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Investing The Hard Way: The Caesars Spin-off By The Numbers

TAGs: buffalo studios, Caesars Entertainment, CZR, Editorial, gambling news, investing the hard way, PENN, planet hollywood, Playtika, Vince Martin, world series of poker, Zynga

Investing The Hard Way: The Caesars Spin-off By The NumbersLast week I covered the recent decision by Caesars Entertainment (CZR) to spin off part-ownership of its interactive assets into a new, publicly traded company to be known as Caesars Acquisition Corporation and traded under stock symbol CGP. Much of the coverage of the spin-off focused on Caesars’ attempt to distribute ownership of those interactive assets – unencumbered by the parent’s $21 billion debt load – to its shareholders, maintaining some equity value if Caesars’ land-based operations wind up facing a bankruptcy and/or restructuring.

 As I wrote a week ago, it’s not entirely clear that Caesars’ plan will work, and the lack of control for shareholders of the new entity, along with a number of features that clearly benefit CZR over CAC, should give investors pause. The S-1 filing with the Securities and Exchange Commission shows just how complicated the spin-off will be, while also disclosing several triggers for the eventual dissolution of CAC over the next few years.

That filing also disclosed financial information about the new entity, information that Caesars has heretofore kept private. In previous reports, Caesars lumped its interactive assets in with corporate expenses and income from minority-owned subsidiaries, making it difficult to estimate the earnings power and growth rates of its social gaming and online gambling businesses, or the income from the company’s ownership of the World Series of Poker. With that information at last publicly available, investors can now attempt to more accurately value the interactive assets, and thus shares in both CZR and CGP.

Indeed, this information is of value not just for shareholders in the spin-off, but for Caesars shareholders as well. Caesars will, after the spin-off, still own 57 percent of what will be known as Caesars Growth Partners, while CAC shareholders will own the remaining 43 percent. (This assumes that all shareholders exercise their rights to purchase CAC shares and/or that other shareholders request allotment of those rights not exercised. Given the importance of the interactive assets to Caesars, and the fact that majority shareholders have already agreed to purchase at least 70 percent of potential CAC shares, this seems highly likely.) The value of Growth Partners, as such, is critical not just to CAC shareholders but owners of the corporate parent as well.

While much was made of the spin-off of the interactive assets, CGP will maintain a presence in the land-based industry as well, through ownership of Las Vegas’ Planet Hollywood, a minority stake in Maryland’s Horseshoe Baltimore, and 50% equity in management fees from both properties. The new entity will pay Caesars $360 million, and assume $514 million in debt related to Planet Hollywood. This part of the deal looks far more beneficial to Caesars than to the spin-off. To begin with, the Planet Hollywood loan comes due in 2015; if CGP is not able to re-finance that loan or raise additional debt to pay it off, the cash needed to re-pay that loan would significantly impair CGP’s ability to fund new projects over the next two years. Indeed, nearly $900 million of the $1.2 billion to be raised in the spin-off would be targeted for these properties; the lion’s share of that would go to the acquisition of Planet Hollywood.

And yet, Planet Hollywood isn’t making very much, if any, money. According to the filing, the casino posted a net loss of $1 million in 2012, though it did post a gain in the first quarter of this year. The purchase of 50 percent of management fees will boost PH’s bottom line – management costs were $16 million annually over the past two years – but even adjusting for the removal of half that cost, CGP is paying over 100 times 2012’s net income for the property. Nor has Planet Hollywood shown much growth; both revenue and pre-tax income were down modestly in 2012, though both figures showed year-over-year growth in Q1. All told, the spin-off is valuing Planet Hollywood at roughly 10x its pre-tax and pre-interest income from 2012, a reasonable valuation but hardly a compelling one. Given the fact that its debt is coming due, it seems highly unlikely that Caesars could have found a private buyer for anywhere near that valuation. Still, the properties have some value; when Caesars sold Harrah’s St. Louis to Penn National Gaming (PENN) last year, it received a multiple of 8.3 times pre-tax income. That multiple would value Planet Hollywood around $630 million; add in the equity in Baltimore and the revenue stream from management fees and the casino assets could be valued as high as $800 million. That would represent a small discount from the cash paid, and debt assumed, by CAC in the spin-off.

