Caesars Entertainment: not well placed to fight against inflation

atosan

Company Overview: History and Operations of Caesars Entertainment

Caesar Entertainment (NASDAQ:CZRlisten)) is one of the largest casino operations in the United States, controlling 46 casinos (including 20 owned and 26 leased), primarily in Nevada. In 2020, they merged with “Former Caesars”, in a deal valued at about $17 billion. As a result, the new CZR saw its long-term net debt increase from $2 billion to $10 billion (2019 vs. 2020), new lease funding obligations of $12 billion and goodwill of $9 billion. The result of the merger is a behemoth that now controls 47,700 hotel rooms and 2,900 table gas across the United States.

While EBITDA grew from $700m in 2019 to over $2.9bn in 2021 (post-covid), net leverage went from 2.85x to 4.0x, leaving a much riskier business with a lower margin of error. Cash flow also hasn’t had a good time, with FCF consistently negative post-merger as the company’s M&A spending far exceeds CFO.

And what is the position of the shareholders after the merger? Well, about $3 billion of the acquisition cost was borne by shareholders through a capital raise in 2020.

Outstanding CZR Shares

Number of shares outstanding (Look for Alpha Charting)

Outstanding shares have fallen from 68 million at the end of 2017 to 213 million today, marking a substantial dilution of existing shareholders, who have seen their weight (and their voting rights) reduced by around 70%. A 10% owner in 2017 would now end up with only 3% of the capital.

Caesar’s real problem: a huge balance sheet full of variable-interest debt

Like many other businesses that require large PP&E assets and capital expenditures, Caesars has a ton of long-term debt on its balance sheet. This debt, mainly in the form of term loans and credit facilities, results from the merger completed in 2020.

Caesars Entertainment long-term debt

long-term debt (CZR Last 10-Q)

This is what the facilities look like in their docs. It is very clear that the main problem is the variable rates, which are applied to 6 different installations for a total amount of approximately $6.6 billion in book value. Usually, companies prefer to hedge themselves by entering into interest rate swap contracts, in order to be covered in case the FED decides to raise rates by 3% in 9 months. Well, CZR is pretty much fully exposed instead, with the swap only covering $1.2 billion in variable interest debt and expiring in December 2022.

This means that from January 2023, the company will be 100% exposed to $6.6 billion in variable debt, which will be subject to rates 3-4% higher than in January 2022 (depending on the amount that the FED will continue to raise). Calculating the additional expenses using an average increase of 350 basis points, CZR would have to pay around $210-230 million in additional interest. That may sound reasonable for over $13 billion in outstanding debt, but in reality, it’s about 10% of 2021 Adj. EBITDA and 17% of operating cash.

For a company with an already deeply negative FCF, this is certainly not a good addition to expenses, which will only further reduce shareholder value, as it is clearly already compressed by the enormous importance of creditors.

Caesars Entertainment Interest Charge

Interest expense (Custom table)

This chart shows how much interest expense is, as a % of EBITDA, and it’s clear that even after a return to normal post-Covid, the business is still struggling to contain interest expense. Indeed, it is expected to rise from around 80% of EBITDA to over 90% in 2022, due to both higher tariffs and lower EBITDA.

Inflation: expect higher rental charges and lower income

As I had previously anticipated, the company currently operates 26 of its 48 casinos under lease agreements, entered into after the merger closed. In particular, VICI Properties is the main lessor with 18 properties under their agreement, so basically they own the business. Under their rental agreement there is a dangerous clause (for CZR) which is a rent increase based on the increase in CPI (i.e. inflation) over the last fiscal year .

This means that from January 2023, they will be subject to an 8-10% increase in their rent charges of $1.1 billion, which means an additional rent charge of $90-110 million ( which is actually recorded as interest).

And then there is the other important question: how will demand be affected by inflation hitting consumers? I see two main problems: a direct effect due to the decline in purchasing power and an indirect effect due to the increase in interest charges on mortgages (caused by the rise in rates). Both of these factors could lead to less travel to Vegas and therefore less spending at Caesars establishments. This could happen during a very delicate and fragile trend back to pre-covid levels, as many statistics suggest there is still much to recover.

