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The Palms Conundrum

What is Station Casinos doing with Palms?

That’s a question that should be on investors’ minds since the company has committed nearly half a billion dollars to the latest addition to its portfolio of casinos in Las Vegas. Adding $146 million of renovation cost to the $312.5-milion purchase price brings the total capex on Palms to $452.5 million. As explained by CFO Stephen Cootey, the company’s “expected returns” on “any capital expenditures” are in the “mid to low teens” range. This would suggest that, in a best-case scenario, investors might see Palms’ making annual EBITDA of close to $70 million (425.5 x 15% = 67.9) after the renovation is done by the end of second quarter next year. This is a much more ambitious target than the $35 million the company originally put forth when it announced the acquisition. (We raised some questions about that projection previously, given our estimate that Palms’ LTM EBITDA was approximately $28 million at the time.) So how will Station Casinos get there?

Palms is not a typical Station Casinos property

A major challenge facing Station Casinos is the fact that Palms is a very different kind of property from what the company is used to operating. Even though Palms was described as a “leading gaming asset” by Station management, it did not generate most of its revenues from gaming. In fact, the casino department contributed only approximately 37% of its property-level gross revenue during the fourth quarter of last year, according to Red Rock Resorts’ 10-K. Even assuming there was some disruption due to the change in ownership and management, that figure shows Palms is a very different breed of casino resort than other Station properties.

(In $ millions) 4Q16 % of Total
Casino revenues (reported) 15.5 37.0%
F&B revenues (reported) 8.7 20.8%
Rooms revenues (reported) 11.6 27.7%
Other revenues (estimated) 6.0 14.5%
Gross revenues (estimated)* 41.8

* Red Rock reported the net revenues were $38.5 million at Palms in 4Q16. Assuming promotional allowances of 8% of gross revenues, we calculated the gross revenues to be $41.8 million.

In fact, Palms seems to be very similar to a Strip resort in terms of its revenue mix. Here’s the revenue breakdown of major Strip properties last year, according to the most recent Nevada Gaming Abstract.

(in $ millions) FY2016 % of Total
Casino 5,396 34.1%
Rooms 4,419 28.0%
Food 2,527 16.0%
Beverage 1,126 7.1%
Other 2,335 14.8%
Total 15,805

This is not how Station Casinos has run its business. Before Palms, Station Casinos properties had always generated most of their revenues from the casino floor. Back in 2006, gaming made up anywhere from just under two thirds to over 80% of gross revenues at the company’s “large properties” in Las Vegas (according to a report filed during the Station Casinos Chapter 11 case).

(In $ millions) Gross Revenues Gaming Revenues Gaming as % of Gross
Palace Station 176.1 126.0 71.6%
Boulder Station 216.9 174.7 80.5%
Texas Station 143.3 107.9 75.3%
Sunset Station 222.9 168.0 75.4%
Santa Fe Station 184.1 150.3 81.6%
Green Valley 297.9 202.9 68.1%
Fiesta Rancho 73.2 58.0 79.3%
Fiesta Henderson 83.9 61.0 72.7%
Red Rock (Opened 4/18/06) 250.3 158.8 63.4%
Total 1,648.6 1,207.6 73.2%

This heavy reliance on gaming was true of even Green Valley Ranch (which had been open for five years) and Red Rock Station (which had been open for less than a year). It is true that these “hybrid” properties, which according to the company “appeal to both Las Vegas residents and tourists”, have a greater non-gaming side to their operations, but they still seem to be very different than Palms.

And we do not believe the revenue mix has changed significantly at GVR and Red Rock, since the most recent pre-Palms financial disclosures continued to show the overweighting of casino revenue in its Las Vegas properties. In the first nine months of 2016, Station Casinos earned approximately 67% of its gross revenues from gaming at its Las Vegas properties (i.e., company-wide gross revenues excluding management fees revenues).

