Quick Pitch: Long on Caesar (NYSE: CZR) Bonds

Contributor: Matthew Stolzar
Firm: Independent
Location: New York, NY

Recommendation: Long unsecured CZR 5.75% 10/1/17 notes
Timeframe: 2 Years and Beyond

Quick Thesis
Caesars Entertainment Corporation (the “Company”), formerly known as Harrah’s Entertainment, is a casino entertainment provider that owns 52 casinos worldwide, under the Harrah’s, Caesars and Horseshoe brand names. The Company was taken private in 2008 by TPG and Apollo.

The Company currently has $22.5 billion face value of debt. I am long the unsecured CZR 5.75% 10/1/17 notes. There is $2 billion of subordinated debt on the Company, the Notes represent the last $500 million of this tranche to mature.

As of March 15, 2012, the bid price was $58.625, implying a 17.8% yield to maturity and a 10% current yield. I believe the Notes present an attractive risk / reward profile, based on the potential to trade up prior to maturity and the potential of getting repaid at par.

Recent IPO Implies High Valuation
In 2010, the sponsors attempted a $500 million IPO that failed. In February 2012, the Company sold 1.5% of its shares (NASDAQ: CZR) for $9 per share. Since then, the stock has traded to $12.50, implying a $1.6 billion market cap, and a multiple of enterprise value to 2011 EBITDA (“TEV Multiple”) of 11.7x. This valuation seems high for a large casino operator.

Caesar’s competitors trade at the following TEV Multiples: Penn National (Nasdaq: PENN) trades at 8.7x, Boyd Gaming (NYSE: BYD) trades at 9.0x, Wynn (Nasdaq: WYNN) trades at 10.1x, MGM Resorts (NYSE: MGM) trades at 11.5x and Las Vegas Sands (NYSE: LVS) trades at 13.9x.

With a larger float, this should probably slot CZR in the 10x-11x range. The face net debt / EBITDA ratio is 10.9x, implying the junior CZR 5.75% 10/1/17 bonds are likely impaired. So why is the current equity trading at an 11.7x multiple? Aside from recent momentum in the stock market and potential growth in the casino industry back to peak levels, the other explanation is online gambling.

Online Gaming
Analysts estimate the online gambling market in the US would generate $4-10 billion of revenue, with 50% of that coming from poker. This implies ~$2 billion of projected EBITDA from US online gambling. This will be shared across the industry, but Caesars Entertainment Corporation is the best set up to capitalize. Their World Series of Poker brand is the most popular brand, and the Company has the largest loyalty program with over 40 million members. Analysts estimate CZR could add an incremental $300-$400 million of EBITDA with a federally regulated online gambling market. It’s no coincidence that the Notes traded from below 40 cents to 60 cents in December 2011 when the DOJ made their clarification.

Debt Structure
While investors hope for growth through casino and online gambling revenues, the Company must service an extensive amount of debt. What makes the Notes interesting is the timeline of the capital structure. Due to recent extensions, there are no major debt maturities until 2015. However, there are $3.6 billion of Opco maturities in 2015, $2 billion in 2016 and $3 billion in 2017. The Propco debt also matures in 2015.

Based on my review of the filings and analyst research, the Company appeared to cover interest at 1.1x in 2011.In 2011, the Company had -$200 million of free cashflow after capital expenditures, and is projected to have -$400 million in 2012 and -$100 million in 2013. High capital expenditures are largely due to casino development, and thus are not recurring. There is currently over $1 billion of cash on the balance sheet to cover this, and the company will likely continue to sell equity in the public market.

So there seems to be minimal risk until 2015. In 2012, the company was able to extend $2.9 billion of debt from 2015 to 2018, making the 2015 load more manageable. In the meantime, continued positive news in the gaming sector will likely cause the CZR 5.75% 10/1/17 bonds to trade up, and federal regulation passing would probably cause the bonds to trade near PAR, implying 70% price appreciation on top of 10% annual current yield.

Scenario
The upside scenario of federal online gaming legalization implies 70% gross price appreciation along with 10% annual current yield. The downside scenario would be that the online gambling market never materializes, the global economy struggles such that casino revenues remain stagnant, the Company is unable to refinance its maturities between 2015-2017, and the subordinated position of the Notes is deemed impaired in a bankruptcy proceeding. In this downside case, holders would earn 30-50% of their money back from the current return plus whatever recovery is awarded in bankruptcy. Given that the treasury yield remains near 2%, and 5-year BBB corporate bonds are trading for under 4%, this seems like an interesting way to invest in the credit markets today.

Risks
This a very risky investment. Despite the implied 11.7x TEV Multiple from the recent IPO of the parent, if the Company were liquidated today, it is likely that the Notes would be impaired. The Company has significant debt maturities starting in 2015 that it may not be able to refinance, along with a significant interest burden.

Gaming revenues have declined heavily since the peak, and without an industry recovery or the development of an online gambling market, the company may not be able to repay the bonds. In addition, interest rates are currently near all-time lows. If they rise significantly prior to the materialization of online gambling, it would make the potential upside of the investment decline.