Should Value Investors Take a Stake in Caesars Entertainment?

Check out the latest Caesars Entertainment earnings call transcript.

Thinking of building a position in Caesars Entertainment Corporation (CZR)? In the following video, Motley Fool Industry Focus host Nick Sciple and contributor Asit Sharma provide listeners with an overview of the casino conglomerate and discuss why it's so difficult to understand the company's cash flow following its emergence from bankruptcy.

A full transcript follows the video.

This video was recorded on Jan. 15, 2019.

Nick Sciple: All right, Asit, let's swing into talking about some of these major U.S. casino companies. There are an innumerable number of operators out there, and suboperators. Let's talk about Caesars and MGM (MGM -1.24%). First off, let's talk about Caesars.

We mentioned at the top of the show, Caesars came out of bankruptcy in late 2017. There's been a lot of questions around the company. Their CEO, Mark Frissora, announced a couple of months ago back in November that he was going to leave the company effective February 8th. Looking at my calendar, that's only a couple of weeks away, and we don't know who the heir apparent is going to be. Their balance sheet is still showing side effects from their bankruptcy. To give some background on the bankruptcy, it was an $18 billion chapter 11 filing. It took two years from the start to finish. They shed $10 billion of debt, then totally reorganized their business into a realty operation, which now trades publicly as the Vici Properties  (VICI 0.42%) REIT, ticker VICI. Then, we have Caesars Holdings, which is the casino operations, the hospitality part of the business.

You called out to me, Asit, an interesting phenomenon with their balance sheet. It's a little-known area of accounting when it comes to the failed to sale leaseback transaction which governs those real estate assets that Caesars spun off to VICI Properties in the bankruptcy. Can you walk us through what that means and what difficulties it provides to investors trying to analyze Caesars's books?

Asit Sharma: Sure. Listeners, I'm going to take a little bit of time with this because there are some of you out there today that probably own Caesars or are interested in owning it, and I wanted to commiserate with you. I happen to be a CPA, and I had trouble figuring out what the heck is going on with this balance sheet. Let's break it down. I'll try to tweet a link that'll summarize what I'm going to talk about if I lose you.

Basically, Nick mentioned that Caesars had created a separate entity which holds its real estate, Vici Properties. It's a real estate investment trust. It was able to take basically the $10 billion of debt and put that into the trust along with the properties. When the company first envisioned this, they envisioned that this would work as a sales leaseback transaction. That simply means that I own a property, I sell it to you, Nick, but I still want to stay in the property, so I start paying you rent. It's a very common type of transaction. You see it a lot with professional services. Doctors' offices will do this to unleash equity in their buildings once they've paid off their buildings.

But what happened was, after the transaction, Caesars realized that because of certain covenants within the lease terms, they could not account for it as a sale leaseback transaction. So, they account for the real estate now as a failed sales leaseback transaction. Just what it sounds like, it's an actual accounting term that they used in their filings. In this failed leaseback transaction, Caesars is actually required to keep the sold real estate assets on its own books at the originally booked value. If you look at both balance sheets, it looks like the properties never moved. Sort of an accounting quirk, but because the payment stream didn't fulfill certain accounting requirements under GAAP -- generally accepted accounting principles -- it has to be done this way.

Looking at that balance sheet as of this latest balance sheet date, there's roughly $10 billion of what's called a financing obligation and $8.9 billion of long-term debt. That $10 billion of financing obligation is exactly the same number that Nick mentioned earlier that they supposedly shed and put over into the other company. They have to account for all of their lease payments going forward for the real estate as a so-called financing obligation. But, simply, you can think of it as more long-term debt.

Now, the quirk comes when Caesars makes a rental payment. Every time it makes a rental payment over to Vici Properties for, let's say, a casino that it's operating and occupying, it actually does it a little bit like you or I would for a mortgage payment. It writes a check, it books part of it to a principal payment and part of it to interest expense. The only problem is, as this failed leaseback transaction is highly technical, the values of the properties on both the entities' books -- that is, Vici Properties' and Caesars' -- is sort of different, so they have to book excess interest and excess depreciation expense they normally would.

And what all this means is that, if you look at the interest expense on Caesars' books, it's through the roof. I looked at the first three quarters of this year, they've booked $1 billion in interest expense in nine months. Not all of that is actually true cash paid for interest.

So, how do you figure out how leveraged this company is? I have a simple formula. I'm going to walk through it. Again, if you're still awake and still interested after the show, I'll tweet it out so you can follow this if you're a shareholder. Basically, I think the easiest way to figure out how to look at this debt is to take the company's EBITDA, that's earnings before interest, taxes, depreciation, and amortization, reduce that by the actual cash paid for interest that Caesars has incurred over a given time period, and then reduce that by the actual rental payments they're making over to Vici, plus any principal payments on their other debt. That gets you closer to figuring out how the company is burning its cash.

The net of that so far this year, Caesars had $1.7 billion in adjusted EBITDA. After you remove all those items that I just walked through, they're left with about $444 million of capital to operate with in the nine months.

Looking at the big picture, the good news is that Caesars is generating enough to meet its interest and also its principal payment obligations and its rental payments to Vici Properties. The not-so-good news is, there's not much left in the kitty for this capital-intensive expenditure that a casino operator has to make in terms of opening up new properties and constantly refurbishing, renovating existing properties. Give them props for being able to come out of bankruptcy and pull this structure and pull it off. But be watchful and be wary if you own shares. Hopefully, we'll revisit this later in the year, we'll see how they're doing.

What are your thoughts on all that that I just walked through? If you're still awake, Nick, what are your thoughts?

Sciple: Thoughts are, these books are just a mess when it comes to trying to understand them as an individual investor. You look at Caesars on paper, and some of their assets, if you take the position that over the longer term, we're going to see regulation that moves more toward on-site betting, Caesars does have the most robust regional casino footprint of everybody else. But that's the big question with all of these casino operators, Caesars and MGM at the very least. How do they navigate their leverage situation? It's going to be determined.

Caesars has used that Vici Properties arm to finance some additional acquisitions and moves in the past year. They acquired Centaur Gaming, which is a racetrack and some casino facilities in Indiana. They did that using a sale leaseback to Vici Properties. If they can get out of this whole morass coming out of bankruptcy, it's an interesting financing vehicle, the Vici business. MGM has a similar operation there. Any additional thoughts there, Asit?

Sharma: Some of the things that we'll talk about with MGM are applicable to Caesars, too. Looking at higher-margin revenue streams the company can get, that may be related to the Supreme Court regulation that changed and allowed casino operators to move into sports betting and implications for online betting. I think that Caesars does have potential, it's just a little tenuous. I see it as a value play, and I think anyone who invests in Caesars is investing in a value company. Over the past 12 months -- I might correct this later, but I believe the stock lost about 66% of its value over the last two years. It has potential. It has a mobile betting app centered in New Jersey. That's one of the opportunities it has to increase the revenue streams that are coming in. You mentioned the presence of more sports teams in Las Vegas. That's obviously going to help, the partnerships with the Las Vegas Raiders and Golden Knights that it has, also the New Jersey Devils and the Philadelphia 76ers and Baltimore Ravens.

Caesars is an ongoing story. If you're interested in taking a position, I would take small bites and monitor it from quarter to quarter. There's so much of the industry that's in flux since last year that there's positive potential, as well, so I don't want to mislead anyone with the explanation I had before to say that because of this complex transaction that they undertook, they won't be able to come out of their hole. At the same time, watch that cash flow. We'll see in a few quarters how they're doing.

Sciple: I own a few shares of Caesars myself. I'm not looking to add a significant stake here. As I mentioned earlier, I think the addition of sports betting will make some of those regional casinos a little bit more valuable. This is one extra reason to come there. We'll just have to see.

We've also seen them do a couple of non-casino-oriented moves. They're opening Caesars-affiliated resorts that do not have casino operations in both Cabo and Dubai. That's an opportunity to grow their presence. Their Total Rewards loyalty program has about 55 million members worldwide.

You can tell yourself a story of sports betting driving more people to the regional casinos, increasing engagement with the loyalty program, and pushing people to Vegas. But it's a story that we're just going to have to follow. There are a lot of moving parts that we just don't control, and the business doesn't control, either, from a regulatory point of view. Definitely something to revisit later on in the year as things develop.

I will say, not having a CEO named is definitely very concerning to me. It's been several months since that announcement came out. We're a couple of weeks away from when he's going to step down, and there hasn't been any clear communication of who that heir apparent is going to be. There's a lot of questions around the company right now. I wouldn't be rushing out to buy shares. But I do agree with you, there could be an opportunity, particularly from a value point of view right now as the shares are really beaten down.

Sharma: I want to jump in with one really quick last thought that occurred to me. Mark Frissora, the outgoing CEO, led the company out of bankruptcy, and successfully, too. So one would think that there'd be a tighter succession plan or, after all that hard work and successful work, that it would be more transparent and clear to investors what the next step in terms of the CEO succession is. But we'll just have to wait.