The Rule Breaker Portfolio, Selling Short Trump, 04/23/97

Fool Shorts DJT
April 23, 1997

Trump Hotels & Casino Resorts (NYSE: DJT)

Type: Buzzard-Bait Short
HQ: 725 Fifth Avenue, 24th Floor
New York, NY
Phone: 212-688-7267
Closing price: $9

1996 net sales: $976.2 million
1996 earnings per share: -$3.27
Last quarter reported: Q1 Fiscal '97 (December)
Next quarter reported: Q2 '97, around July 29th
Consensus EPS for quarter: $0.09
Consensus EPS for fy97: - 0.43
Fool Ratio: N/A

Trade: SELL $10,000 worth of shares

OVERVIEW

The Fool Portfolio takes on its first short position in over four months, having located a debt-heavy, troubled gambling enterprise that appears, in our Foolish opinion, to have snake eyes ahead.

The Fool Portfolio has not featured a shorted stock since we covered our Quarterdeck (Nasdaq: QDEK) short for a 23% profit on December 3rd, 1996. Quarterdeck subsequently has fallen from our cover price of $5 1/2 to $2 1/2. Blammo!

Whenever our portfolio is lacking a short, it often feels that there's a little something missing. We're talking about a little money on the other side of the table. We like shorting stocks, and we believe in doing so. The idea is to make money both ways on the stock market, up and down, preferably at the same time.

As we've written in The Motley Fool Investment Guide, if you purchase stocks because you believe you can find undervalued ones, you should just as well be able to locate overvalued or troubled situations to sell short. Because most market watchers look one direction -- up -- much of the investment world is focused on hoping it can squeeze a given stock for a few points more on the upside.

When you Foolishly short a stock, you're turning that point of view on its head, looking downward at the potential for a fall. While we would never encourage taking this point of view for the market overall (historically on average, the market doubles every six years), we do consider it useful and profitable to go short in the case of individual companies.

About Trump Hotels & Casino Resorts

I. Breaking out the Financial Statements

Angling down the rural road at us comes TRUMP HOTELS & CASINO RESORTS (NYSE: DJT), sporting rainbow bermudas. The company is a compilation of eighteen subsidiaries, with the focus on operating casino resorts. Trump generates revenues from three primary rivers, though the second two are merely ancillary:

1) Casinos (80% of revenues)

2) Food & Drink (12% of revenues)

3) Hotel Rooms (8% of revenues)

Of the $976 million in 1996 sales, erase a full $113 million; that's the company's promotional expense to obtain those revenues (e.g. free games, bus rides, rooms, and food). The numbers show that fully 13% of their gambling revenue was spent to entice people to "do business with The Donald." Meanwhile, DJT spent $536 million on casino expenses.

Dropping down to the next level, last year Trump raked in $205 million on hotel rooms and food, but it spent $61 million on room and food expenses, and $200 million on administrative costs. Toted up you have, up on the very top-line, a business model that last year cleared just under $200 million. Not too bad.

What about down on the bottom-line?

There the company has been swamped with heavy losses. In fiscal 1996, DJT lost $65 million, or $3.27 per share.

II. The Issue of Debt

How does a company come up with the money to pay for this sort of blood-letting? Trump's vehicle of choice: debt.

Trump Hotels is currently run on debt of about $1.7 billion, and that debt is financed at percentage rates of 11.25% to 15.50%. In the last fiscal year the company paid $150 million in interest expenses alone (or about $6.25 per share). Meanwhile the debt, through acquisitions, appears to be growing rather than shrinking.

What are the odds that Trump can earn enough income to pay down its massive debt, as well as its hefty interest payments? To the Foolish eye, odds don't look good. The gaming industry is increasingly competitive nationwide, while revenues haven't been growing aggressively enough to please eveyone.

Odds are worsened by the fact that leading gaming enterprises, including Mirage, Circus Circus and Boyd Gaming, are laying plans to build in Atlantic City, where Trump has owned about 32% of gambling revenues this entire decade. Trump has used that controlling position to lose $65 million in 1996 and accumulate $1.7 billion in obligations. What will happen when the competition arrives?

