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

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?

Deutsche Bank Sells 19.6 Million Class A Shares After IPO Lock-Up Period Expired

Update 2: Deutsche Bank sells off its ownership stake, per Red Rock Resorts 8-K filing on Nov. 10, 2016.

Update 1: See “Deutsche Bank to sell $400m stake in Las Vegas gambling group” in Financial Times (Oct. 30, 2016).


Deutsche Bank will soon be able to dispose of its 17% ownership of Red Rock Resorts (NASDAQ: RRR), when the Las Vegas gaming company’s IPO lock-up period expires on October 24.

Deutsche Bank is in dire need of additional capital, so we expect it to sell off the Las Vegas casino stake as soon as it can on or after October 24. Deutsche Bank investors should certainly welcome the cash infusion and capital boost that can come from selling and exiting the casino assets.

Deutsche Bank is in the process of selling other non-core assets such as Abbey Life and its stake in China’s Hua Xia Bank. CEO John Cryan noted in July that the lender’s second-quarter revenues “benefited from the IPO of Red Rock Resorts.”

We estimate the German bank’s Las Vegas casino stake to be worth approximately $440 million. (The bank has not disclosed the specific number of Red Rock shares it beneficially owns.) In addition, according to the tax receivable agreement Red Rock signed as part of its IPO, the company is required to pay Deutsche Bank and other pre-IPO owners 85% of certain tax benefits to be realize when Deutsche Bank and other pre-IPO owners sell their ownership interests. The TRA payments will need to be made in cash before the company makes its dividend payments. As of June 30, the company’s TRA liability was $44.5 million.

As Deutsche Bank gaming analysts observed on May 22: [I]t is worth noting that at present, ~21% of the shares outstanding are held by legacy strategic investors, whose core business does not include owning gaming equities. Thus, post the 180 day, from IPO, lock up expiration, we believe the risk of secondary issuances could potentially weigh on shares.”

Fidelity Would Have Valued Station Casinos at $9.19 at the End of January

If Fidelity bond funds valued Station Casinos at an estimated $9.19 per share at the end of January, what will Fidelity equity funds value the company at if they decide to participate in the upcoming Red Rock Resorts IPO?

As a result of Station Casinos’ Chapter 11 bankruptcy reorganization in 2011, Fidelity owns approximately 8.7% economic interest in the gaming company in the form of Station Holdco LLC units held by several of its bond funds. These funds disclose the value of their Station Holdco holdings regularly.

Most recently, 22,418,968 Hold LLC units in the Fidelity Capital and Income Fund (FAGIX) were given a value of $78.018 million as of 1/31/16 in a 3/30/16 N-Q filing.

Using the same methodology as before, we estimate that this implies a valuation of Station Casinos’ equity at approximately $1.06 billion, which would translate to about $9.19 per share based on the fully-diluted number of shares outstanding of Red Rock. That is, Fidelity would have valued Red Rock at $9.19 at the end of January.

What valuation will Fidelity give Red Rock if the mutual fund giant decides to participate in the IPO, which has an offering price range of $18 to $21 per share? Will Fidelity ask itself, internally, how Station Casinos could have doubled in value in less than three months?

Deutsche Bank Would Have Valued Red Rock at $5.39 Per Share a Year Ago

Prospective investors in Red Rock Resorts should ask Deutsche Bank how, in its opinion, the value of Station Casinos could have more than tripled in little over a year.

According to a 2/17/15 analyst report by Deutsche Bank gaming high-yield analyst Andrew Zarnett, Station Casinos LLC, as of 12/31/2014, was estimated to have an enterprise value to be $2.59 billion, which would have implied an equity valuation of $624.6 million after subtracting net debt of $1.97 billion. That equity valuation would have translated to about $5.39 per share with the fully-diluted number of shares outstanding of 115.9 million found in Red Rock’s 4/15/16 S-1/A filing

Red Rock’s 4/15/16 S-1/A filing shows an IPO price range of $18.0 to $21.0 per share. Using the mid-point of $19.5 per share and the fully diluted shares outstanding figure of 115.85 million, the company and its underwriters, one of whom is Deutsche Bank, are offering an equity valuation of $2.26 billion and, adding net debt of $2.04 billion, an enterprise value of $4.30 billion for Station Casinos LLC.

