BUSINESS

Investing The Hard Way: The Value of Debt

TAGs: Boyd Gaming, Caesars Entertainment, Editorial, Harrah's Entertainment, investing the hard way, las vegas sands, MGM Resorts, penn national gaming, Pinnacle Entertainment, Vince Martin, Wynn Resorts

value-of-debt-investing-the-hard-way“When the facts change, I change my mind. What do you do, sir?” – John Maynard Keynes.

Over and over again in this column, I have counseled investors to avoid highly indebted gambling companies and their shares. My worries have been simple: first, interest payments can overwhelm any potential profits from gambling companies. One need only look at the 2012 interest payments from companies such as MGM Resorts and Entertainment (MGM) and Caesars Entertainment (CZR), both of whom paid over $1 billion in interest alone in 2012, to understand the pernicious effect that debt can have, where the interest from that debt – let alone principal payments on the debt itself – can negate any profits that might be returned to shareholders.

The second issue is the fact that debt can overwhelm equity holders, leading companies to be essentially “zombie companies,” existing solely to pay off interest to bondholders for a few years until the principal of the debt comes due, at which point the company enters either a restructuring – in which shareholders, or equity owners, are severely diluted or wiped out – or a bankruptcy, which leaves shareholders clinging to the crumbs of a once-proud business that now faces liquidation.

Despite my worries, however, highly indebted gambling companies have been among the star performers over the last twelve months. Over the past year, shares of Boyd Gaming (BYD) – with $4.6 billion in net debt and a market capitalization of about $1.2 billion – have doubled. MGM is up 80 percent, closing Friday at a five-year high of $19.29 per share. And Caesars – despite some $23 billion in debt – has more than quintupled from its November lows, hitting an all-time high of $25 per share last week before closing Friday at $24.56, up nearly 150 percent from its early 2012 IPO price of $10 per share.

What that performance shows is the flip side – the positive side – of debt. In investment circles, debt is often called “leverage” and a company that adds debt is described as “levering up.” Indeed, well-used debt can indeed perform the same function as a lever: to lift a company up well beyond its potential levels based solely on its own capital. Just like a worker who takes out a loan to buy a car that enables him to get to his $60,000 per year job – when he could only earn $40,000 a year at a job to which he could walk – debt allows companies to expand their businesses and create earnings that would be otherwise unattainable.

In the gambling industry, however, the effect of debt is magnified, as the essential business model already contains a great deal of leverage. Land-based casinos – even disregarding the millions or billions of dollars of debt usually needed to build the properties, whether they are tribal casinos in Oklahoma or massive, multi-purpose complexes in Macau – are inherently a high-leverage business. Casinos have high fixed costs, to pay for maintenance, labor, utilities, and licensing fees. Like restaurants, most gambling establishments make the majority of their profits – if they are profitable – on the last few customers through the door.

A hypothetical example shows just how levered the casino model is. Assume there is a company called Vince Martin Casinos, with the stock symbol VMC. (I’m kind of like Donald Trump, only I don’t have a dead squirrel on my head and I’m not an a—hole.) VMC owns three casinos; the company does $1.1 billion in revenue a year, and has $1 billion in costs. All told, VMC generates $100 million in annual pre-tax profits (also known as EBITDA: earnings before interest, taxes, depreciation, and amortization.) VMC has no debt, and the market gives it a 10x multiple of its EBITDA and values VMC at $1 billion, equal to its annual revenue. (That multiple is slightly high for US casinos, but it’s a nice round number, so let’s run with it.)

Now, let’s assume that VMC increases its revenue by 10 percent. Half of the gains come from a 4.9 percent gain in customer visits, and the other half comes from a 4.9 percent increase in how much each customer spends per visit (including hotel, restaurant, and gambling revenue.) VMC’s revenue is now $1.21 billion per year; but its costs certainly don’t rise by the same level as its revenue. Increasing visitation by 5 p0ercent results in modest increases in labor costs; but those salaries are in large part based on tips, so a few extra employees make little impact to the bottom line. The 5 percent increase in traffic results in a small rise in maintenance expenditures; carpet needs to be replaced slightly more quickly, and escalators break down slightly more often. VMC might also have increased promotional spending to bring more customers in the door, keep them longer, and boost spend per trip. But executives aren’t paid more; dealers can mostly absorb the small amount of extra traffic (one or two new dealers might be required here or there); and licensing fees (depending on the state or national regime) may not rise in tandem with the revenue growth. All told, we’ll assume that costs for VMC rise 5 percent, roughly half the gain in revenue.

