Kent State University Kerrisdale Capital Investment Case Study

Caesars Entertainment Corporation

Evan Gallagher | Daniel Shuster | Shervon Preston

Highlights

Competitive Landscape: Caesars lags behind its competitors in

terms of profit margin, and lacks a physical presence in Macau, Chi-

na, the largest gambling hub in the world.

Bankruptcy Proceedings: Caesars’ primary revenue generating

unit, Caesars Entertainment Operating Company is in the midst of a

bankruptcy filing. The proposed restructuring plan calls for a de-

crease in the operating unit’s debt, however there is significant con-

troversy surrounding the shifting of assets between Caesars’ various

entities.

Negative Cash Flow: Caesars currently operates with negative free

cash flow and will continue to do so well into 2020.

Ticker: CZR

Current Price: $10.95

Recommendation: SELL

Market Data

Company Overview

Caesars Entertainment Corporation Equity Research Report

26.74

8.51

10.93

1,570

-25.00

52– week High ($)

52– week Low ($)

Previous Close ($)

Market Cap (Millions $)

EPS (ttm) ($)

Caesars Entertainment Corporation

owns, operates, and maintains casi-

no and resort properties across four-

teen states and five countries. The

company is headquartered in Las

Vegas, Nevada. $0

$5

$10

$15

$20

$25

$30

CZR Daily Adjusted Stock Price

1

Kent State University

This report is published for educational purposes

only by students competing in the Kerrisdale

Capital Investment Case Study for the Econo-

mist

Industry Overview

Industry Overview

Caesars Entertainment Corporation operates in the casinos and resorts industry. The industry is competitive, heavily

regulated, and very sensitive to economic conditions. Commercial casino gaming takes a variety of forms, the most rec-

ognizable of which consists of what are called Las Vegas-style casinos. Other commercial gaming venues include ex-

cursion (mobile) and dockside (permanently moored) riverboats, card rooms, and racetrack casinos, commonly called

racinos.

Economic Slowdown

The Casino industry is heavily depended on the level of disposable income available to the general consumer. The eco-

nomic recession brought a fall in consumer discretionary spending which in turn caused the casino industry to suffer,

and despite the general market recovery, the casino industry has yet to fully recover. The Las Vegas Strip was hit hard

by the economic recession, and it continues to suffer. An increasing number of states have legalized gambling, which in

turn has led to a decrease in traffic to Nevada, and this lower profits for some of the largest casinos. There are currently

twenty-one states and two U.S. territories that allow commercial casinos in some form.

Macau

Macau, China is the world’s largest gambling hub, which recently saw its first full year decline in revenue since the

early 2000’s. China’s high profile corruption crackdown is to blame, specifically that of Xi Jinping, the President of

China, who’s crusade against mobsters has deterred ultra-high net worth and VIP gamblers away from the gaming ta-

bles. These gamers account for two-thirds of Macau’s casino receipts, and their absence has sent revenues down by

2.6%. The fate of the gaming industry in Macau is largely dependent on how far the Chinese government will take the

war on corruption. While Macau is suffering, Japan is taking steps to legalize casinos. With projections of an increase in

high net worth individuals, Japan may soon be a key destination.

2

Industry Overview (cont)

Regulatory Environment

The casino and resort industry is subject to a variety of federal, state, foreign, and local regulations. Most states, includ-

ing Nevada, require casinos to adhere to a set of state procedures typically known as the “Minimum Internal Control

Standards (MICS).” The MICS focus on several aspects of casino operations including conduct of games, movement of

cash, and the accounting and record keeping of transactions. Due to the high volume and high denomination of such

transactions, casinos must meet many of the same requirements as banks including anti-money laundering regulations.

The Bank Secrecy Act, which pertains to anti-money laundering requirements, amongst others, requires banks to docu-

ment every transaction above $10,000 USD.

Competitive Situation – Domestic & International

The casino and resort industry is highly competitive, with competitors varying in size, quality of facilities, brand, amen-

ities, and a number of other factors. In some locations, such as Las Vegas, Caesars competes directly with other casinos

and resorts in the immediate area. In other locations, there is competition from the immediate area as well as surround-

ing markets.