Station Casinos Valuation Jump

12/31/14 4/15/16
Enterprise value $2,590 million $4,298 million
Net debt $1,965 million $2,039 million
Equity $625 million $2,259 million
Implied per share price on 115.85 million shares outstanding $5.29 $19.5

From 12/31/14 to 4/15/16, the share prices of four publicly-traded regional gaming operators (BYD, PENN, PNK, ISLE) rose by an average of 61%.

Investors should ask Deutsche Bank how, in its opinion, the value of Station Casinos could have more than tripled in little over a year.

(See also our earlier piece on the estimated valuation Station Casinos equity as implied by SEC filings by Fidelity, a current minority owner.)


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:

The $460-Million Fertitta Entertainment “Internalization Fee”

See our follow-up post, “More Questions about the $460-Million Valuation of Fertitta Entertainment”.


Based on the company’s presentation at the Nevada gaming regulators’ meeting on Jan. 21, Red Rock Resorts’ acquisition of Fertitta Entertainment is to be understood as the internalization of an external manager. How does the $460-million Fertitta Entertainment “internalization fee” compare to those commonly found in REIT internalization transactions?

REIT internalization fee from 1997 to 2013Fertitta Entertainment internalization fee
As % of acquirer equity2.7% – 10%43.0%
As % of acquirer’s invested capital0.9% – 6.0%14.4%
As multiple of manager’s TTM EBITDA2.9x – 14.0xNA

The historical REIT internalization fee figures in the table above are from a September 2014, study of REIT internalization fees by Sherry Cefali and Nick Tarditti of Duff & Phelps, which shows the range of REIT external manager valuations from 1997 to 2013.

The $460-million Fertitta Entertainment internalization fee is much higher compared to these figures:

Three more observations:

  1. The internalization fee will be paid entirely in cash instead of equity or a combination of cash and equity. Red Rock will pay the $460 million “internalization fee” entirely in cash instead of equity or a combination of equity and cash as has been done in the REIT sector. For example, common shares were used in January 2016 to finalize the internalization of management of Starwood Waypoint Residential Trust, merging them with Colony American Homes inside the larger company known Colony Starwood Homes.
  1. Some REITs have internalized external managers with no fee. The Duff & Phelps study excludes transactions with no internalization fees. While some REITs have been criticized for large internalization fees, some “have stopped paying their management companies any money to bring them in-house.” In 2008, Healthcare Trust of America was one of the first to “transition into a self-managed company without an internalization fee” and many have followed suit. Philips Edison – ARC Shopping Center REIT waived the internalization fee of its external managers in 2010, and Chamber Street Properties “internalized its management structure, with no separate fee paid” in 2012 before announcing its IPO in 2013.
  1. The non-insider cost for acquiring Fertitta Entertainment should be closer to $50 million, not $460 million, based on termination provisions in the casino management agreements. The $460 price tag is 8.9x the $51.7 million trailing-twelve-month management fee Fertitta Entertainment received from Station Casinos as of September 30, 2015. According to the Fertitta Entertainment management agreement covering 13 of the 19 Station Casinos properties, termination of the agreement upon sale of the managed properties to a third party would only cost Station Casinos a fee equal to the trailing-twelve-month management fee. See Exhibit “D” Financial Terms of this management agreement, which can be found as Exhibit 10.21 of Station Casinos LLC’s 10-K, filed 3/10/15.

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

An Update on Station Casinos Valuation, as Implied by Fidelity Filings

Last November, we noted that a Fidelity fund’s SEC filing implied that it valued Station Casinos’ equity at approximately $1.12 billion at the end of August. On January 28, the same Fidelity fund filed a new quarterly report and presented the values of its holdings as of November 30. The value of its Station Casinos stake dropped by over 5%.

Value as of 8/31/15Value as of 11/30/15Change
1,194,419 shares of Station Holdco LLC$4,384,000$4,157,000-5.2%

Source: Fidelity Puritan Trust Form N-CSR filed 10/28/15 and Form N-Q filed 1/28/16

The implied valuation of Station Casinos would have thus dropped to $1.06 billion at the end of November.