So, now, VMC, instead of making $100 million in profits, is making $160 million in profits ($1.21 billion in revenue, and $1.05 billion in costs.) In other words, a 10 percent increase in revenue results in a 60 percent increase in profits, and assuming the EBITDA multiple remains unchanged, a 60 percent increase in the share price. This is the leverage created by the high-fixed-cost casino business model: minor changes in revenue can create massive changes in profits.

That change comes not from any usage of debt, but solely from the nature of the land-based casino model. When a company with high fixed costs hits breakeven, each additional customer becomes massively profitable. Think of the restaurant industry: once the lease, financing, and (usually minimal) labor costs are paid, a restaurant is selling a steak that costs $5 per pound wholesale for $35 per pound retail. At that point, profit grows exponentially: each additional customer is paying a massive markup for his or her meal. Similarly, once a casino hits breakeven, the next people who walk through the doors come at a minimal cost to the operator; their gambling losses (or food, drink, entertainment, or hotel spending) represent nearly pure profit for the operator.

The leverage of the business model can be substantially amplified by the usage of debt. Going back to the hypothetical VMC, let’s instead assume that the company has $800 million in debt. The business – generating $1.1 billion in revenue, with $1 billion in costs – is still valued at 10 times EBITDA, or $1 billion. But $800 million of that valuation is debt, with the remaining $200 million accounted for as equity for VMC shareholders.

As in our previous example, let’s now assume that revenue rises 10 percent, and costs rise 5 percent – again, owing to the fixed-cost nature of the land-based casino business model. As in our no-debt example, VMC’s pre-tax profits rise to $160 million annually, and the total value of the business (at a 10x multiple) rises to $1.6 billion. But the debt remains unchanged at $800 million. As such, equity rises from $200 million to $800 million. In this scenario, a 10 percent gain in revenue results in the equity value of the company rising by 300 percent, quadrupling based on relatively modest gains in visits and customer spend.

To be sure, this example is completely rudimentary and rather optimistic; most notably, it ignores the impact of annual interest costs (which, of course, depress profits and lower pre-interest and tax earnings multiples). But the overall point is still important for investors: when a company is leveraged, small improvements in revenue can create massive gains in stock prices. When the use of debt is combined with the already-leveraged business models of most casinos, whether in the US or Macau, there are huge opportunities for earnings growth to outpace revenue growth. This is one of the reasons that many US regional operators have, of late, seen their shares outperform those of the more prestigious, more profitable, and faster-growing Macau-facing companies such as Las Vegas Sands (LVS) and Wynn Resorts (WYNN): the US operators have much more debt. To be sure, those US regionals have seen little or no revenue growth, but they have been able to manage their costs, and the continued hope for an economic rebound in the US means that future profits for companies such as Boyd or Pinnacle Entertainment (PNK) could grow substantially with only a tiny boost from the US economy. So if revenues in Macau grow by 15 percent year-over-year, and the US grows by 5 percent, some US operators may still be able to see their share prices increase faster than Sands or Wynn simply because they are much more leveraged, and the effect of that modest growth translates into far greater gains in the equity – and share prices – of those companies.

And in the bull market of the last two years, the debt held by US companies has hardly been an albatross. Rather, valuations of the overall companies have continued to grow; and with the debt held constant, equity values across the sector have surged. This is the positive side of debt, one which seems almost elementary amidst a strong stock market and a reasonably stable, albeit sluggish economy. But there are substantial risks, as shown by returning to our hypothetical VMC. As in our debt-laden scenario above, let’s assume that VMC is again doing $1.1 billion in revenue, has $1 billion in costs, and has $800 million in debt. The market is assigning the company a 10x pre-tax income multiple, valuing the entire company at $1 billion and the equity at $200 million.

Now, let’s assume that VMC sees revenue drop, instead of rise. Perhaps it’s the effect of an economic downturn in the US; perhaps the company owns casinos in regions that are seeing significant competition, cannibalizing VMC’s business. Revenues at VMC drop 5 percent, as customer trips drop 2.4 percent, as does customer spend per trip. (Again, as in our optimistic scenario, both the visits and spend assumptions are hardly groundbreaking moves.) But VMC’s costs don’t budge much at all: dealers can’t be fired on a whim, state governments don’t lower licensing fees, and the utility companies don’t change their rates. Revenue falls from $1.1 billion to $1.045 billion; costs, however, fall by half the rate of the revenue drop, decreasing 2.5 percent from $1 billion to $975 million.

