Trimming Hedges with Manual Shears

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?