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Red Rock Resorts is a Second-Class Gaming IPO

Download our unauthorized roadshow presentation and presentation notes here.

Investors who buy Red Rock’s second-class shares on offer will gain a minority (33%) stake in the once-bankrupt Las Vegas casino and tavern operator, Station Casinos. The terms of the offering beg questions about company insiders’ confidence in its long-term prospects.

Prospective investors should ask management the following questions:

Should new shareholders expect significant dilution soon after the IPO thanks to Deutsche Bank’s expected exit? After the IPO, Deutsche Bank owns 16.2-18% of the company after selling very few shares in the current offering. The German lender, which is also an underwriter of this IPO, has been selling off its non-core assets at a loss, including a Las Vegas Strip resort and a New Jersey port operator as it continues to deal with its capital and regulatory challenges. Will it sell off its large Station Casinos/Red Rock stake immediately after the 180-day lock-up period, which may even be waived by Deutsche Bank and J.P. Morgan as underwriters?

Why is Red Rock paying $460 million in cash to insiders to internalize management with the Fertitta Entertainment acquisition? Red Rock’s prospectus does not present any specific potential benefits of this proposed transaction, yet the price represents (1) 20% of the $2.3-billion IPO valuation of Station Casinos’ equity at the mid-point of its offering price range; (2) 8.7x TTM management fees instead of the 1x TTM management fees for a potential termination of the Fertitta Entertainment management agreements covering at least 13 of 19 casinos; and (3) 31x our estimate of Fertitta Entertainment’s 2015 pro forma EBITDA of about $14.8 million. Even though it did not complete a $300-million dividend recapitalization last spring, Station Casinos has paid out over $477 million to its existing owners from 2013 through April 2016, before consummating this pricy acquisition.

How confident is management in Red Rock’s growth prospects? The Las Vegas locals market, which made up over 90% of Red Rock’s total EBITDA in 2015, has been contracting in terms of total amount wagered and number of slot units, and gaming revenue at the company’s Las Vegas operations grew at an annual compounded rate of only 1.4% from 2012 to 2015. The company has even listed hard-to-come-by potential casino sites in Nevada for sale. As for its tribal business, the company has not signed any new tribal gaming development or management agreements since 2004. Its two current contracts are due to expire in 2018 and 2020, with only one more project in development.

If the Fertitta family is cashing out, why should investors buy Red Rock’s second-class shares with uncertain prospects for dividends? The Fertitta family’s Class B Red Rock shares with 10:1 voting power make the Class A Red Rock shares second-class shares in more ways than one. Furthermore, a lopsided tax receivable agreement without a hard cap on future payments to pre-IPO owners will lead to uncertainty about Red Rock’s future free cash flow and its ability to pay dividends to Red Rock’s second-class shareholders.

It is alarming that potential investors in Red Rock’s second-class IPO are being asked to buy out an insider management company at a high, $460-million valuation, instead of paying down company debt or funding new growth initiatives. Data on the ground in Las Vegas show tepid growth in Red Rock’s core business, underscoring the contrast between an IPO that strengthens a gaming company’s finances and one that drains funds to buy a related-party management company, like Red Rock.


See more of our analysis of the Red Rock Resorts/Station Casinos IPO:

 

 

More Questions about the $460-Million Valuation of Fertitta Entertainment

A key feature of the Red Rock IPO is the use of proceeds, plus additional debt, to acquire Fertitta Entertainment for $460 million in a related-party transaction. Investors should ask the company how it arrived at and agreed to this price.

First of all, here is some perspective on the price tag of this insider deal. $460 million equals:

  • 93% of the estimated IPO net proceeds of $495.9 million (assuming the mid-point of the offering price range and that the underwriters do not exercise their options to purchase additional shares)
  • 20% of the IPO valuation of Station Casinos’ equity of $2.26 billion (with the same assumptions as above)
  • 8.7 times Fertitta Entertainment’s 2015 management fee revenue from Station Casinos
  • 31 times Fertitta Entertainment’s 2015 pro forma EBITDA of $14.8 million (which we calculated by comparing the financials of the consolidated Station Holdco LLC and Station Casinos)

In addition, we believe prospective investors should ask Red Rock management the following questions:

  • Is Red Rock projecting $34 million of incremental annual EBITDA and therefore only $18 million in annual corporate expenses on a going-forward basis after buying Fertitta Entertainment and internalizing management?
  • If yes, does that projection include potential equity-based compensation expenses?
  • And what is the plan to keep corporate expenses at $18 million a year for 13.5 years?