VMC is now seeing pre-tax profit of $70 million per year. Based on the same 10x EBITDA multiple, the company is valued at $700 million. But its debt is $800 million; a 5 percent decline in revenue has essentially wiped its shareholders out. This is the risk in any casino stock, and this explains why gambling stocks are so much more volatile than other stocks. This is the argument I’ve made repeatedly in questioning Caesars’ large rise: I simply do not believe that the company’s land-based operations have any value relative to its debt. The company’s pending spin-off of its interactive assets has kept investor attention, but it remains unlikely that the legacy Caesars business – its properties across the Las Vegas Strip, or its regional casinos across the US – will ever create the profits or the cash flow to pay off its $23 billion in debt and return any money to shareholders at any point in the future.

That said, there is one key word in that sentence, one that provides another positive aspect of debt from the standpoint of the shareholder: “unlikely.” To the shareholder of an indebted company, the prospect of bankruptcy or restructuring is unpleasant, for sure: it will likely result in a loss of all, or nearly all, of the invested capital. But beyond the breakeven point, a company’s performance does not matter. Whether Caesars is able to pay back $19 billion, or $19 million, of its debt, is immaterial to shareholders if the company’s land-based operations are eventually declared insolvent. But there remains a small chance – if the US economy snaps back, if Las Vegas sees a sharp gain in convention bookings, or if Caesars can find a way to increase market share – that Caesars could see substantial revenue increases over the next few years.

(As an aside, I’m entirely skeptical of this possibility. The most damning assessment of the potential for Caesars’ land-based operations came from Penn National Gaming (PENN) CFO Bill Clifford at a conference held by JP Morgan (JPM) earlier this year. Clifford noted that Penn’s expenses would be higher than expected, in part due to its 2012 purchase of Harrah’s St. Louis from Caesars. The executive explained to listeners that Penn’s increased maintenance budget came from the St. Louis property’s decrepit condition. “The place was filthy,” he told listeners. “It was disrepair. It was just – elevators didn’t work.” If Caesars is cutting its maintenance budgets – as it clearly has, based on the condition of its Missouri property – and is still burning cash – as it clearly is – any profits from revenue gains will first need to go to keep the other fifty-odd properties from collapsing on themselves. This minimizes the already-small chance that Caesars will see a magical rebound in the US. But the larger, theoretical point remains.)

Even if an investor feels that Caesars equity is worthless right now, it doesn’t mean that shares are worthless. As an analogy, imagine you have bet $100 on the San Francisco 49ers to beat the Detroit Lions by 7 points. It’s the end of third quarter, and the Lions are up 3. The bet is quite clearly losing; but it’s not necessarily worthless. To be sure, no one would pay you $100 for your ticket (at least nobody sober), but it might be worth $15 or $20 to take a chance on the 49ers making a ferocious fourth quarter comeback.

The same goes with gambling stocks, particularly those utilizing extensive leverage. Caesars’s current business may be valued at substantially less than its net debt; but there is a range of future possibilities. Assuming that the company is already worth less than its debt, a downturn means nothing to equity holders: whether the business is worth $17 billion or $15 billion is immaterial to shareholders if the company has $20 billion in net debt, as Caesars does. (The different valuations are, of course, of great importance to bondholders, but that’s a different discussion.) But there remains a chance – however small – that Caesars could snap back, create substantial revenue growth, reverse its recent history of massive losses, and create substantial value for equity holders. It’s one reason famed hedge fund manager John Paulson – who made billions betting correctly on the housing collapse of 2007-2009 – told a conference last year that Caesars, in an optimistic scenario, could reach $138 per share, nearly six times its current levels. Even if there is a 10 percent chance of reaching those levels – or half of those levels – it creates, on a probability-weighted basis, some value. To again use a gambling analogy, it’s like betting on the Baltimore Ravens to win the Super Bowl last year at 20-1 odds; if you think they will win 1 out of 10 times, it’s an excellent bet, even if it will lose most of the time.

All told, the effect of debt is to magnify movements in profits, based on revenue, and thus magnify movements in share prices. It’s why gambling stocks are so volatile. It’s why high-debt gambling stocks have seen such massive moves over the past few years. MGM went from $90 per share in 2007 to $2 per share in 2009 to $19 per share in 2003. Over the same period, BYD went from $50 to $4 to $13. Caesars – then known as Harrah’s Entertainment – saw its shareholders receive $17 billion in cash in a buyout in 2007; even after quintupling, the company’s equity now is worth just $3 billion. If the market continues to rise; if economic sentiment continues to improve; and the gambling industry continues to stabilize, high-debt gambling stocks could continue to see strong gains. But investors must understand just how quickly they can turn, and how far they can fall.

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