Caesars currently operates casinos and resorts across the country, with a large concentration in Las Vegas and Atlantic

City. Caesars also operates casinos in the United Kingdom, Egypt, South Africa, Canada, and Uruguay. One region that

Caesars lacks a presence is Macau, China. As stated earlier, Macau is the world’s largest gambling hub, and the lack of

a physical presence puts Caesars at a severe competitive disadvantage. Caesars did purchase land in Macau in 2007 for

$525 million, however the company was unable to receive permission to begin construction of a new property. In No-

vember 2013 it sold property to Pearl Dynasty for $438 million.

Despite the relative slow down in Macau, we believe that the lack of a presence in the region will have a serious impact

on Caesars’ revenue growth. Macau is the premier gambling destination for ultra-high net worth individuals who pro-

vide large streams of revenue and high profit margins. As the economy continues to improve, casinos in Macau will see

improved business from the ultra-high net worth consumer, business that Caesars will not have access to.

Las Vegas Sands Corp and Wynn Resorts International continue to be major players in the casino and resort industry.

Both companies have also expanded into Macau and have taken advantage of the growing and high margin gambling

market in the region. The additional revenue has allowed Sands and Wynn to build new properties as the legalization of

gambling improves both domestically and abroad.

Many casino operators, including Caesars, are reinvesting in existing markets, adding amenities to attract new custom-

ers, and intensifying competition in regional markets. Operators are also looking to expand to other markets to even out

revenues. Caesars has experienced negative results in regards to expansion. Attempts at expansion in Maryland, New

York, California, and Pennsylvania have had negative impacts on operations in New Jersey. Expansion is critical for

Caesars’ revenue growth and its inability to do so without cannibalizing its existing operations is cause for concern.

3

Company Background

Caesars Entertainment Corporation (NASDAQ: CZR) is a diversified casino-entertainment company. The company is

operated through its wholly owned subsidiary, Caesars Entertainment Operating Company, Inc. Caesars operates fifty

casinos in fourteen U.S. states and five countries. Figure 1, below, outlines Caesars’ domestic operations. Caesars also

owns an online gaming venue, bingo, poker games, and has alliances with gaming operators in Italy and France.

The company’s resorts operate primarily under the Harrah’s, Caesars and Horseshoe brand names. Caesars Entertain-

ment Corporation is comprised of the subsidiary Caesars Entertainment Operating Company, Caesars Entertainment

Resort Properties, and Caesars Growth Properties.

In 2005, Harrah’s Entertainment Corp, founded by William Fisk Harrah in 1937, completed its takeover of Caesars En-

tertainment Inc. and chose to operate under the Harrah’s brand. Shortly thereafter in 2010, Harrah’s changed its name to

Caesars Entertainment Company which is the current publicly traded entity.

2008 was a volatile period for Caesars, which at the time still maintained the Harrah’s moniker. It began with Harrah’s

delisting from the New York Stock Exchange and culminated with a leveraged buyout (LBO) by private equity firms

Apollo Global Management, LLC and TPG Capital, LP. Harrah’s assumed around $20 billion in debt when acquired.

Caesars Corp currently has a joint venture with Apollo Global Management, with TPG Capital and the Blackstone

Group owning a large portion of stock. Although Caesars may have seen this move as beneficial to the company, it

would be the start of a rather grim journey.

4

Arizona Mississippi New Jersey

Harrah's Phoenix Ak-Chin Tunica Roadhouse Bally's Atlantic City

Horseshoe Tunica Caesars Atlantic City

California Harrah's Gulf Coast Harrah's Resort Atlantic City

Harrah’s Resort Southern California

Missouri North Carolina

Illinois Harrah's North Kansas City Harrah's Cherokee

Harrah's Joliet

Harrah's Metropolis Nevada Ohio

Harrah's Laughlin Horseshoe Cincinnati

Indiana Nobu Hotel at Caesars Palace Horseshoe Cleveland

Horseshoe Hammond Bally's Las Vegas ThistleDown Racino

Horseshoe Southern Indiana Caesars Palace Las Vegas

Harrah's Las Vegas Pennsylvania

Iowa The Cromwell Las Vegas Harrah's Philadelphia

Horseshoe Council Bluffs The LINQ Las Vegas

Harrah's Council Bluffs Harrah's Lake Tahoe Ontario-Canada

Harrah's Reno Caesars Windsor

Louisiana Harveys Lake Tahoe

Harrah's Louisiana Downs Paris Las Vegas

Horseshoe Bossier City Planet Hollywood Resort & Casino

Harrah's New Orleans Rio All-Suite Hotel & Casino

Flamingo Las Vegas

Maryland

Horseshoe Baltimore

Figure 1: Caesars’ domestic operations Source: Caesars Total Rewards

Pre-Bankruptcy Financial Structure and Performance

It is hard to fathom that Apollo Global Management and Texas Pacific Group (TPG) seriously believed in the financial