III. Prospects Going Forward

The company is saddled with debt and bleeding red ink, and we believe that it will increasingly need to spend money to market and improve itself against competition. Trump Hotels will only be able to make those investments to defend its business after it has generated the income to pay off the interest on its debt.

Simultaneous to this problem, DJT offers a service that is injurious to an individual's savings position. We're not debating this on moral grounds. No, no, no! The point is purely mathematical. Gambling is fundamentally not a growth industry because its enduring growth results in the disintegration of its customers savings base.

The numbers show that Trump Hotels & Casinos is highly-leveraged in a business that disadvantages its customers. Uh-oh.

How Did We Find It?

On the simple financial level, this investment kept appearing on the Fool's spreadsheet as meeting the requirements of our Buzzard Bait short approach, originally outlined in the Fool's Smart Money magazine column one year ago.

Trump Hotels and Casino Resorts came public in June of 1995 at $14 per share. The initial public offering (IPO) was 10 million shares. The company sold more shares in April of 1996 at $31.25 a piece, and now has total shares outstanding of 24 million. In June of last year, when the stock hit a peak of $35.50, the company was capitalized above $700 million. Here at $9.25, the Company is priced at around $220 million -- again, with $1.7 billion in long-term debt. Not surprising, the stock has fallen 74% from its June 1996 high while the S&P has gained about 18% during the same time.

SHORTING

The approach is only suitable for aggressive, experienced investors who can stomach above-average risk and follow the stock market more closely than most.

In shorting this stock, The Fool is following the belief that business models which don't result in net earnings and are reliant upon heavy debt (high-interest debt at that) can often be recipes for failure. Fifth-grade math reveals the formula and the possible conclusions.

Whether the overall market rises or falls, given the possibility of continued red ink, we believe this debt-strapped stock can continue to make new lows, providing us a good shot at hitting our target return of 20% -- possibly more.

I. A Word to the Foolish

Before moving on to further discuss and analyze Trump, it behooves us to digress briefly -- but importantly -- on the subject of shorting.

First off, if you're new to shorting and interested in learning about it, go directly to our article on shorting in the Fool's School, one of our 13 Steps to Investing Foolishly. It is, in fact, the Eleventh Step, which means that we feel those who consider shorting should only do so as experienced investors who have been investing in and learning from the Dow Dividend Approach, small- and medium-cap growth stocks, world-beaters, etc., time enough to feel confident and self-reliant.

Second, shorting is by nature a shorter-term activity for us (though we're going into this investment feeling it could be quite a long-term short). Either way, shorting any stock does not mean that we'll be quoting prices on it five times a day. But it does mean that an investor needs to stay on top of any short investment on at least a weekly, if not daily, basis. Thus, shorting is most appropriate for those of us who truly enjoy investing, are fairly aggressive at heart, have the time to dedicate to the process, and can stomach investment losses should failure rear its ugly head.

We've written at length about shorting, both online in our Fool's School, and offline in our Motley Fool Investment Guide. Further, among Fooldom's interactive features are a Trump Hotels message folder, and a Shorting Stocks folder. We encourage you to make use of these resources to learn more about short selling. To help inform you even before using those resources, please read our Foolishly Answered Questions (FAQ) section on the subject of Shorting Stocks.

THE BUSINESS

Trump Hotels & Casino Resorts relies on a business model that must first advertise in order to draw people into its resorts (or onto gambling boats). Next, importantly, the people must lose money gambling. Also, ideally, the people will spend more money on hotel rooms, and spend yet more money on the resort food.

Trump is an entertainment company. It's all about money. You're supposed to be entertained by going to Trump resorts and spending your money on necessities (room and board), but mainly, by spending much more money on gambling. Entertain yourself by:

1. Insert coin.

2. Pull lever.

3. Lose your money to Trump Resorts.

Much better than a vacation of sailing, fishing, and golf, eh?

Oh. But you hope to win money? Of course the odds are stacked against you -- stacked several chips high. Thus, Trump earns money with its casinos but once the company's interest expenses are paid, Trump is losing money too.

