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When Management Destroys 2% of Shareholder Value with a Related-Party Deal

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In its recently filed 10-Q, Red Rock Resorts discloses that it borrowed $120 million from its revolver to buy the land under two of its Las Vegas casinos from a related party. This means the April 27 transaction reduced the company’s equity by approximately $0.43 per share, or 1.93%. Investors should ask why Red Rock management thought this was a smart thing to do and whether the company’s independent directors reviewed and approved the costly related-party transaction.

Shareholder value destruction

On the first-quarter conference call with analysts, then-CFO Marc Falcone claimed the Boulder Station and Texas Station land purchase would let the company “pick up approximately $7 million of incremental EBITDA” on an annual basis (approximately the total savings of not having to pay rent anymore under those two leases.) What this implies is that the transaction created an approximately $70-million bump in the company’s enterprise value, if we use a 10x EV/EBITDA multiple on its Las Vegas business.

But the company added $120 million of debt in the process, which means that, net-net, there was in fact a negative $50 million hit on the equity value of the company, or the reduction of approximately $0.43 of equity value per share (based on a share count of approximately 116 million).

Equity Impact of RRR’s April 27 related-party land purchase

Add: Incremental EBITDA $7M
EV/EBITDA multiple 10x
Increase in Enterprise Value $70M
Subtract: Additional Net Debt $120M
Net Change in Equity Value ($50M)
Shares 116M
Net Change in Equity Value Per Share ($0.43)

The pre-transaction closing price of RRR Class A shares was $22.34. Red Rock management thus directly destroyed 1.93% of the company’s shareholder value with the April 27 related-party transaction. Alternatively speaking, management made its public shareholders take a $50M hit in their RRR holdings to pay for this related party deal. On a pro rata basis, Cohen & Steers, Red Rock’s largest institutional shareholder, lost $3.85M million of the value of its RRR shares; Fidelity lost $3.44M, Diamond Hill lost $1.88M, and Baron Capital lost $1.86M. No wonder some shareholders sounded less than thrilled with the related-party deal when approached by Bloomberg.

GAAP implications

Our analysis above would hold even if the company had use cash on hand to pay for the deal. Spending down cash would have increased net debt in the same way as borrowing more, which would have resulted in the same negative impact on equity value. But since Red Rock borrowed money to fund the transaction, there are implications for the company’s financials beyond EBITDA, a non-GAAP number that does not account for interest expense. At the very least, not all of the $7 million incremental EBITDA will flow through to net income and earnings per share because there would be increased interest expense on the new $120 million debt.

In addition, the 10-Q also states:

As a result of such acquisition and the termination of the ground leases, the Company expects to recognize a charge in an amount equal to the difference between the aggregate consideration paid by the Company and the acquisition date fair value of the land and residual interests, which charge is expected to have a material impact on its net income and earnings per share for the three and six months ending June 30, 2017 (emphasis added).

This begs the question: why did Red Rock pay more than market value? And, again, did the company’s independent directors review and approve the deal?

Red Rock Resorts buys out two related-party land leases for $120 million

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Red Rock Resorts disclosed in its DEF 14A, filed on May 1, that it had bought out two long-term land leases it had with a related party in Las Vegas:

On April 27, 2017, the Company purchased entities that own the land subject to the Boulder land lease and the Texas land lease from the Related Lessor for aggregate consideration of $120 million.

On its quarterly conference call with analysts on May 4, the company stated that the deal “will be immediately accretive to cash flow and will provide the company full control of this real estate.” Specifically, it would “pick up approximately $7 million of incremental EBITDA related to the purchase of the two ground leases.” This figure likely refers to the combined savings on annual rent payments. Monthly rent was $222,933 per month under the Boulder lease and $366,435 per month under the Texas lease, so total annual lease payment by Red Rock was approximately $7.1 million. The company therefore paid about 17 times annual rent to terminate the two leases.

It is unclear how the company paid for the purchase. If it had financed the purchase – perhaps under its $350-million revolving credit facility — it would have incurred some additional interest expense, so not all of the $7-million incremental EBITDA would flow through to the bottom line.

The two ground leases covered 27 acres of land under Boulder Station and 47 acres of land under Texas Station (The size of the Boulder Station parcel can be found in Station Casinos LLC’s 2017 10-K, p. 77). Red Rock thus purchased 74 acres for $120 million, or approximately $1.62 million per acre.

To put this $1.62-million-per-acre purchase by Red Rock in further context:

For further context, we note that $120 million equals approximately:

  • 8.3% of Red Rock’s 2016 net revenues of $1,452 million
  • 24.8% of its 2016 adjusted EBITDA of $484 million
  • 34.7% of its 2016 cash flows from operations of $346 million, and
  • 77.0% of its net income of $156 million in 2016

The announcement in Red Rock’s proxy does not say whether an independent appraisal was performed to determine a fair market price for either or both of the two properties before the company consummated the transaction. It is also unclear whether the transaction was reviewed and approved by the Audit Committee of the company’s Board of Directors.

Should You Pay Someone Else’s Income Taxes?

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Would you like someone else to pay $40 million in income taxes for you? How would you like to pay some else’s income taxes with $40 million of cash?

Tax returns, or the lack thereof, have been in the news these past several months. While there are many ways people can manage their income tax obligations, one of the more interesting tactics appears to be what owners of Station Casinos LLC set up when they took it out of Chapter 11 bankruptcy in 2011. The company became party to a “tax distribution agreement” that requires cash payments to cover each LLC member’s share of the LLC’s income tax. That is, the LLC members get cash from the company to pay their share of the income tax bill based on the company’s profits.

This arrangement has persisted after Station Casinos became a subsidiary of Red Rock Resorts, Inc., which currently owns approximately 57% of the economic interest in Station Casinos. As described in Red Rock’s recently filed 10-K for the year 2016:

Tax Distributions

Station Holdco [which is partially owned by Red Rock Resorts and owns 100% of the economic interest in Station Casinos LLC] is treated as a pass-through partnership for income tax reporting purposes. Federal, state and local taxes resulting from the passthrough taxable income of Station Holdco are obligations of its members. Net profits and losses are generally allocated to the members of Station Holdco (including [Red Rock Resorts]) in accordance with the number of Holdco Units held by each member for tax reporting. The amended and restated operating agreement of Station Holdco provides for cash distributions to assist members (including [Red Rock Resorts]) in paying their income tax liabilities. 

None of this has been a secret. The term sheet for the company’s reorganization filed in bankruptcy court back in October, 2010, called for “the making of distributions to equityholders of amounts estimated to be necessary to pay taxes (including estimated taxes) on taxable income allocated to them by New Propco Holdco from time to time”. A “Holding Company Tax Distribution Agreement,” dated June 16, 2011, has been referenced in several of the company’s debt agreements going back to August, 2012, even though this tax distribution agreement itself was never publicly disclosed. During the Red Rock IPO last year, the LLC agreement of Station Holdco LLC filed with the SEC describes how the firm should fulfill its obligations to make these tax distributions in cash every quarter. In fact, over the year Station Casinos has taken to describing such payments to cover its owners’ income tax expenses simply as “customary tax distributions” in its public filings.

What has not been disclosed until now is how much Station Casinos has actually spent on these tax distributions. Thanks to Station Casinos’ most recent 10-K filing (separate from Red Rock Resorts’ 10-K filing), we now know how much in cash the company paid out to its owners for their LLC income tax bills in 2016.

During [the year ended December 31, 2016], cash distributions totaled $153.9 million, consisting of $142.8 million paid to members of Station Holdco and Fertitta Entertainment, of which $43.6 million represented tax distributions, and $11.1 million paid by MPM to its noncontrolling interest holders [emphasis added].

In other words, Station Casinos spent approximately 9% of the company’s adjusted EBITDA ($484 million), 12% of its cash flows from operations ($346 million), or 27% of its net income ($164 million) in 2016 to cover some of the federal income tax obligations of the Fertitta family and other owners.

Should Red Rock shareholders continue to let Station Casinos, of which they own 57%, spend cash on covering the income tax liabilities of pre-IPO owners like the Fertittas?