position of Caesars Entertainment in the wake of their 2008 leveraged buyout that left the firm with over $20 billion in

debt. Although their combined $6 billion equity stake in the post-Harrah’s company has been substantially impaired in

the wake of Caesar’s 2009 financial troubles, there is ample evidence that Apollo and TPG have netted lucrative cash

flows from the deal. It has been reported that Apollo and TPG collected a $200 million transaction fee in 2008 as part of

the deal. In addition, both companies reap annual management fees of $35 million, fueling controversy among limited

partners that object to such fees being retained by the general partner. In any case, the private equity firms have a vested

interest in perpetuating Caesars’ existence, and they have gone to great lengths to shield the company from creditors by

aiding in the creation of a disturbingly convoluted financing structure. Figure 2 is an organization chart provided by

M&A due diligence consulting firm Xtract Research, shows just how complex Caesars’ corporate structure has become.

Figure 2: Caesars’ corporate structure Source: Xtract Research

5

Pre-Bankruptcy Financial Structure and Performance (cont)

It is noteworthy that this chart refers to Caesars Acquisition Company (NASDAQ: CACQ), a separate publicly traded

unit that was formed in 2013 by Caesars Entertainment Corporation to shift property holdings away from the original

holding entity (NASDAQ: CZR). The logic behind this maneuver was clearly to create another layer of separation be-

tween Caesars Entertainment Corporation’s (formerly Harrah’s) most valuable holdings and aggrieved creditors. Cae-

sars did not stop there however. As the chart depicts, most of the properties are actually owned by an L.L.C. under the

name of Caesars Growth Partners, only 34% is owned by CACQ, with the remaining 66% directly owned by Apollo and

TPG (Carey, Keller 2015). Recognizing the need for protecting intangibles from creditors, Caesars formed yet another

L.L.C. that constitutes a joint venture between the now-bankrupt Caesars Entertainment Operating Company (CEOC),

CZR, and CACQ.

While shifting assets away from CZR and CEOC, the company shifted a considerable portion of its debt into CEOC

through a complex series of internal transactions and refinancing in 2014, the year leading up to the January 2015 bank-

ruptcy. These transactions are facilitated by a dedicated financing subsidiary of Caesars Growth Partners called Caesars

Growth Properties Finance, Inc. (CGPF). According to Bloomberg, CGPF routinely deals with creditors in the Cayman

Islands and Bermuda to obtain additional financing (2014).

This complex system of nested companies, subsidiaries, and related parties ought to be alarming to investors in either

CZR or CACQ. Legal games such as this can protect assets from creditors for a time, but they cannot shield the compa-

ny from the raw market forces that will ultimately drive Caesars to failure. Furthermore, the nature of the internal trans-

actions poses serious questions of whether or not substantial corporate fraud is occurring. The legal risks associated with

potential fraud are significant enough to collapse the entire company (CZR, CACQ, CGP, etc.). These possibilities will

be further explored in a subsequent section.

6

Bankruptcy Proceedings and Money Laundering Allegations

Bankruptcy Proceedings

On January 15, 2015, Caesars Entertainment Operating Company (CEOC) filed for Chapter 11 bankruptcy protection

after months of asset shuffling and negotiation with first-lien creditors, spearheaded by Apollo and TPG. In a December,

2014 press release, Caesars Entertainment Corporation announced that 80% of creditors backed the restructuring plan,

effectively making Caesars’ bankruptcy plans “pre-packaged” in nature. This press release failed to tell the entire story,

however. Three days prior, on January 12, a group of second-lien creditors had sued to force Caesars Entertainment

Corporation (as opposed to its operating subsidiary) into what legal experts describe as a “free-fall” Chapter 11 proceed-

ing in the U.S. bankruptcy court in Wilmington, Delaware, where Caesars is incorporated (Church, 2015). This would

have been a significant development, as a Chapter 11 bankruptcy for the publicly-traded holdings company would have

given creditors the opportunity to liquidate some of the company’s more lucrative properties, and would have massively

devalued the company’s common stock. In a ploy to avoid this, Caesars motioned to move bankruptcy proceedings to

the Northern Illinois federal district court in Chicago, where the operating company was incorporated. After several

days of argument, a federal judge sided with Caesars’ attorneys, moving the Chapter 11 to Chicago where only the se-

verely indebted (and asset deprived) operating company would be affected.