Donald Trump is a respected real estate developer, but he hasn't been as lucky in the casino industry. At the end of 1995 his company sported $800 million in long-term debt. By the end of 1996 it had debt over twice that amount -- $1.7 billion. From the beginning there have been debt concerns, and in 1990 the situation appeared serious enough that bankruptcy was anticipated. Mr. Trump himself was able to climb out of personally-backed loans totaling nearly $1 billion, yet he and his company didn't learn to avoid debt.

Casinos are typically highly-leveraged operations, but Trump's are the most leveraged in the industry. The amount of debt on the books is said to have stalled and ended recent Trump negotiations with Rank Group, which owns Hard Rock Cafe, and also with Colony Investment.

In March, Colony was considering an investment in Trump's Castle, as was Rank Group weeks earlier. In both cases, Trump Hotel claims to have ended the talks, but both groups separately claim that they ended the talks themselves. Both companies were considering an investment in the re-theming of "Trump's Castle" in Atlantic City to "Trump Marina," a project which Trump contends will take place anyway and be finished by the end of summer. The Trump Castle had $348 million in debt and only $50 million in trailing cash flow prior to the negotiations. These numbers are said to have turned investors away.

That the business is divided into EIGHTEEN subsidiaries is a large reason for the $200 million in administrative costs last year, or nearly 20% of revenues. Eighteen parts. A logistical, financial, and legal nightmare. Why do it?

Protection.

If a debt-heavy subsidiary is going down it won't sink the entire Trump ship. Bankruptcy is a firewall and can be claimed for each subsidiary separately. Trump Inc. can excise the bankrupt subsidiary and make a clean break to those that are performing better.

Trump Hotels owns and operates Trump Plaza Hotel and Casino, Trump Taj Mahal Casino Resort (known as "The Taj" (say it like you mean it)), and Trump's Castle Resort in Atlantic City. It also owns and operates Trump Indiana, a casino boat on Lake Michigan near Chicago. The boat has been marginally profitable since it opened last June, but it's been in a "honeymoon" period and strong, new competition from Showboat and Empress have recently opened down the road.

But it's much more complicated than that, so let's list each subsidiary. We haven't memorized what each branch does, but the more branches the merrier. Certainly each one creates more expenses.

Trump Hotels & Casino Resorts, Inc.

Name of Subsidiary State of
                   Organization/Incorporation
------------------ --------------------------
THCR Holding Corp. Delaware
THCR/LP Corporation Delaware
Trump Hotels & Casino
Resorts Holdings, L.P. Delaware
Trump Hotels & Casino
Resorts Funding, Inc. Delaware
Trump Atlantic City Holding, Inc. Delaware
Trump Atlantic City Funding, Inc. Delaware
Trump Atlantic City Associates New Jersey
Trump Casino Services, L.L.C. New Jersey
Trump Communications, L.L.C. New Jersey
Trump Taj Mahal Associates New Jersey
Trump Atlantic City Corporation Delaware
Trump Plaza Associates New Jersey
THCR Enterprises, Inc. Delaware
THCR Enterprises, L.L.C. New Jersey
Trump Indiana, Inc. Delaware
Trump's Castle Associates, L.P. New Jersey
Trump's Castle Funding, Inc. New Jersey
Trump's Castle Hotel & Casino, Inc. New Jersey

Historically Trump has owned 25% of capacity and 32% of the gambling revenues in Atlantic City, but now that Atlantic City is showing increased interest in accommodating casinos, big Vegas names are planning to move to the area. Competition likely to build casinos over the next three years includes Circus Circus, Boyd Gaming, and Mirage, while MGM Grand is also acquiring land on the Boardwalk and plans to enter the market.

In light of these changes, DJT recently announced that it was suing Atlantic City for its plans to fund a highway leading to a stretch of land Mirage Casino is working to develop. The land intended to hold Mirage's new facilities will also hold those of Circus Circus and Boyd Gaming. Trump is of course upset about the road, while adding to his anger is his personal dislike for Mr. Wynn, the CEO of Mirage. The two are in a long-standing, well-publicized battle. The highway is a major point of contention for Trump's business, as it would lead to three new 100,000 square foot casinos. Bidding for the road will take place in June. Approval would set Mirage into step two of its plans, with hopes of breaking ground on a new 2,000 room resort by summer of 1998. The road approval should also set Circus and Boyd into motion. All could conceivably have casinos in operation before the end of the year 2000.