An underrated aspect of the spin-off is that Caesars is giving Growth Partners a portfolio of debt notes, with a face value of $1.1 billion. These notes provide substantial cash flow and income for the spin-off; CGP recorded interest income of $145.1 million in 2012, with cash interest payments appearing to approach $70 million annually. (Accounting technicalities account for the difference, as the bonds were purchased at a sharp discount.) The cash flow from the notes will help fund development projects, or new initiatives in social gaming or online gambling. The problem is that the notes are issued by Caesars; this is yet another way in which the spin-off is far more reliant on the parent’s survival than many realize. Indeed, Caesars itself has valued that $1.1 billion face value in debt at just $750 million, based on market prices for Caesars bonds. (The bonds trade well below face value in large part to account for the risk of a Caesars restructuring or default.) Caesars’ estimate of the portfolio’s value is likely fairly accurate given current Caesars bond prices. But a Caesars default would hit the value of the portfolio substantially.

With the land-based and debt assets worth roughly $1.5 billion, the key question is: what is the interactive segment worth? At first glance, CIE would appear to show a good deal of potential. The business was created largely through two acquisitions: the purchase of Playtika in May 2011 and the addition of Buffalo Studios at the end of last year. Caesars had not previously announced the prices for  the two purchases, but did so in the S-1. Buffalo Studios was acquired for $47 million, with an additional $5.6 million payable based on future performance. Meanwhile, Caesars spent $108 million for Playtika (including bonus payments and accounting for the cash already on Playtika’s books). This figure was well below the the $170-$200 million price estimated at the time.

So far, the purchases appear to have been a success. Indeed, revenues in the interactive segment were $207.7 million in 2012 and $68.6 million in the first quarter of 2013; year-over-year growth in Q1 exceeded 50 percent. While much of the growth came from acquisitions – Buffalo Studios results were not included in 2012’s first quarter, for instance – organic growth has still been solid. In the filing, Caesars reported results for the new entity as if the acquisitions had occurred on January 1, 2011. The combined entity would have created year-over-year revenue growth of 37 percent and net income growth of 76 percent – with all of the revenue growth created in interactive. All told, the interactive entertainment segment created operating income of $50 million in 2012, with Adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) of $76.2 million. It’s the profit margins that are particularly strong; CIE’s full-year EBITDA margin was better than double that of social gaming giant Zynga (ZNGA), while CIE also posted sharply higher revenue growth.

There is one big risk to the interactive division, however. The company’s revenues are essentially tied to two products: Slotomania and Bingo Blitz. According to the S-1, a stunning 94 percent of social and mobile revenue in the interactive segment came from Slotomania in 2012; that figure moderated to 70 percent in the first quarter of 2013, thanks to the addition of Buffalo Studios’ Bingo Blitz. Adding to the risk is the relatively tiny base of paying players: just 200,000 customers per month paid for credits on Slotomania in the fourth quarter of 2012. That represents just 1.2 percent of the average monthly user base for the game.

To be fair, this is a double-edged sword; the concentrated nature of revenue in terms of games and paying customers could mean that there are many more areas for new growth. The interactive segment could develop (or acquire) new games, or tweak the games to add incentive for customers to purchase in-game features. But Zynga’s experience also shows the danger of relying on a few hits for revenue; the company has yet to replace the interest in titles such as Mafia Wars and Farmville, and its profits and stock price have sunk as a result.

Still, CIE deserves credit for its execution in social gaming; it recently took over the top spot in market share from Zynga, and it clearly paid good prices in its major acquisitions and has done an excellent job integrating those purchases. But what of the other interactive assets: real-money online gambling and the WSOP?