Fidelity, whose funds collectively own 8.7% of economic interest in Station Casinos, did not disclose its valuation methodology. A Fidelity spokesman did say in a statement to the Wall Street Journal last October that the firm has “a rigorous and thorough fair market valuation process for mutual fund holdings.”


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

The Tax Receivable Agreement of the Red Rock Resorts IPO

Read our in-depth analysis of the tax receivable agreement here.

Investors should demand a cap on the TRA payments to protect themselves and Red Rock Resorts against potentially unlimited exposure and draining of the company’s cash.

Tax receivable agreements are criticized by experts. TRAs found in IPOs are frequently criticized for benefiting pre-IPO owners at the expense of the public company and outside shareholders. Moreover, TRAs have been promoted by corporate tax firms as a way to monetize tax attributes for the
pre-IPO owners during an IPO even though such agreements “are not fully understood by public stockholders.”

What are the terms of the Red Rock Resorts TRA? Red Rock Resorts will be required to pay pre-IPO owners a yet-to-be-disclosed, “substantial” amount of money for the tax benefits it realizes from acquiring partnership interests in Station Holdco LLC. The January 14th amended S-1 filing states that the public corporation will pay pre-IPO owners 85% of its tax benefits in cash and keep only 15% for itself. The 15-plus year agreement will not be based on continued ownership by the pre-IPO owners and the Fertittas, who will be the controlling shareholders after the IPO, can cause Red Rock Resorts to accelerate the TRA payments at any moment.

TRA payment liabilities can increase after the IPO. An examination of other companies which have gone public with similar TRAs reveals that estimates made at the time of an IPO commonly increase, exceeding the company’s IPO proceeds and annual EBITDA. Red Rock Resorts admits its calculations will be “imprecise” and there is no guarantee the company will realize the tax benefits it is paying to insiders. Furthermore, the company discloses that payments made under the agreement will spur additional payments to insiders and may significantly impact the liquidity of the company.

Investors deserve more information and protection. Red Rock Resorts should provide justification for the 85%-15% split, clear estimates of the annual and lump-sum payments to the pre-IPO owners, and disclosures regarding how the payments will affect free cash flow and capital expenditures. Furthermore, prospective investors should demand a cap on Red Rock Resorts’ TRA payments to the Fertittas and other pre-IPO owners to avoid potentially outsized or even unlimited exposure in the future.

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

How much is Station Casinos worth?

Last week, news broke that Fidelity, the mutual fund giant, had lowered its valuation of Snapchat Inc., the video messaging app company, by 25%. (See, for example, here, here, and here.)

The story got us thinking about how much Fidelity values Station Casinos LLC, of which it owns 8.7%. Fidelity’s valuation would provide a useful baseline for prospective investors in the Station Casinos IPO.

Here is what we found: a Fidelity fund’s filing implies that it valued Station Casinos’ equity at approximately $1.12 billion at the end of August.

  • Station Casinos LLC’s last 10-K, filed on 3/10/15, shows that Fidelity affiliates owned a total of 26,613,550 of Station Holdco LLC units, which constituted 8.7% of ownership interest in the company. This means there were approximately 305,902,874 Holdco LLC units overall.
  • The N-CSR filing by Fidelity Puritan Trust, filed on 10/28/15, shows that the Fidelity Puritan Fund valued 1,194,419 Station Holdco LLC units at $4.384 million on 8/31/15. This implies a valuation of $3.67 per Station Holdco LLC unit.
  • Total value of Station Holdco LLC units is therefore: $3.67 * 305,902,874 = $1,122,787,062.

Station Holdco LLC holds 100% of the economic equity interest in Station Casinos LLC. Therefore, Fidelity’s filing implies that it valued Station Casinos’ equity at approximately $1.12 billion at the end of August.

This also means that Deutsche Bank’s indirectly-owned 25% stake in Station Casinos is worth about $280.7 million.

Will Station Casinos be able to raise enough money through the IPO to buy out Deutsche Bank, whose regulatory troubles could have implications for new investors in the highly regulated gaming business, and pay $460 million to insiders to buy the company’s exclusive management company? (We will take a closer look at the value of the management firm, Fertitta Entertainment LLC, in a coming report.)


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