Caesars restructuring plan will transfer what real property CEOC retains to a publicly traded real estate investment trust

fund, or REIT. This REIT will likely be merged with the property holding entity CACQ, which will then lease proper-

ties back to a newly formed operating subsidiary of Caesars Entertainment Corporation. A comparison of the pre-

bankruptcy organization with the proposed structure shows that there is actually little difference, beyond more asset

shifts, and a few name changes. Of course, reduced debt and associated interest payments will alleviate some of the

burden on the operating company. The bottom line, however, is that cash flows will remain unhealthy for the operating

company, and that it is unlikely to survive another economic shock, regulatory change, or major litigation.

Money Laundering Allegations

Caesars has also been fighting allegations of money laundering being brought against it by the Financial Crimes En-

forcement Network (FinCEN). FinCEN alleges that Caesars’ Desert Palace division violated the Bank Secrecy Act,

which pertains to money laundering and the documentation of large transactions. We view this as yet another hurdle for

Caesar’s to overcome as fines for such violations often total in the tens of millions of dollars. An important note is that

Caesars currently does not have provisions on its balance sheet to cover such legal fines. If found guilty, such fines as

imposed by FinCEN would add to the stress of Caesar’s low cash and high leverage position. In addition, criminal find-

ings against Caesar’s may discourage potential creditors.

In an attempt to mitigate any future legal implications, Caesars has hired one of Wal-Mart Inc.’s senior compliance of-

ficers, Benjamin Floyd, to focus solely on anti-money laundering practices. Even if Floyd proves successful in mitigat-

ing any future money laundering issues, Caesars still operates with negative cash flows as can be seen in a later section.

7

Financial Overview

In looking at the financials for Caesars, we began with a ratio analysis of Caesars and its peers, Las Vegas Sands and

Wynn Resorts, using data from year-end 2013. As can be seen from Figure 3, Caesars lags far behind its competitors

with a negative ROA (-11.9%), a negative debt-to-equity (-8.9), and a negative profit margin (-34%). Of chief concern

is Caesars’ times-interest-earned ratio of -1.0, indicating that the company is earning less than it requires to service its

debt, let alone earn a profit. Despite the proposed bankruptcy restructuring and subsequent debt write down, we believe

that a negative profit margin coupled with a weak position in terms of assets will cause any reprieve from such a re-

structuring to be short lived. These ratios outline how poorly Caesars performs compared to its peers; and given its dis-

advantage from a competitive standpoint, we believe there is little chance for improvement.

From a market standpoint, Figure 4 shows the performance of Caesars’ publicly traded stock against that of Las Vegas

Sands, Wynn Resorts, and the S&P 500 (NYSEARCA: SPY) from January 2012 through January 2015. As can be seen,

Las Vegas Sands and Wynn resorts have generally moved with the market whereas Caesars has remained flat to nega-

tive. We expect a slight improvement should the bankruptcy be resolved successfully, however such an uptick in market

valuation will be short lived as is discussed in the subsequent section.

$0

$50

$100

$150

$200

$250

2012 2013 2014 2015

Adju

sted

Clo

se

Caesars Monthly Adjusted Close

Caesars Entertainment Las Vegas Sands Wynn Resorts S&P 500

Figure 4: Market Performance

Source: Yahoo! Finance, Kent State University

Figure 3: Comparative Margin Analysis Source: Morningstar, Kent State University

8

Caesars Entertainment Las Vegas Sands Wynn Resorts

ROA -11.9% 10.1% 8.7%

ROE 94.2%* 30.1% -394.1%*

D/E -8.9 2.0 -46.3

Profit Margin -34% 17% 13%

Current Ratio 1.5 1.8 2.0

Times Interest

Earned-1.0 12.6 4.3

*high % due to negative income and/or equity

DCF Analysis

In examining Caesars from a valuation standpoint, we performed a discounted cash flow analysis (DCF) out to the year

2020 under what we believe are optimistic assumptions. Using Bloomberg estimates, we anticipate revenue growth of

3% annually and held all other balance sheet and income statement items as a percentage of revenue. In regards to Cae-

sars’ debt levels, the analysis takes into account the proposed bankruptcy restructuring and subsequent write down of

~$10 billion in debt for Caesars Entertainment Operating Company (Reuters). This write-down allows Caesars to con-

tinue to operate with a positive cash balance to sustain ongoing operations. An important note to make is that we project

short-term debt to grow at ~3% annually, however we feel that this is a wildly optimistic assumption as Caesars may

face difficulty in acquiring short term financing should its chief operating unit emerge form bankruptcy.

