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Three Reasons to Eliminate Red Rock’s Dual-class Voting Structure

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Lagging Performance

Since Red Rock Resorts went public 5 years ago, its Class A share price has underperformed its peers and the market.

As of 5/26/21, RRR’s Class A shares have gained 116.61% over a 5-year period. Over the same timeframe, the share prices of other regional gaming operators Golden Entertainment, Inc. (GDEN), Boyd Gaming Corp. (BYD), Monarch Casino & Resort, Inc. (MCRI), and Penn National Gaming, Inc. (PENN) share prices went up 231.16%, 243.55%, 241.32%, and 463.43%, respectively. The NASDAQ also went up 180.27.91% over the same period.

Doing away with the dual-class share structure would be a good first step toward maximizing the value of Class A shares of Red Rock Resorts. In the words of a recent Wall Street analyst report: “RRR’s dual-class share structure is suboptimal for most investors and has historically been an impediment to valuation optimization.” (1)

An Entrenched Board

Two years ago, CalPERS raised the issue of board diversity with Red Rock. See Red Rock’s All-White, All-Male Board Draws Calpers’ Attention (Bloomberg, June 2019). At the time, Red Rock said “because the casino business requires an extensive licensing process for board members,” it is “difficult to find qualified candidates.”

Two years later, Red Rock continues to nominate the same five white men to its board and again blames the gaming licensing process for making it difficult to find diverse candidates in this year’s proxy. The company, however, fails to mention that other public-traded Nevada gaming companies have all somehow managed to seat women on their boards.

Doing away with the dual-class share structure is a smart step toward reforming an entrenched, all-white, all-male board at Red Rock Resorts.

Greater Transparency

Family office investments and share pledging by Red Rock’s controlling insiders raise questions about potential conflicts of interest.

Red Rock’s chairman and vice-chair, Frank and Lorenzo Fertitta, have dual roles at Fertitta Capital, their family office founded in 2017 that has overlapping business interests with Red Rock in gaming, sports, betting, leisure, wellness, and food and beverage.

In 2019, Fertitta Capital led a $17.5 million funding round for a sports betting media company, The Action Network.  It remains unclear if Red Rock’s board vetted the deal and whether the family firm receives opportunities owed to shareholders and now competes with Red Rock.

Also, Frank and Lorenzo Fertitta pledged six million or 13% of Class B shares in Red Rock in September 2018 for a margin loan worth up to an estimated $155 million from UBS AG, a bank that was a lender to Red Rock but stopped doing so. The loan pledges appear no longer to be in effect.

To date, Red Rock has not made any disclosures about Fertitta Capital, nor has it explained why UBS started lending to company insiders and stopped lending to the company.

Doing away with the dual-class share structure is a smart step toward transparency and fully protecting Red Rock from potential conflicts of interest.

(1) J.P. Morgan, “Red Rock Resorts: Takeaways from Investor Meetings. Story Still Has Legs. Reaffirm Overweight. PT to $48 (+$1),” North America Equity Research, p. 6 (May 14, 2021).

Red Rock Resorts Silent on Sports Betting

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Red Rock Resorts has not made any significant moves to bolster its position in sports betting following the overturn of the Professional and Amateur Sports Protection Act (PASPA) in May 2018. Public investors in Red Rock Resorts should ask: Does management at Red Rock Resorts have plans to pursue sports betting or other gaming opportunities outside of Nevada? If not, why not?

Read our new report, “Red Rock Resorts Silent on Sports Betting“. 

Estimates about the potential size of a mature, national U.S. sports betting market vary from $67 billion to $287 billion in annual wagers.[1],[2] Legal sports betting in the U.S. has amounted to $763 million of gaming win over the last twelve months.[3] Over half of the gaming win in the last twelve months ($430 million) was generated outside of Nevada.

Other gaming companies acted quickly by partnering with sports leagues and teams, betting and data firms, and even with competitors in order to build strong foundations for emergent sports betting markets.

Frank and Lorenzo Fertitta reportedly led a $17.5 million investment round in The Action Network via their family office, Fertitta Capital, in February 2019.[4] Fertitta’s investment in The Action Network not only presents a potential conflict of interest to Red Rock Resorts public shareholders, but also a potential risk.