Likely the most interesting fact in the volume of numbers released by Caesars is just how insignificant the WSOP brand is financially. WSOP and RMG revenue totaled $14.4 million in 2012, just seven percent of the interactive segment’s revenue and less than three percent of the new entity’s total sales. $2 million of that revenue came from Caesars itself, in exchange for the right to hold the WSOP at the corporate parent’s Rio property in Las Vegas. Licensing fees for real-money gambling – primarily in Europe, in partnership with 888 Holdings (888.L) – appear to be almost nil, given the small amount of total revenue and the streams from television and video game licensing of the WSOP brand.

All told, the interactive division’s current valuation – like its revenue – is largely based on social gaming. Zynga’s operating business – excluding its $1.6 billion in cash and investments – is now valued at roughly $1 billion. While Caesars Interactive is out-growing and likely out-performing Zynga, its sales are vastly lower (roughly one-sixth of Zynga’s) and its EBITDA will likely be lower than Zynga’s this year, based on Caesars’ growth and guidance given by Zynga management. It would be difficult – but not impossible – to imagine Caesars Interactive being given a similar valuation to Zynga, but $1 billion would appear to be the ceiling.

It’s also worth pointing out that Caesars has a committee that calculates its “fair value” for Caesars Interactive shares. Based on current share count, and data from the filing, Caesars itself values the interactive division – which encompasses social gaming, real-money gambling, and the WSOP – at roughly $735 million. It’s worth pointing out that this valuation includes the projected profits from iGaming, as in the filing Caesars notes that it dramatically escalated its fair value for CIE after the late 2011 re-interpretation of the Wire Act. It’s also important to note that Growth Partners (again, jointly owned by Caesars and CAC) would only own 75 percent of CIE once convertible debt and stock options are exercised.

So, all told, the assets of CAC include the land-based operations, valued at $800 million; the Caesars notes, valued at $750 million; and 75 percent of Caesars Interactive, valued at roughly $550 million. The sum of the parts valuation for CAC assets comes to about $2.1 billion.

But CAC will also have debt; it already has $400 million in net debt, and will add another $515 million in its acquisition of Planet Hollywood. After raising nearly $1.2 billion from the purchase of shares by existing CZR shareholders, it will then send $360 million of that cash to its corporate parent. So CAC’s assets come in around $2.1 billion; its liabilities, however, will total nearly $1.3 billion. In other words, the equity value of the assets being spun off is roughly $800 million.

But CZR’s current market capitalization is $2 billion. The gap between the $800 million valuation, net of debt, for the interactive assets, plus Planet Hollywood and the Horseshoe Baltimore needs to come from somewhere to justify Caesars’ current share price. Where? Real-money gambling might be one answer. But, again, Caesars management attempted to project the real-money opportunity in valuing its interactive subsidiary, and still came up with a $735 million figure despite a thriving social gaming business. The remaining assets of Caesars – its legacy land-based operations – might have some equity value. But the chances of those assets escaping the $20 billion debt load remains slim, and even slimmer now that the positive cash flow operations of CAC are headed out the door. The Caesars notes now held by CAC could provide positive returns if CZR can stay solvent; the portfolio matures between 2015 and 2018 and could gain substantially in value if the loans are repaid. But even the gap between the book value and face value of the bonds is $350 million, not enough to cover the difference in valuation.

Put another way, if Growth Partners were spun off in a pure fashion, with 100 percent of its shares being transferred from the Caesars parent, it would appear to be worth $800 million, and likely no more than $1 billion. In that scenario, would CZR maintain a post-spinoff value of $1 billion? It seems unlikely, given the massive losses and massive debt hanging over its head. And yet, this is not a pure spinoff. CZR shareholders will still own 57 percent of these assets – an ownership that would be subject to a corporate default – and, as I wrote a week ago, it’s untrue to suggest that the spin-off is completely protected from Caesars’ mountain of debt.

All told, the 43 percent ownership of the new asset group held by potential CGP shareholders is worth somewhere in the range of $350 million, and even optimistically no more than $500 million. Thus, the market is arguing that equity in the remaining Caesars assets – a non-voting stake in CGP plus slow-growth, high-debt, land-based casinos – is worth $1.5 billion. It might be; but there are over twenty billion reasons why it seems the market is wrong.

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