming industry in Macau is largely dependent on how far the Chinese government will take the war on corruption. While Macau is suffering, Japan is taking steps to legalize casinos. With projections of an increase in high net worth individuals, Japan may soon be a key destination. 2

4 Industry Overview (cont) Regulatory Environment The casino and resort industry is subject to a variety of federal, state, foreign, and local regulations. Most states, including Nevada, require casinos to adhere to a set of state procedures typically known as the Minimum Internal Control Standards (MICS). The MICS focus on several aspects of casino operations including conduct of games, movement of cash, and the accounting and record keeping of transactions. Due to the high volume and high denomination of such transactions, casinos must meet many of the same requirements as banks including anti-money laundering regulations. The Bank Secrecy Act, which pertains to anti-money laundering requirements, amongst others, requires banks to document every transaction above $10,000 USD. Competitive Situation Domestic & International The casino and resort industry is highly competitive, with competitors varying in size, quality of facilities, brand, amenities, and a number of other factors. In some locations, such as Las Vegas, Caesars competes directly with other casinos and resorts in the immediate area. In other locations, there is competition from the immediate area as well as surrounding markets. Caesars currently operates casinos and resorts across the country, with a large concentration in Las Vegas and Atlantic City. Caesars also operates casinos in the United Kingdom, Egypt, South Africa, Canada, and Uruguay. One region that Caesars lacks a presence is Macau, China. As stated earlier, Macau is the world s largest gambling hub, and the lack of a physical presence puts Caesars at a severe competitive disadvantage. Caesars did purchase land in Macau in 2007 for $525 million, however the company was unable to receive permission to begin construction of a new property. In November 2013 it sold property to Pearl Dynasty for $438 million. Despite the relative slow down in Macau, we believe that the lack of a presence in the region will have a serious impact on Caesars revenue growth. Macau is the premier gambling destination for ultra-high net worth individuals who provide large streams of revenue and high profit margins. As the economy continues to improve, casinos in Macau will see improved business from the ultra-high net worth consumer, business that Caesars will not have access to. Las Vegas Sands Corp and Wynn Resorts International continue to be major players in the casino and resort industry. Both companies have also expanded into Macau and have taken advantage of the growing and high margin gambling market in the region. The additional revenue has allowed Sands and Wynn to build new properties as the legalization of gambling improves both domestically and abroad. Many casino operators, including Caesars, are reinvesting in existing markets, adding amenities to attract new customers, and intensifying competition in regional markets. Operators are also looking to expand to other markets to even out revenues. Caesars has experienced negative results in regards to expansion. Attempts at expansion in Maryland, New York, California, and Pennsylvania have had negative impacts on operations in New Jersey. Expansion is critical for Caesars revenue growth and its inability to do so without cannibalizing its existing operations is cause for concern. 3

5 Company Background Caesars Entertainment Corporation (NASDAQ: CZR) is a diversified casino-entertainment company. The company is operated through its wholly owned subsidiary, Caesars Entertainment Operating Company, Inc. Caesars operates fifty casinos in fourteen U.S. states and five countries. Figure 1, below, outlines Caesars domestic operations. Caesars also owns an online gaming venue, bingo, poker games, and has alliances with gaming operators in Italy and France. The company s resorts operate primarily under the Harrah s, Caesars and Horseshoe brand names. Caesars Entertainment Corporation is comprised of the subsidiary Caesars Entertainment Operating Company, Caesars Entertainment Resort Properties, and Caesars Growth Properties. In 2005, Harrah s Entertainment Corp, founded by William Fisk Harrah in 1937, completed its takeover of Caesars Entertainment Inc. and chose to operate under the Harrah s brand. Shortly thereafter in 2010, Harrah s changed its name to Caesars Entertainment Company which is the current publicly traded entity was a volatile period for Caesars, which at the time still maintained the Harrah s moniker. It began with Harrah s delisting from the New York Stock Exchange and culminated with a leveraged buyout (LBO) by private equity firms Apollo Global Management, LLC and TPG Capital, LP. Harrah s assumed around $20 billion in debt when acquired. Caesars Corp currently has a joint venture with Apollo Global Management, with TPG Capital and the Blackstone Group owning a large portion of stock. Although Caesars may have seen this move as beneficial to the company, it would be the start of a rather grim journey. Arizona Mississippi New Jersey Harrah's Phoenix Ak-Chin Tunica Roadhouse Bally's Atlantic City Horseshoe Tunica Caesars Atlantic City California Harrah's Gulf Coast Harrah's Resort Atlantic City Harrah s Resort Southern California Missouri North Carolina Illinois Harrah's North Kansas City Harrah's Cherokee Harrah's Joliet Harrah's Metropolis Nevada Ohio Harrah's Laughlin Horseshoe Cincinnati Indiana Nobu Hotel at Caesars Palace Horseshoe Cleveland Horseshoe Hammond Bally's Las Vegas ThistleDown Racino Horseshoe Southern Indiana Caesars Palace Las Vegas Harrah's Las Vegas Pennsylvania Iowa The Cromwell Las Vegas Harrah's Philadelphia Horseshoe Council Bluffs The LINQ Las Vegas Harrah's Council Bluffs Harrah's Lake Tahoe Ontario-Canada Harrah's Reno Caesars Windsor Louisiana Harveys Lake Tahoe Harrah's Louisiana Downs Paris Las Vegas Horseshoe Bossier City Planet Hollywood Resort & Casino Harrah's New Orleans Rio All-Suite Hotel & Casino Maryland Horseshoe Baltimore Flamingo Las Vegas Figure 1: Caesars domestic operations Source: Caesars Total Rewards 4