(In $ millions) 9M16 % of Gross
Casino revenues 706.2 67.0%
F&B revenues 196.6 18.6%
Rooms revenues 99.6 9.4%
Other revenues 52.4 5.0%
Gross revenues 1,054.6

What kind of management experience can a company like this bring to Palms? Does Station Casinos have the management know-how to operate an almost-Strip property like Palms?

Will casino revenue at a “Stationized” Palms go from one-third of total revenue to two-thirds of the total? If that is indeed the goal, then presumably the strategy is to grow gaming revenue at Palms and not to shrink the non-gaming business there. How would then Station Casinos go about doing that?

Management instability

Whatever the strategy there is for growing revenue (and EBITDA) at Palms, why is Station Casinos already onto its third general manager at the property in less than a year’s time?

When Stations Casinos officially took over last year, Michael Jerlecki, formerly the general manager of Palace Station, which is not one of the company’s “luxury” properties, was made the new Palms general manager. By January 2017, Jerlecki was quietly replaced by Anthony Faranca (according to Faranca’s LinkedIn page), who had been general manager of the Parx racino outside Philadelphia, a change the company didn’t officially announced until April. Then, in July a local magazine profiled new Palms executive Jon Gray and described him as the property’s general manager, in spite of any formal announcement from the company. (Gray did sign as the general manager letters informing workers of their termination due to the closing of several F&B venues at Palms in early September.)

The hiring of Gray was something of a homecoming, for he was an executive at the Palms when it was still owned by the Maloofs and was general manager of N9Ne Group heading up the hotel’s nightclubs, restaurants, and pool events at the property. He also opened the non-gaming F&B/entertainment LINQ District on the Strip and worked for Nike in Oregon before returning to Palms. What is missing from this impressive resume, though, is any significant experience with casino operations.

Assuming he lasts longer than his two predecessors as Palms’ general manager, is Jon Gray the right person to “Stationize” and grow casino revenue at Palms?

Why is Red Rock Resorts’ Share Price Underperforming the Market and Its Peers?

Why is Red Rock Resorts’ Share Price Underperforming the Market and Its Peers?

In the first quarter of 2017, Red Rock Resorts’ Class A share price declined by 7% while the S&P 500 index went up by 4.65%.

rrrvsp500-1q17

(Source: Yahoo Finance)

RRR’s share price dropped while other regional gaming operators’ share prices rose in the quarter:

rrrvregionals-1q17

(Source: Yahoo Finance)

What explains this significant underperformance of RRR stock? We believe investors are likely concerned with the Palms acquisition and the uncertainty in the company’s growth pipeline:

Is the Palms acquisition meeting management expectation?

When the $316-million Palms acquisition was first announced last May, the company said that “[f]actoring in anticipated synergies, the Company estimates that the Palms will generate $35 million in EBITDA during the Company’s first full year of ownership.” Is the company on track to meet this goal?

When Station Casinos officially took ownership of the Palms on Oct. 1, Michael Jerlecki, who had been the general manager of Palace Station, became the resort’s GM. However, Jerlecki was replaced by Anthony Faranca by early February without any public announcement from the company. (The new GM is mentioned in passing in a local columnist’s write-up on new assistant manager Jon Gray.) We do know from the company’s recently filed 10-K that Palms had a net pretax loss of $1.3 million in the fourth quarter on net revenues of $38.5 million.

Given these numbers, investors might wonder whether the Palms is on track to make $35 million in EBITDA through September 30 this year. While the company did not provide property-level breakout of Palms’ EBITDA for the fourth quarter, investors should demand greater clarity going forward so they can better understand whether the expensive, debt-financed purchase is paying off as management had anticipated.

What happened to the Palms Place hotel rooms?

The company’s 10-K shows there were 713 hotel rooms at the Palms, but makes no mention of the condo-hotel units at Palms Place. Back in September, the company’s investor presentation showed that, at Palms, in addition to 713 rooms across two hotel towers, there were “approximately 448” condo units at the stand-alone Palms Place tower in the “room rental program, pursuant to which the Company receives 50% of the room rate and 100% of the resort fee on any such rentals.”