Even though the company’s IPO prospectus filings do not describe any specific financial benefits of the Fertitta Entertainment acquisition, Red Rock management explained the valuation basis of the Fertitta Entertainment deal what they presented to Nevada gaming regulators on January 21. During the special meeting of the Nevada Gaming Control Board meeting to approve the IPO, CFO Marc Falcone said:

With the transaction and the acquisition of Fertitta Entertainment, we actually improve, EBITDA will go up by $34 million, approximately. So we are basically taking the management fees that were historically paid to Fertitta Entertainment, those now will remain within Red Rock Resorts, Inc., and Station Casinos LLC. We are also adding back some expenses that related to salaries and wages for the employees that are currently employed at the Fertitta Entertainment level that will now be employed at the Station Casinos LLC level [emphasis added].*

That is, the company believes that internalizing Fertitta Entertainment would lead to incremental annual EBITDA of $34 million because that’s the amount it would “save” by (1) not paying out management fees ($52 million in 2015) anymore but (2) paying corporate expenses covering its executives and corporate employees directly, who are currently employed and paid by Fertitta Entertainment. If $34 million incremental EBITDA is the basis for the $460 million price, a 13.5x multiple was used. It thus appears the company has agreed to transfer 13.5 years of potential EBITDA “savings” as an immediate lump-sum cash payment to the owners of Fertitta Entertainment as part of the IPO.

Mr. Falcone’s statement implies that the company is expecting to pay only $18 million a year in corporate expenses going forward ($52 million minus $34 million). Is $18 million in corporate expenses a realistic number for a company the size of Red Rock/Station Casinos?

Let’s consider what Station Casinos used to do when it was a publicly-traded company. In the last three full years when it was a publicly-traded company before the disastrous insider-led leveraged buyout of 2007, the company paid on average about 4.9% of its net revenues out as corporate expenses.

($ millions) 2004 2005 2006
Net revenues $986.7 $1,108.8 $1,339.0
Corporate expenses $47.2 $57.6 $63.1
Corporate expenses as % of net revenues 4.8% 5.2% 4.7%

In 2015, Station Casinos had net revenues of $1.35 billion. If it had paid its own corporate expenses at a level like it used to during the three-period listed above, it would have spent $61 million in corporate expenses. We believe it would be unrealistic to expect to pay only $18 million in corporate expenses after Red Rock internalizes Fertitta Entertainment.

Another concern investors should be aware of is how the company accounts for equity-based compensation. According to section 3.08 of the disclosure schedule of the execution copy of the Fertitta Entertainment purchase agreement (filed as Exhibit 10.10 in Red Rock’s 2/12/16 S-1/A):

With respect to [Fertitta Entertainment LLC’s] consolidated financial statements for the years ended December 31, 2012, 2013 and 2014 and for the six months ended June 30, 2015, the Company did not record share-based compensation expense associated with equity incentives issued to current and former executives of the Company from FI Station Investor LLC.  FI Station Investor LLC is an entity that is owned by the parent entities of the Company.  Pursuant to GAAP, this non-cash share-based compensation is required to be recorded as a component of the Company’s statement of operations since these executives were employees of the Company and FI Station Investor LLC is a common-controlled entity of the Company’s equity holders.  The Company’s auditor, Ernst & Young LLP, has determined that each of the foregoing financial statements would require to be restated and has withdrawn its opinions for each audit period that are dated March 25, 2015, May 14, 2014, April 16, 2013 and May 15, 2012, respectively.

This disclosure should lead investors to ask whether Station Casinos has an accurate handle on historical, current and projected costs of equity-based compensation, which could be an expensive component of cost for any company. (We have sent a letter to the SEC asking some other questions based on this disclosure, too.)

* The transcript of the Jan. 21, 2016, special meeting of the Nevada Gaming Control Board can be ordered by calling Sunshine Litigation Services at 775-323-3411. The quote is from pp. 32-33.


See more of our analysis of the Red Rock Resorts/Station Casinos IPO:

Selling Growth While Cashing Out

Read our updated report, “Selling Growth While Cashing Out”.

Is the Las Vegas locals market in decline? Data from the Nevada State Gaming Control Board show a continuing decline in the number of slot machines in the Las Vegas locals market since 2009. This is accompanied by a similar decline in the total amount wagered by customers in the locals market. Both total slot units and amounts wagered have declined to 2003 levels. Station Casinos derives “approximately 80% to 85%” of its gaming revenue coming from slot play.

Why is Red Rock Resorts selling hard-to-come-by casino sites? Historically, Station Casinos built its leading position in the Las Vegas locals gaming market by acquiring a portfolio of competing locals casinos and undeveloped land shielded from competition thanks to Nevada’s SB 208 legislation. The company touts its gaming-entitled land holdings in its IPO prospectus, but it has not disclosed that some of its casino sites are now on the market or explained why it is ceding some of its “highly desirable” and “strategically located” gaming-entitled locations in Las Vegas.

When will Red Rock Resorts grow again? Station Casinos has seen little growth in its core Las Vegas business over the last several years. Casino revenues from its properties in Las Vegas barely increased from 2009 to 2014, with a compound annual growth rate of only 0.07%. A significant portion of the company’s EBITDA growth over the past three years has come from its tribal casino management agreements, but the company has not signed a new tribal casino development agreement in over a decade.

Investors deserve better analysis of Las Vegas economic conditions. We reviewed how the company in its IPO filings describes certain of its own key metrics for understanding the Las Vegas economy and the potential for growth in the Las Vegas locals gaming market (e.g. average weekly wages and home value appreciation). When Station Casinos says that it believes the Las Vegas locals gaming market is one of the most attractive in the U.S. because of, among other things, “its strong economic and demographic fundamentals,” what is the company talking about? How confident is the company in its claims?