6 Pre-Bankruptcy Financial Structure and Performance It is hard to fathom that Apollo Global Management and Texas Pacific Group (TPG) seriously believed in the financial position of Caesars Entertainment in the wake of their 2008 leveraged buyout that left the firm with over $20 billion in debt. Although their combined $6 billion equity stake in the post-harrah s company has been substantially impaired in the wake of Caesar s 2009 financial troubles, there is ample evidence that Apollo and TPG have netted lucrative cash flows from the deal. It has been reported that Apollo and TPG collected a $200 million transaction fee in 2008 as part of the deal. In addition, both companies reap annual management fees of $35 million, fueling controversy among limited partners that object to such fees being retained by the general partner. In any case, the private equity firms have a vested interest in perpetuating Caesars existence, and they have gone to great lengths to shield the company from creditors by aiding in the creation of a disturbingly convoluted financing structure. Figure 2 is an organization chart provided by M&A due diligence consulting firm Xtract Research, shows just how complex Caesars corporate structure has become. Figure 2: Caesars corporate structure Source: Xtract Research 5

7 Pre-Bankruptcy Financial Structure and Performance (cont) It is noteworthy that this chart refers to Caesars Acquisition Company (NASDAQ: CACQ), a separate publicly traded unit that was formed in 2013 by Caesars Entertainment Corporation to shift property holdings away from the original holding entity (NASDAQ: CZR). The logic behind this maneuver was clearly to create another layer of separation between Caesars Entertainment Corporation s (formerly Harrah s) most valuable holdings and aggrieved creditors. Caesars did not stop there however. As the chart depicts, most of the properties are actually owned by an L.L.C. under the name of Caesars Growth Partners, only 34% is owned by CACQ, with the remaining 66% directly owned by Apollo and TPG (Carey, Keller 2015). Recognizing the need for protecting intangibles from creditors, Caesars formed yet another L.L.C. that constitutes a joint venture between the now-bankrupt Caesars Entertainment Operating Company (CEOC), CZR, and CACQ. While shifting assets away from CZR and CEOC, the company shifted a considerable portion of its debt into CEOC through a complex series of internal transactions and refinancing in 2014, the year leading up to the January 2015 bankruptcy. These transactions are facilitated by a dedicated financing subsidiary of Caesars Growth Partners called Caesars Growth Properties Finance, Inc. (CGPF). According to Bloomberg, CGPF routinely deals with creditors in the Cayman Islands and Bermuda to obtain additional financing (2014). This complex system of nested companies, subsidiaries, and related parties ought to be alarming to investors in either CZR or CACQ. Legal games such as this can protect assets from creditors for a time, but they cannot shield the company from the raw market forces that will ultimately drive Caesars to failure. Furthermore, the nature of the internal transactions poses serious questions of whether or not substantial corporate fraud is occurring. The legal risks associated with potential fraud are significant enough to collapse the entire company (CZR, CACQ, CGP, etc.). These possibilities will be further explored in a subsequent section. 6