What happened to these 448 hotel units at Palms Place? They would account for about 39% of total available hotel units at the company’s new acquisition. The 10-K does not say anything about this Palms Place condo-hotel program. Has the company decided not to manage Palms Place’s hotel pool anymore? If so, how might that affect the goal of making $35 million in EBITDA at the Palms through September 30?

Why is no one adding significant capacity in the Las Vegas locals market?

We recently took a closer look at the company’s new development pipeline in Las Vegas and found little that was “shovel ready.” Given the lack of discussion on this issue during the analyst call, we believe some further questions are warranted.

For example, when will the company tell investors more about the planned second hotel tower at Palace Station, which received planning approval in September? The planned tower is absent from the discussion of the on-going $115-million “upgrade” of Palace Station in the company’s latest investor presentation from March 20.

While the company continues to tout its “Existing Development Sites” in Las Vegas such as “Durango” and “Viva” in its March presentation, it has not announced any concrete plans to build out those sites. Moreover, there are ten “Gaming Enterprise Districts” in the Las Vegas Valley which are not owned or controlled by Station Casinos.

non-rrr_geds

(See our interactive map of casinos and casino sites in the Las Vegas locals market.)

The existence of these non-Station future casino sites should make investors skeptical of any claims of barriers of entry to the Las Vegas locals market. Moreover, if the Las Vegas locals market is growing significantly, why have these other developers not seen fit to build out new Las Vegas locals casinos?

What will happen in the company’s tribal casino management segment in 2021?

Outside of Las Vegas, there are looming challenges in the company’s tribal casino segment. Its two existing management agreements expire in February, 2018, and November, 2020, respectively. The company estimates that its only other tribal casino project will require another 36 to 48 months to begin construction and 18 months after construction begins to complete and open.

This means the earliest opening date would fall around September, 2021, and that the company most likely will not have a tribal casino management fee revenue stream in 2021. To be clear, the tribal casino management segment accounted for 7.6% of the company’s net revenues and 18.0% of adjusted EBITDA in 2016.

It should be noted that the company’s $225-million Term Loan A and $685-million Term Loan B both mature in June 2021, and its $500 million of 7.5% senior notes are due March 1, 2021. That is a total of approximately $1.4 billion of debt coming due when the company will likely not have any tribal casino management revenue. Will the company be able to roll over that debt given this potential lack of tribal casino management revenue in 2021?

Questions about the Palms Acquisition

When will Red Rock disclose the Palms purchase agreement?

Since the May 10 press release announcing the acquisition, Red Rock has not filed the definitive purchase agreement with the SEC yet. Investors should be able to review and evaluate the details of this significant transaction, which, at $312.5 million, cost nearly 70% of the company’s 2015 Adjusted EBITDA ($451 million) and is expected to be financed with new debt.

What will Red Rock have to do to bump up Palms’ EBITDA by 25% in one year?

Back in May, Red Rock management stated that they expect the Palms to generate “over $35 million” in EBITDA in the first full year of ownership by Red Rock. At the same time, they say the property’s EBITDA run rate is at “approximately 60% below its peak level.”

The Palms reportedly had EBITDA of about $70 million before the Great Recession, according to Debtwire/Financial Times. If one assumes that was the peak, then “60% below peak” would imply current annual EBITDA of about $28 million. Will Red Rock be able to expand Palms’ EBITDA by 25% (to $35 million) during its first full year of ownership? What kind of revenue growth and/or cost cutting will be required to achieve such a large increase in EBITDA in one year?

Will “Palms Station” cannibalize Palace Station?

Also back in May, Red Rock management described Palms as being “located in one of our most underpenetrated areas in the Las Vegas Valley from a boarding pass member standpoint.”

But the Palms is only 2.3 miles away from Red Rock’s Palace Station, and if you draw a five-mile-radius circle around each of these two properties, there is a 71% overlap between the two circles. How will the company ensure that its efforts to grow the business of Palms will not come at the expense of Palace Station?