Read our new report here.

Notes

[1] $67 billion estimate. Jay L. Zagorsky, “Opinion: The U.S. market for sports betting is far smaller than the $150 billion proponents claim,” MarketWatch, May 15, 2018, https://www.marketwatch.com/story/the-us-market-for-sports-betting-is-nowhere-close-to-150-billion-no-matter-what-proponents-say-2018-05-15.

[2] $287 billion estimate. Oxford Economics, “Economic Impact of Legalized Sports Betting,” American Gaming Association, May 2017, p. 5, https://www.americangaming.org/wp-content/uploads/2018/12/AGA-Oxford-Sports-Betting-Economic-Impact-Report1-1.pdf.

[3] Last twelve months refers to November 2018 through October 2019. Gaming win data come from state government gaming agencies or lotteries.

[4] Action Network Staff, “The Action Network Completes $17.5 Million Series B Financing Round Led by Fertitta Capital,” The Action Network, press release, February 21, 2019, https://www.actionnetwork.com/press/action-network-funding-series-b-fertitta-capital.

How much has Palms cost Red Rock Resorts shareholders?

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The simple cost of Palms to Red Rock Resorts so far is well known: the company paid $312.5 million to buy the casino in May, 2016, and by the end of September this year had completed a $690 million project to “fully reimagine and repurpose the property.”[i] In spite of the billion-dollar overall capex, management disclosed on the third-quarter conference call that Palms has not generated significant incremental EBITDA. The property’s 3Q19 adjusted EBITDA was either negative $9.8 million (including the now-shuttered KAOS day/nightclub) or positive $3.7 million (excluding KAOS). (The company overall had $110 million in adjusted EBITDA in the quarter.) It appears the property is unlikely to achieve management’s one-time “mid-teens return” goal any time soon.

For Red Rock shareholders, there is a significant cost to management’s decision to borrow and spend $1 billion on a project that has ended up not meeting ROI expectations. Net long-term debt increased from just under $2.00 billion at the end of 1Q16 (just before the Palms purchase was announced) to over $2.94 billion at the end of 3Q19 (when the renovation was completed). The company essentially borrowed and spent a billion dollars to gain no new EBITDA when it comes to Palms.

In a basic valuation model: EV (EBITDA x multiple) – debt = equity. With no new EBITDA and thus constant enterprise value, one billion dollars of additional debt means one billion dollar less of equity value. Therefore, Red Rock’s $1 billion “Palms debt” means a $1 billion reduction of Red Rock’s equity value. With the Palms project, Red Rock management wiped out $1 billion of shareholder equity. More than $8.00 per share of equity value (with 117 million diluted shares outstanding) evaporated because of the Palms project.

On the company’s quarterly call on Nov. 5, management announced the company’s goal is now to “[reduce] our net leverage ratio to a targeted level of 4x or less through a combination of paying down debt and increasing EBTIDA.” There was no acknowledgement that the company had levered up its balance sheet for no gain in EBITDA from Palms and thus significantly hurt shareholder value. In fact, if Red Rock had not borrowed $1 billion to spend on Palms over the last three-plus years and stuck with organic growth from its pre-Palms Las Vegas operations and tribal management fees, it would have already achieved a pro forma leverage of 3.94x at the end of 3Q19. Instead, now more of the company’s cash flow must go toward paying down the “Palms debt”, leaving less free cash flow for potential share buybacks or dividend increases.

It is true that Red Rock enjoys relatively low borrowing cost because of the company’s strong overall cash flow. But even at its current blended long-term debt interest rate, $1 billion of debt would require about $45 million of annual interest expense. Some Wall Street analysts have projected Palms to produce $25 million in annual EBITDA by the end of 2021.[ii]

Notes

[i] Red Rock Resorts, 3Q19 conference call, 11/5/2019, transcript by FD Wire.

[ii] JP Morgan, “Red Rock Resorts: Another Mixed Quarter; 3Q19 Core LV Fine, Palms Not So; Palms’ Chaos and EBITDA Losses Coming to an End. PT to $24”, 11/5/2019.