8 Bankruptcy Proceedings and Money Laundering Allegations Bankruptcy Proceedings On January 15, 2015, Caesars Entertainment Operating Company (CEOC) filed for Chapter 11 bankruptcy protection after months of asset shuffling and negotiation with first-lien creditors, spearheaded by Apollo and TPG. In a December, 2014 press release, Caesars Entertainment Corporation announced that 80% of creditors backed the restructuring plan, effectively making Caesars bankruptcy plans pre-packaged in nature. This press release failed to tell the entire story, however. Three days prior, on January 12, a group of second-lien creditors had sued to force Caesars Entertainment Corporation (as opposed to its operating subsidiary) into what legal experts describe as a free-fall Chapter 11 proceeding in the U.S. bankruptcy court in Wilmington, Delaware, where Caesars is incorporated (Church, 2015). This would have been a significant development, as a Chapter 11 bankruptcy for the publicly-traded holdings company would have given creditors the opportunity to liquidate some of the company s more lucrative properties, and would have massively devalued the company s common stock. In a ploy to avoid this, Caesars motioned to move bankruptcy proceedings to the Northern Illinois federal district court in Chicago, where the operating company was incorporated. After several days of argument, a federal judge sided with Caesars attorneys, moving the Chapter 11 to Chicago where only the severely indebted (and asset deprived) operating company would be affected. Caesars restructuring plan will transfer what real property CEOC retains to a publicly traded real estate investment trust fund, or REIT. This REIT will likely be merged with the property holding entity CACQ, which will then lease properties back to a newly formed operating subsidiary of Caesars Entertainment Corporation. A comparison of the prebankruptcy organization with the proposed structure shows that there is actually little difference, beyond more asset shifts, and a few name changes. Of course, reduced debt and associated interest payments will alleviate some of the burden on the operating company. The bottom line, however, is that cash flows will remain unhealthy for the operating company, and that it is unlikely to survive another economic shock, regulatory change, or major litigation. Money Laundering Allegations Caesars has also been fighting allegations of money laundering being brought against it by the Financial Crimes Enforcement Network (FinCEN). FinCEN alleges that Caesars Desert Palace division violated the Bank Secrecy Act, which pertains to money laundering and the documentation of large transactions. We view this as yet another hurdle for Caesar s to overcome as fines for such violations often total in the tens of millions of dollars. An important note is that Caesars currently does not have provisions on its balance sheet to cover such legal fines. If found guilty, such fines as imposed by FinCEN would add to the stress of Caesar s low cash and high leverage position. In addition, criminal findings against Caesar s may discourage potential creditors. In an attempt to mitigate any future legal implications, Caesars has hired one of Wal-Mart Inc. s senior compliance officers, Benjamin Floyd, to focus solely on anti-money laundering practices. Even if Floyd proves successful in mitigating any future money laundering issues, Caesars still operates with negative cash flows as can be seen in a later section. 7

9 Adjusted Close Financial Overview In looking at the financials for Caesars, we began with a ratio analysis of Caesars and its peers, Las Vegas Sands and Wynn Resorts, using data from year-end As can be seen from Figure 3, Caesars lags far behind its competitors with a negative ROA (-11.9%), a negative debt-to-equity (-8.9), and a negative profit margin (-34%). Of chief concern is Caesars times-interest-earned ratio of -1.0, indicating that the company is earning less than it requires to service its debt, let alone earn a profit. Despite the proposed bankruptcy restructuring and subsequent debt write down, we believe that a negative profit margin coupled with a weak position in terms of assets will cause any reprieve from such a restructuring to be short lived. These ratios outline how poorly Caesars performs compared to its peers; and given its disadvantage from a competitive standpoint, we believe there is little chance for improvement. Caesars Entertainment Las Vegas Sands Wynn Resorts ROA -11.9% 10.1% 8.7% ROE 94.2%* 30.1% %* D/E Profit Margin -34% 17% 13% Current Ratio Times Interest Earned Figure 3: Comparative Margin Analysis Source: Morningstar, Kent State University *high % due to negative income and/or equity $250 Caesars Monthly Adjusted Close $200 $150 $100 $50 $ Caesars Entertainment Las Vegas Sands Wynn Resorts S&P 500 Figure 4: Market Performance Source: Yahoo! Finance, Kent State University From a market standpoint, Figure 4 shows the performance of Caesars publicly traded stock against that of Las Vegas Sands, Wynn Resorts, and the S&P 500 (NYSEARCA: SPY) from January 2012 through January As can be seen, Las Vegas Sands and Wynn resorts have generally moved with the market whereas Caesars has remained flat to negative. We expect a slight improvement should the bankruptcy be resolved successfully, however such an uptick in market valuation will be short lived as is discussed in the subsequent section. 8