Caesars Entertainment - Las Vegas Tourism Statistics

Las Vegas Tourism Statistics (LVCVA )

This official report released by authority LVCVA shows that visitors are still 11% lower than in 2019 and hotel occupancy (crucial for CZR) is down about the same.

Caesars Entertainment - Las Vegas Hotel Occupancy

Las Vegas Tourism Statistics (LVCVA)

Inflation reaching the positive trend seen so far in 2022 could be deadly for many casinos and hotels.

Modeling Scenarios: CZR Fair Value Measurement

In recent years, Caesars’ EV has exploded following the merger completed in 2020.

Fair value of CZR shares

CZR VE (Look for Alpha Charting)

Right now, he stands at $33 billion, with $8.5 billion in net worth and $24.5 billion in debt. Excluding liabilities derived from leasing obligations, this latter figure can be reduced to $14.5 billion (total EV of $23 billion).

To correctly price CZR, I will use a DCF model with different scenarios: low, medium and best case, as well as a scenario with price, which is derived from reverse engineering the current market value of CZR shares (this is i.e. market capitalization). This scenario with embedded pricing will help us understand the assumptions the market is making (roughly) about CZR’s future growth, margins and Capex requirements; and possibly free cash flow available for distribution. To end up with a valuation of $8.5 billion, the market expects the following from CZR (according to my model):

  1. Growth rate between 14% (2022) and 3% (from 2026).

  2. EBITDA margin increasing from 26% (2022) to 28% (2024 and beyond).

  3. FCF between $57 million (2022) and $2.5 billion (end of period, 2030).

To calculate FCF, I use net income, not NOPAT, to properly include interest expense from leases and long-term debt, which is an appropriate cost weighting for shareholders. All of the above assumptions, when calculated in the model, result in a net fair value of $35 per share, close to the $39 it currently trades at. To give some perspective, their current unadjusted EBITDA margin is 23-24% for the last 6 months and 27% for 2021, while FCF was negative $300m and $6bn. in 2021 and 2020 respectively, due to costly acquisitions. .

Let’s see the assumptions of the other scenarios:

  • Worst case scenario: Revenue growth rate of 3%, EBITDA margin of 12% (2022) to 14% (2024 and beyond), FCF between -1.1 billion (2022) and $700 million (2030 ), mainly due to margins unable to cover interest costs.

  • Medium case: revenue growth rate between 10% (2022) and 2% (2026 and beyond), EBITDA margin increasing from 21% in 2022 to 25% from 2026 and beyond, FCF between – 500 million (2022) and 2.1 billion dollars in 2030.

  • Best case: revenue growth rate between 14% (2022), 5% (2024) and 3% after 2024, EBITDA margin starting at 27% and increasing to 29% after 2026, FCF between $86 million (2022 ) and $3.5 billion (2030).

Caesars Entertainment planned FCF

CZR FCF expected (Homemade DCF model)

The results with the probabilities I assigned for each scenario are as follows:

  • Low scenario: EV of $3 billion, resulting in net worth of $0. The probability of this scenario is 10%.

  • Average case: EV of $16 billion, resulting in a net worth of $2.2 billion ($11.5 per share). The probability of this scenario is 70%.

  • Best case: EV of $30 billion, giving a net worth of $16 billion ($80 per share). The probability of this scenario is 20%.

This distribution is clearly distributed in favor of the best scenario, compared to the worst, but the result remains quite bearish, suggesting an overall fair value per share (weighted average) of $24. From the current share price of $39, that’s about a 40% decline.

Conclusion

Caesars Entertainment is not well positioned to weather the current environment of rising rates, inflation and rents. In my view, their reliance on expensive variable interest debt to fund their expensive acquisitions could soon turn negative in the form of lower CFO and FCF, which would effectively hurt shareholders. After calculating their fair value and taking into account all the factors that could put pressure on the business in the following months, I conclude that CZR is a sell with a target price of $24.

Comments are closed.