Not only is Trump Hotels in lawsuits over the highway, but DJT has also been in lawsuits in hopes of keeping proposed gambling sites from infringing upon its territory. On April 22nd the New Jersey Casino Redevelopment Investment Authority announced that it was filing a lawsuit against Trump, alleging anti-competitive behavior. Lawsuits cost money.

Another concern is the retention of customers. When a bright new casino opens in town, with flashing lights, promotional freebies, and giant billboards, all the potential customers truly gain is unmerited hope and the chance for expensive entertainment. Once visitors begin to see the resort as the giant sinkhole that it usually is, the "glamour" quickly disappears. Thus, casinos constantly pay money to put forth a fresh, enticing image (one example is the costly re-theming of Trump Castle to Trump Marina). Also, competition increases the need to offer promotional freebies. The thirteen-cent investment required to obtain each dollar of gambling revenue at Trump Hotels could increase as more big casino competition arrives, promenading with deep pockets and willing to offer a little more pizzaz.

The business of Trump Hotels is clear: Gambling, with hotel rooms and food and drink on the side. The competition is fierce from both large names and from Indian casinos. Analysts expect the industry to grow 18% per year, and though two analysts predict a profit at Trump in 1998, we lean on the side of the other analyst who expects continued losses (projecting a $0.30 loss in 1998). The struggle to remain attractive to gamblers is expensive, and the threat of new casinos coming to town should make it more expensive. Meanwhile, Trump's debt is back-breaking.

THE FINANCES

Boys and girls, mothers and fathers of all ages... witness perhaps the most amazing, most astounding, most difficult to comprehend collection of numbers ever to grace the page...

The man whom we consider the CFO at the Fool -- sporting a background in business analysis and financial models -- spent the better part of a flight from D.C. to L.A. trying to piece together the recent financial dealings of Trump Hotels, mainly arriving at only more questions rather than answers. The result is understandable. Paul Larson (TMF Parlay), who runs our Gaming Area in the Fool's Industry Area, tried to read the company's 10-K for ten minutes and ran for the bottle of Aspirin before continuing. His eyes were falling out of his head. (By the way, certainly check out the Fool's Industry Area, for both more information on Trump, and the competition, and for any other industries that interest you!)

We've broken down the Trump numbers here and going forward they shouldn't be so complicated, as 1996 was a year of change. Making the books more confusing, Trump Hotels acquired properties and businesses from Donald Trump in entirety last year (in one instance, upsetting shareholders who felt $100 million too much was paid to Trump for certain property.) Figuring numbers for eighteen subsidiaries, you can imagine that the Trump accountants aren't the happiest men and women on the planet.

The numbers for Trump's fiscal 1996 are in part confusing because DJT added the Taj Mahal operations to its books in April, the Indiana Riverboat operations in June, and the Castle in October. These new operations added assets and revenue to Trump's statements, but also long-term debt.

In the fourth quarter of 1996 the company reported consolidated net revenues of $326 million. The net loss was $30.9 million, or $1.28 per share, well below analysts' estimates of approximately breakeven. For the year, the company reported net revenue of $976.3 million, and losses of $65.7 million, or $3.27 per share.

While comparing 1996 to 1995 is of arbitrary value, as the company added many properties in 1996, comparing the numbers of Plaza Associates and Trump AC (the company that became Trump Hotels and Casino Resorts) over the past five years is an interesting exercise. The company has primarily grown larger by increasing its debt. Very little growth has been internally financed, while the company appears less able to finance growth internally now. A look at the trend is revealing:

  (not all expenses are shown)

Interest expense grew quickly enough to adversely affect net income. In Trump's favor, if not for interest expenses, the company would have been profitable over the past five years. Instead, it appears to be on a slope going in the opposite direction. Interest expenses grew 282% in 1996, while long-term debt more than doubled. Granted, gross revenues grew 200% due to acquisitions, but was it worth the price? In the fourth quarter of 1996 alone Trump's interest expense was $52.8 million, or nearly 17% of net revenues. At that rate, we can expect interest expenses of well over $200 million in 1997 -- or $8.25 per share.