 

What is the Red Rock Resorts IPO?

Download our unauthorized roadshow, “Red Rock Resorts: A Second-Class IPO”.


Red Rock Resorts, Inc. is not planning to use IPO proceeds to grow through either asset purchase or new development. It is not planning to reduce its overall indebtedness with the IPO proceeds. Instead, concurrent with the IPO, it is paying out a large sum to insiders in an “internalization” deal that will not generate any new revenues. It is not even planning to buy out the ownership stake held by Deutsche Bank.

Highlights from the report:

  • RRR to pay insiders $460 million to buy zero new revenue. The $460-million price tag of the Fertitta Entertainment acquisition is 8.9 times the trailing-12-month management fee the firm receives from Station Casinos. The non-insider cost for acquiring Fertitta Entertainment should be closer to $52 million, not $460 million because its management agreement covering 13 of the 19 managed properties provides for a termination fee of 1x TTM management fee upon third-party sale of the properties. And existing Fertitta Entertainment executives and corporate employees will stay on and become directly employed by RRR. Moreover, Fertitta Entertainment, whose only existing business is to manage Station Casinos properties, will not generate any revenues after the acquisition, which effectively “internalizes” management. The planned $460-million payout follows payments of over $1.25 billion to the Fertittas and other company insiders over the past decade. If the Fertittas are confident in the future of Station Casinos, why aren’t they taking further equity in the company instead of cashing out?
  • RRR is letting insiders cash out substantial funds through the IPO instead of reducing debt, funding growth or simplifying risks. A Fidelity fund’s filing implies that it valued Station Casinos’ equity value at approximately $1.12 billion at the end of August. This means that the $460 million to be paid for Fertitta Entertainment would equal approximately 41% of RRR’s equity based on this value. Why are the Fertittas choosing to take the new IPO money out of the company rather than strengthen its financial condition or improve its growth prospects?
  • RRR is not planning to buy out Deutsche Bank as an owner, which poses licensing risks because Deutsche Bank has a criminal affiliate. Red Rock Resorts makes it clear that Deutsche Bank is not selling all of its 25% in the company. But RRR has not disclosed the bank’s recent and mounting regulatory problems: a bank subsidiary recently pled guilty to felony wire fraud, the bank itself paid a record $2.519 billion in fines to the U.S. Treasury and world financial regulators, and Deutsche is still under ongoing criminal investigations. These regulatory problems, which are not disclosed in the registration filings, could have implications for RRR shareholders because the company primarily operates in the highly regulated Nevada gaming industry.
  • RRR’s Class A shares will be second-class shares with negligible votes and unclear prospects for dividends. The company will remain controlled by the Fertittas after the IPO. While the family will sell a portion of their equity interest in the offering, they will enjoy 10:1 super voting rights for the foreseeable future, while new public shareholders’ prospects for dividends may be hamstrung by the company’s debt restrictions and tax-benefit obligations that limit Holdco’s ability to pay dividends to the new public company. Moreover, the cost of dual class shares was recently illustrated in hospitality when Marriott prevailed in a contest to acquire Starwood Hotels over a company whose shares had disparate voting rights.
  • How confident are RRR and its controlling shareholders in the company’s core Las Vegas locals business if they are selling valuable casino sites? The company has disclosed in its registration filings that it is selling potential casino sites in spite of the “legal limitations that restrict the development of additional off-Strip gaming properties.” Those sales listings, coupled with a substantial transfer of cash from the company to the Fertittas in this IPO beg the question: Do the Fertittas and the company they control have confidence in its core Las Vegas “locals” business, which provides over 90% of its net revenue?

See more of our analysis of the Red Rock Resorts/Station Casinos IPO:

Our Response to SEC Request for Comment on the Effectiveness of Financial Disclosures about Entities Other than the Registrant

Read our full letter to the SEC here.

On Nov. 30, we sent a letter to the SEC in response to the commission’s request for comment on “Effectiveness of Financial Disclosures About Entities Other Than the Registrant”. We ask the Commission to consider three specific amendments to Rule 3-05. We have arrived at our suggestions after reviewing recent filings by Station Casinos LLC and Station Casinos Corp.

An excerpt from our letter:

We think investors would find it difficult to evaluate the proposed $460-million purchase price of Fertitta Entertainment LLC as neither registrant has provided historical financials of the target. The purchase agreement filed in an 8-K by Station Casinos LLC on Oct. 13 does not include any exhibits showing historical financials of Fertitta Entertainment. And these are not disclosed in Station Casinos Corp.’s IPO filings, including an S-1 filed on Oct. 13 and an S-1/A filed on Nov. 24, either.

Investors are thus left in a quandary: they cannot know whether the Fertitta Entertainment acquisition is “significant” because they do not have the necessary information to check the significance of the purchase using the tests provided for under Rule 3-05. They therefore cannot assess and evaluate whether the purchase of an affiliate under common control is a good one for Station Casinos LLC and its proposed new parent Station Casinos Corp.

See more of our analysis of the Red Rock Resorts/Station Casinos IPO: