Andrew Tottenham - February 11, 2015

Ail Caesars!


The big news recently is the filing by Caesars Entertainment Operating Company (CEOC), in the Chicago courts for Chapter 11 bankruptcy. The filing is not for the whole of Caesars Entertainment Inc. but for one of its many subsidiaries. This subsidiary owns a large part of the Caesars’ empire, mainly the competitively challenged older properties and is weighed down by over $18 billion in debt. But how did the mighty Caesars get in to this mess?

The cause was the 2008 buyout by the private equity firms Apollo Management and TPG. Perhaps I need to explain how these buyouts work. To put it simply what happens is that the company borrows money, sometimes a great deal of money, to buy out all of the existing shareholders and almost simultaneously sells shares to the new owners. In Caesars case the value put on the company was €30 billion, Caesars borrowed $24 billion and with the approximately $6 billion, arranged and provided by the private equity firms to buy the new equity, the company bought all of the outstanding shares from the old owners and delisted the company, leaving the new investors (Apollo, TPG et al) owning 100% of the company.  However, in the process they saddled the company with an additional $24 billion of debt. Caesars went to bed $6 billion in the hole, easy to handle when you have pre-interest cash flow of $2 billion, and woke up the following morning with a very large hangover.

Private equity deals usually leave companies highly leveraged (owing a large amount of money). The advantage is that if the company does well following the transaction the new owners can get a great return on their investment. For example, imagine a company that has EBITDA (earnings before interest, taxation, depreciation and amortisation) of $10 million and it has a valuation of 10 times EBITDA = $100 million. A private equity firm buys the company, invests $20 million for the new equity and puts $80 million of debt on the balance sheet of the company; the company uses the proceeds to acquire all of the outstanding shares. Within the next couple of years let’s say EBITDA improves to $12 million and the owners manage to sell the company for the same valuation multiple, $120 million but note the buyer will only pay the difference between the valuation and the value of the debt on the balance sheet. $120 million minus $80 million; the new buyer will pay $40 million to the old owners, leaving the $80 million of debt on the balance sheet. For the old owners $20 million invested turns into $40 million. The company’s valuation increased 20% but the owners’ return was 100%.

These types of deals work very well when earnings improve either through increases in revenue or cost cutting or both. But when things go wrong it is the equity that gets hit first; in the deal just described a 20% reduction in value wipes out the entire equity. Things started to go wrong for Caesars from the start. Just as the deal closed in 2008 the world economy fell off a cliff and global economic crisis began.  Demand slackened and revenues decreased. When this happens operators reduce the room rates to maintain occupancy and cut costs. The decrease in room rate has a knock on effect on other revenue streams – if you sell a computer for $1500 you can sell software to run on it for $300 but if you sell the computer for $500 you have to reduce the price of the software. Similarly, if you sell a room for $350 per night you can charge $30 for breakfast, and they did, but when you sell the room for less than $100 per night…. Need I say more?

Not only was Caesars hit by falling revenues because of the crisis but also by the effects of  increasing competition. Caesars Entertainment is the combination of Harrah’s and Caesars that merged in 2005. The old Caesars had properties in Las Vegas, Atlantic City, Canada and Uruguay and Harrah’s had properties in Las Vegas, Atlantic City and throughout Middle America. The combined group operated 37 properties but had a concentration in Atlantic City and Las Vegas.  Atlantic City, more than any other US casino market, has been hit by the increase in competition from new casinos in the surrounding States.  When Atlantic City first opened in 1978 the casinos there enjoyed a monopoly on the East Coast. In the 1990s Native American casinos opened in Connecticut and upper New York State, major feeder markets for Atlantic City and also taking customers from nearby wealthy New England.  Then casinos opened in Pennsylvania (the state next door,) Baltimore, racinos opened in the suburbs of New York City with devastating impact. In 2006, Atlantic City’s twelve casinos generated $5.2 billion of GGR, in 2014 it was $2.9 billion.

Needless to say declining revenues had a dramatic impact on Caesars ability to make its interest payments. Last year, CEOC had debts of over $18 billion, EBITDA of approximately $1 billion to pay interest charges of almost $2 billion. Ouch! Despite the best efforts of Caesars to restructure its debt the scale of the problem was just too great; the writing was on the wall and the filing just a formality.

Other companies got into similar trouble; when the global meltdown happened. MGM Resorts and Las Vegas Sands too were caught with large amounts of debt on their balance sheet.  But they have not had to go the bankruptcy route, far from it. In 2007, LVS had gross revenues of $2.7 billion and for the twelve months ending September 2014 it was $14 billion. MGM’s over leveraging came about because of the escalating cost of the City Centre development in Las Vegas and Las Vegas Sands debts were due to its development of Marina Bay Sands in Singapore and more resorts in Macau.  Short term debts were coming due just at the time when banks stopped lending money, share prices dropped to the floor and it was touch and go but they managed their way through it. MGM found an equity partner for City Centre and also developed a resort in Macau with Pansy Ho and Las Vegas Sands managed to refinance its debts but not before Sheldon Adelson, the company’s founder and Chairman, had to reinvest $1 billion of his own money – the best investment he ever made. LVS’s Singapore property opened as did the Macau properties and both companies have never looked back. Today LVS generates more revenue and EBITDA than Caesars ever did. And there lies the difference. MGM and LVS borrowed money to develop new revenue and profit streams, Caesars borrowed money solely to pay off its old shareholders. In the end it turned out to be the worst bet Caesars ever made.