Seeing how gross revenues leapt from $371 million to over $1 billion last year, a person may think growth is finally at hand. But remember, Taj Mahal and the Castle, two giant casinos, were added to the books in 1996, along with the Indiana Riverboat. A very worthwhile comparison in searching for growth is comparing individual casino sales and earnings year-over-year:

    (in millions)
    1995 1996 Change
    Trump Plaza Associates $333 $418 + 25%
    Trump Taj Mahal Assoc. 553 566 + 2%
    Trump's Castle Assoc. 302 269 (10)%
    Trump Indiana N/A 83 N/A

EBITDA (earnings before interest, taxes, depreciation, and amortization) (aka operating cash flow):

    (in millions)
    1995 1996 Change
    Trump Plaza Associates $69.6 $78.6 +13%
    Trump Taj Mahal Assoc. 136.5 131.9 -3%
    Trump's Castle Assoc. 50.7 26.0 -49%
    Trump Indiana N/A 20.7 N/A

Growth was obviously less than pleasing aside from the performance at Trump Plaza. But the revenue growth of $85 million there didn't account for the big jump in revenues last year. The majority of last year's growth was strictly acquisition revenue.

Time for a point of contention: the gross revenues above add to $1.336 billion, while in the earlier chart above, 1996 gross revenues only add to $1.088 billion. The discrepancy must result from acquisitions in 1996, and how they were accounted for, although we can't figure out where or why. In the end, the bottom line wasn't impacted positively, so we're not worried about it. It's actually better to argue that gross revenues totaled $1.3 billion and still the loss was $65 million.

The day before this sell report was issued, Trump announced a first quarter 1997 loss of $0.59 cents per share, beating estimates which predicted a loss of $0.71. The company had informed investors several weeks ago that it would outperform estimates. Revenues were up slightly to $343 million. Net loss: $13 million. Interest expense: $52 million. The company did decrease its administrative and casino expenses in the first quarter, which has happened in the past, so it's difficult to draw any conclusions.

That said, DJT is entering a strong period -- as discussed in the "risks" section -- and it should see a better second and third quarter. How much better is the $5,000 question. One analyst expects a $0.09 profit. Either way, the company will be hard-pressed not to show a hefty loss this year, again -- seasonality of the coming two quarters aside. Our focus is on the long-term debt and the debilitating interest payments, not the short-lived experience of increased summer revenues.

The stock is far from trading at a rich price-to-sales ratio -- instead sitting like a duck on still water at 0.20 times sales. Though the enterprise value shows the stock trading at a value of about $1.5 billion (adding long-term debt and subtracting cash from the market cap). It's difficult to call that a bargain price for a company with so much debt and being cash flow negative. The market cap itself -- $200 million -- is, in Foolish eyes, substantial given the company's debt.

It's also notable that much of the Trump property is mortgaged, while the current long-term debt is laid out below (AOL users maximize window):

Earnings estimates are provided by only 2 to 3 analysts, depending on the time frame considered. Estimates currently stand at a loss of $0.43 for the year ended December 31st, with a profit of $0.09 expected next quarter. Two analysts are predicting profits of $0.24 for fiscal 1998, though as stated earlier, we're tossing our hat into the ring with the analyst predicting a loss of $0.30.

Taking into account the current mediocre revenue growth at Trump, and seeing ongoing interest payments on increased debt, we're betting that the Trump operation continues to favor the color red.

RISKS AND OTHER CONSIDERATIONS

Shorting stocks is risky, and shorting a company run by a recognized business mind represents added risk. We've weighed those risks, though, and our considerations follow...

As with any investment, there are risks. Shorting this stock we're assuming above average risk for a number of reasons.

One: Donald Trump is, by many measures, THE MAN.

