When Caesars (CZR) got a default notice from a group of junior creditors in early October, its stock plummeted to $8.50, and for good reason. But now, with rumors of a plan being hatched to split the company into a real estate investment trust (REIT) and an operating company, shares have exploded to over $16 a share. Now, another default notice from senior bondholders has popped up. Caesars says their claims have “no merit”. Take that for what it’s worth from a company over $20B in debt. Will the latest default accusation bring the stock back down another 50% in the short term like before? Impossible to answer, but it’s going to be a wild ride while the courts sort this out and news ping-pongs through the markets.
These wild share price movements reflect a company in severe distress as investors really have no idea what to pay for it, what any of the deals may mean, which creditors will get money back, which won’t, what the company is really worth and so forth. There are bound to be more of these volatile swings as the dust settles and no one can predict how high or low Caesars will go in the short term and for what reason. The real question is where will shares end up after the details are finalized?
The answer, I believe, is that over the long term, shares are headed way down, and that recent strength is simply a reflection of misplaced investor optimism that a deal can be worked out to make everything all better again. While undoubtedly a deal will be worked out and Caesars’ capital it will not simply be buried six feet under never to be operated by anyone again, much of it may be liquidated in a bankruptcy deal to be used by some other industry, in which case the shares will end up being worth very little, and only reflective of the capital that Caesars is able to maintain under its ownership. In other words, as bondholders get paid off by liquidating capital, shareholders who hold title to that capital suffer the losses.
The most basic way to look at it is this. There is debt (bonds) and there is equity (stocks). The objective of debt is to earn interest regardless of what happens to capital. The objective of equity is to earn dividends through the purchase of title to capital. Therefore, the interests of bondholders and stockholders are diametrically opposed when a default happens. The bondholder wants capital liquidated so he can get his money back. The stockholder wants the bondholder to be quiet so he can keep his shareholder value intact. Obviously the objective of a company is to pay off bondholders with revenue while keeping capital intact. It looks like Caesars has failed in that objective, short of some miraculous shuffling of the deck.
Speaking of shuffling, can the REIT deal possibly work? Let’s crunch the numbers.
During the best quarter Caesars has had in the last four quarters, it lost $386.4M. During that quarter, interest expense was $592.3M. So assuming that everything else stays the same, if Caesars transfers its entire debt load to the REIT and the REIT picks up the interest payments, Caesars would have made $206M that quarter. That’s an impossible best case scenario. Why? Because first of all, whoever manages the REIT probably won’t agree to shouldering the entire $22B debt burden. The REIT has to stay viable in order for the real estate not to be sold off and liquidated. It can’t just be a suicide spin off. Second, the operating company gross profit will drop because it will be paying rent to the REIT. Third, in 3 out of 4 of the last 4 quarters, loss exceeded interest payments on the debt, so even assuming the entire debt load is transferred over and gross profit does not fall, the casinos are still operating at a loss.
There is also this relevant paragraph from the Wall Street Journal:
Leave it to the Wall Street Journal to put in the most important caveat as an afterthought.
The time to spin off Caesars’ debt into a REIT was years ago, way before its debt burden went anywhere near $20B. It may have worked then. The chances of it working now are extremely remote, given the probability that interest rates are headed higher on that debt anyway.
The attacks and accusations of bondholders against Caesars will continue to escalate into the courts, and the battle between shareholders and bondholders will intensify. The bondholders will likely win for the simple reason that when you buy a bond, you are contracting for a certain interest rate in exchange for giving money up front, a debt contract that is enforceable by the courts. When you buy a stock, you’re not contracting for any specific dividend or share price. You get what the market pays for. That’s it.
So in the end, ideas will keep popping up in the short term as to how to rescue Caesars’ shareholders at the expense of its bondholders, build up some grand scheme to satisfy both sides, which is unlikely. The bondholders will keep making noise through the judicial system until a judge decides who gets money, how much, and when.
While Caesars as a whole will survive, what it will look like in the end is unknown. But in the tug of war between Caesars stock and its bonds, the bonds will win so long as there is any capital left to liquidate, and shareholders will be left holding the bag, being the titles to whatever capital is left.