10 DCF Analysis In examining Caesars from a valuation standpoint, we performed a discounted cash flow analysis (DCF) out to the year 2020 under what we believe are optimistic assumptions. Using Bloomberg estimates, we anticipate revenue growth of 3% annually and held all other balance sheet and income statement items as a percentage of revenue. In regards to Caesars debt levels, the analysis takes into account the proposed bankruptcy restructuring and subsequent write down of ~$10 billion in debt for Caesars Entertainment Operating Company (Reuters). This write-down allows Caesars to continue to operate with a positive cash balance to sustain ongoing operations. An important note to make is that we project short-term debt to grow at ~3% annually, however we feel that this is a wildly optimistic assumption as Caesars may face difficulty in acquiring short term financing should its chief operating unit emerge form bankruptcy. Despite modest growth in revenue and restructured debt, Caesars remains unable to bring its cash flow levels into positive territory as can been below in Figure 5. We calculated Caesars free cash flow as cash from operations less capital expenditures yielding consistently negative results through It is for this reason that we believe Caesars will ultimately be worthless within the next five years. The capital asset pricing model (CAPM) yielded a cost of equity of ~19%, which when coupled with a post bankruptcy cost of debt of ~7% (Bloomberg), resulted in a weighted average cost of capital (WACC) of 5.73% (Figure 6). Terminal value was calculated using an exit multiple of -15x which we derived from dividing current enterprise value by EBITDA as of year-end 2013 (Figure 7). In discounting Caesars projected cash flows and terminal value using the above-mentioned WACC, we determined Caesars equity to be worth well below zero. As stated previously, we performed our analysis under optimistic assumptions that allowed for Caesars to experience continued growth both in terms of revenue and in issuance of new debt. With a slow down in Las Vegas, a lack of a presence in Macau, and an ongoing bankruptcy, it seems impossible that Caesars will be able maintain sustainable revenue growth and find creditors willing to accept any new debt. Currently, Caesars trades on the NASDAQ at ~$10 per share. Based on our projections, we believe that Caesars is a strong candidate for a short sell strategy that will pay off well within the next five years. Figure 5: Free Cash Flow Source: Kent State University Figure 6: WACC Source: Kent State University WACC Calculation Cost of Equity 19.58% Weight of Equity 6.2% Cost of Debt 7.5% Weight of Debt 93.8% Effective Tax Rate 36.0% WACC 5.73% Figure 7: Exit Multiple Source: Kent State University Enterprise Value Calculation Market Value of Equity 1,557 Total Debt 23,449 Cash 2,771 Enterprise Value 22, EBITDA (1,493) Implied Exit Multiple (15) 9

11 Summary With a shrinking presence in the largest gambling market, an ongoing bankruptcy of its chief operating unit, a complex and somewhat questionable corporate structure, legal issues, and deteriorating financials, we recommend that a short sell position be taken against Caesars Entertainment Corporation (NASDAQ: CZR) with realized returns before the year

12 References Allen, Lisa. "Caesars Makes Another Move to Insulate Healthy Subsidiaries." TheStreet. TheStreet, 23 May Web. 17 Feb Bloomberg Business. "Caesars Growth Properties Holdings, LLC: Private Company Information." Bloomberg.com. Bloomberg, Web. 20 Feb Caesars Entertainment Corp. Form 10-K For Period Ending 12/31/13. Rep. no. 10-K. Las Vegas: Caesars Entertainment, Print. Church, S. (2015). Caesars Wins Bid to Move $20 Billion Bankruptcy to Chicago. BloombergBusiness. Retrieved from Hals, Tom. "Caesars Details Plan as Restructuring Deadline Nears." Reuters. Thomson Reuters, 29 Dec Web. 17 Feb Keller, Laura, and David Carey. "Caesars Letting Apollo, TPG Keep Stake Fuels Creditor Anger." Bloomberg.com. Bloomberg, 15 Jan Web. 18 Feb Trefis Team. "Trends In The Casino Industry." Forbes. Forbes Magazine, 7 Jan Web. 17 Feb Wolf, Brett. "Exclusive: Amid U.S. Probes, Caesars Poaches Top Money Laundering Expert." Reuters. Thomson Reuters, 03 Feb Web. 17 Feb Xtract Research. "Caesars Growth Partners LLC: Capital Growth Structre." (n.d.): n. pag. Xtract Research. Mergermarket Group, Web. 19 Feb