Trump has been in tight situations in the past and survived, and even rebounded. He does have business wit -- and he's commonly considered a huge American success story. He's lived on leverage most of his adult life, and he's well known for his ability to do so -- lavishly.

But, Foolishly, we think that running a business on high interest debt while facing the squeeze of increased competition will present a challenge that Trump hasn't yet seen. Further, the failure of recent negotiations with possible partners underscores the mounting debt that the company faces, and the perception of that by others in the business.

All of that said, one risk is that Donald and Company are more financially flexible than we presume, and that they turn this business on a profitable track with little trouble. If the story changes in that direction we'll of course reconsider our position. Another risk is that the road for Mirage, Circus and Boyd isn't soon approved, putting the competitors' plans to build on hold. Meanwhile, MGM Grand, though contracting land, doesn't yet have plans for breaking ground.

Another micro-level risk is the fact that the company plans to buy back shares. DJT bought back 1.25 million of its shares recently, at an average price of $10.27. Granted, that isn't a huge amount of money, but the company recently announced plans to buy another 1.25 million shares before the close of 1997. Donald Trump stated that the decision to buy the company's stock "underscores management's confidence in the company's future and is an opportunity to further build and maximize shareholder value." Or maybe it's a public relations move. Either way, a share buy-back plan represents buying of the stock that we're shorting.

Yet another risk involves the relatively small number of outstanding shares. 24 million shares means that when the company lost $65 million last year, it equated into a $3.27 per share deficit. Likewise, if the company turns a profit of "only" $65 million next year, the $3.27 per share earnings would give the stock, at $9, a price-to-earnings multiple of less than 3 -- which would almost certainly send the stock flying higher. We certainly don't think the company can make that much money anytime soon -- or any money anytime soon. It's a risk to keep in mind, though, no matter how large a surprise it would be.

On the flip-side of that risk, we remember that the company is paying about $200 million a year in interest on its debt -- or over $8 per share out the window. Ouch.

We figure that the unforeseens are much fewer here than in the technology sector, for example. Gambling is pretty straight forward. One of the largest question marks on the horizon that we see is the increased competition. The question there, though, isn't how much risk that presents to us, but rather how much risk that presents to Trump. We like the coming competition.

The question for us is: how soon will it arrive? The answer: not for at least a few years, though the danger of it will likely loom over DJT continuously.

Another point we considered is the seasonality of gambling. We're entering the strong gambling season in Atlantic City. The strong season lasts from May to October and usually gives Trump increased revenues. We still don't feel this will be enough to bring dollars to the bottom line, but there's probably more chance of that now than in the dead of winter. Again, though, we're looking at the long-term debt, not two quarters of increased revenue due to sunshine and vacations.

Yet another consideration: Atlantic City is in the process of opening a new convention center and attempting to beautify the city through casino tax dollars. These improvements will likely grow the total number of visitors to the city, but we feel any sustained growth in the gaming pie as a whole will be more than off-set by the proposed increase in casino capacity and thus competition.

Five analysts currently rate the stock. Four have it as a moderate buy and one as a hold. Those that rate it a buy have been doing so since the stock was 100% higher, and more, so it means little to us, as usual. Actually, we like going against their recommendations -- recommendations that may be standing more for business relationships than for the fundamentals beneath Trump Inc. That's entirely supposition on our part, but such analyst/company relationships do take place with most public companies at some point -- if you want good relations with a company, you keep a healthy recommendation on that company's stock.

To close, we don't wish for the company to shrivel up and disappear, really. Just as we didn't with Quarterdeck, or any other short that the Fool has made. (Though we don't mind if people slow down with their gambling habits). We only feel that the stock represents a good shorting possibility. We see the chance of making our 20%+ goal by taking this position. Maybe we're wrong. We'll see. Either way, we did our homework, feel we're familiar with the risks, have tried to see forward to determine our risks and opportunities as best as possible, and so we're comfortable taking this position within our diversified, Foolish Four-based portfolio. Hopefully we'll all learn something from the position either way.

Finally, of course, our aim is to beat the returns of the S&P with each position we take, and with our portfolio as a whole -- by double the amount. Though when shorting stocks, our aim is to make 20% or more -- however the cards may fall!