Despite modest growth in revenue and restructured debt, Caesars remains unable to bring its cash flow levels into posi-

tive territory as can been below in Figure 5. We calculated Caesars’ free cash flow as cash from operations less capital

expenditures yielding consistently negative results through 2020. It is for this reason that we believe Caesars will ulti-

mately be worthless within the next five years.

The capital asset pricing model (CAPM) yielded a cost of equity of ~19%, which when coupled with a post bankruptcy

cost of debt of ~7% (Bloomberg), resulted in a weighted average cost of capital (WACC) of 5.73% (Figure 6). Terminal

value was calculated using an exit multiple of -15x which we derived from dividing current enterprise value by

EBITDA as of year-end 2013 (Figure 7). In discounting Caesars’ projected cash flows and terminal value using the

above-mentioned WACC, we determined Caesars’ equity to be worth well below zero.

As stated previously, we performed our analysis under optimistic assumptions that allowed for Caesars to experience

continued growth both in terms of revenue and in issuance of new debt. With a slow down in Las Vegas, a lack of a

presence in Macau, and an ongoing bankruptcy, it seems impossible that Caesars will be able maintain sustainable reve-

nue growth and find creditors willing to accept any new debt. Currently, Caesars trades on the NASDAQ at ~$10 per

share. Based on our projections, we believe that Caesars is a strong candidate for a short sell strategy that will pay off

well within the next five years.

Figure 5: Free Cash Flow Source: Kent State University

Cost of Equity 19.58%

Weight of Equity 6.2%

Cost of Debt 7.5%

Weight of Debt 93.8%

Effective Tax Rate 36.0%

WACC 5.73%

WACC Calculation

Figure 7: Exit Multiple Source: Kent State University

Figure 6: WACC Source: Kent State University

Market Value of Equity 1,557

Total Debt 23,449

Cash 2,771

Enterprise Value 22,235

2013 EBITDA (1,493)

Implied Exit Multiple (15)

Enterprise Value Calculation

9

Summary

With a shrinking presence in the largest gambling market, an ongoing bankruptcy of its chief operating unit, a complex

and somewhat questionable corporate structure, legal issues, and deteriorating financials, we recommend that a short

sell position be taken against Caesars Entertainment Corporation (NASDAQ: CZR) with realized returns before the year

2020.

10

References

Allen, Lisa. "Caesars Makes Another Move to Insulate Healthy Subsidiaries." TheStreet. TheStreet, 23 May 2014. Web.

17 Feb. 2015.

Bloomberg Business. "Caesars Growth Properties Holdings, LLC: Private Company Information." Bloomberg.com.

Bloomberg, 2015. Web. 20 Feb. 2015.

Caesars Entertainment Corp. Form 10-K For Period Ending 12/31/13. Rep. no. 10-K. Las Vegas: Caesars Entertain-

ment, 2014. Print.

Church, S. (2015). “Caesars Wins Bid to Move $20 Billion Bankruptcy to Chicago”. BloombergBusiness. Retrieved

from http://www.bloomberg.com/news/articles/2015-01-28/caesars-judge-hands-20-billion-reorganization-to-chicago-

court

Hals, Tom. "Caesars Details Plan as Restructuring Deadline Nears." Reuters. Thomson Reuters, 29 Dec. 2014. Web. 17

Feb. 2015.

Keller, Laura, and David Carey. "Caesars Letting Apollo, TPG Keep Stake Fuels Creditor Anger." Bloomberg.com.

Bloomberg, 15 Jan. 2015. Web. 18 Feb. 2015.

Trefis Team. "Trends In The Casino Industry." Forbes. Forbes Magazine, 7 Jan. 2015. Web. 17 Feb. 2015.

Wolf, Brett. "Exclusive: Amid U.S. Probes, Caesars Poaches Top Money Laundering Expert." Reuters. Thomson Reu-

ters, 03 Feb. 2015. Web. 17 Feb. 2015.

Xtract Research. "Caesars Growth Partners LLC: Capital Growth Structre." (n.d.): n. pag. Xtract Research. Mergermar-

ket Group, 2012. Web. 19 Feb. 2015.

11