It has been some time since I covered casino stocks; not since owning Wynn Resorts (WYNN) off the multi-year lows. Investors that have missed my efforts on these companies should look for more coverage from me in the coming months. I’ll be spending several days in Macau in early May before heading to China and Hong Kong to spend some time with industrial suppliers in that region. It’s a pilgrimage I’m trying to make more often in order to provide deeper value to Industrial Insights subscribers via “boots on the ground” expertise, but luckily that carries over to other sectors as well.
In the interim, I wanted to highlight one of my favorite picks in a completely different space in gaming: Red Rock Resorts (RRR), which operates in the Las Vegas locals market. There is a world of difference between how an operator tries to run a business on the Las Vegas Strip (competing with the likes of Las Vegas Sands (LVS) and MGM Resorts (MGM) versus how a business is run to cater to the local community. It’s an entirely different demographic. I think the market has been missing a lot of the story for this company over 2017. In fact, the company is dirt cheap and has 40% upside from today’s prices. Contributor Vince Martin has laid out concerns in great coverage since the initial public offering (“IPO”), and I’ll work through a lot of those points today in how I see the bullish case here versus his cautious take. The largest difference in his work and mine, in my opinion, is overly discounting likely tailwinds from strengthening in the local market and potential contribution from current renovations.
Business Overview, Why The Macro Picture Matters
Today, Red Rock Resorts operates ten major gaming and entertainment facilities alongside ten smaller operations. It does so via its 59% interest in the Station Holdco LLC (which itself owns all interests in Station LLC, the actual asset owner). In total, the company has 19,219 slot machines, 319 table games, and 4,316 hotel rooms under its umbrella, all of which are located in Nevada. Red Rock Resorts also manages properties for tribal casinos in certain markets, including Graton Resort & Casino in California and Gun Lake Casino in Michigan (recently expired). A management agreement is in place with the Mono Indians (“North Fork Project”), but that is tied up in litigation. The most recent decision there was the D.C. Circuit affirming the lower court’s decision to throw out a challenge to the casino proposal; most likely a potential 2019 benefit than 2018 in my view. Key owned properties include the namesake Red Rock, Green Valley Ranch, Palace Station, and Santa Fe Station. As an extremely important development, Station LLC also bought the Palms Casino Resort (“Palms”) late in 2016 for $313mm; remodeling and renovation there is ongoing. It also owns eight development sites in Las Vegas and Reno, Nevada which provide optionality for new construction.
*Las Vegas Strip. What attracts tourists to the Strip run counter to what locals look for.
For historical context, the Las Vegas market targeted towards local gaming was fiery hot leading up to the Great Recession for the sole reason that the Las Vegas housing and employment situation was incredibly strong. Back when the company traded under the Stations brand, share prices quintupled from 2000-2006 before the company was taken private. That context is important, as Red Rock Resorts does not make most of its money from tourism, particularly the focus on Chinese tourists that is found on the Strip. The economic health of the everyday Las Vegas resident and the amount of transient workers in the construction/housing industry is far more important. When the Las Vegas market collapsed, understandably home values tanked and unemployment skyrocketed. Peak-to-through declines were harsh and the Las Vegas market was slower to recovery than elsewhere in the country. While Red Rocks Resorts highlights recent positive trends in local consumer health, such as average price of a single family home being up 140% from January 2012 to December 2017, the median home price of $242,000 in February of 2018 is still below the median peak of $315,000 in June 2006. Even years later, there are still long-term homeowners in the region that are underwater on their mortgage.
For Red Rock Resorts, I believe the company is just now reaching an inflection point. Las Vegas is expected to see high-single digit home price increases over the next several years, 300bps or more above the national averages. The current unemployment rate of 4.9% is near an all-time low. Seniors and retirees, which will be needed to fuel slot machine spend given millennials don’t value that type of gaming, are moving to the area in droves. Before tax reform, North Las Vegas and Henderson were already among the fastest growing cities in the nation. Of net immigration to Clark County, California was already one of the largest migration points. After tax reform, which will disproportionately impact neighboring states like California (state and local tax deductibility, caps on mortgage interest deduction), expect more and more residents to locate to the area to take advantage of the still low relative cost of living. If anything, I expect Las Vegas to become an even hotter destination than it already is.
Why The Market Has It Wrong
Near-term results have been marred by ongoing construction disruption. Both Palace Station and the Palms have significant ongoing spending needs to modernize the assets. A relatively simple initiative, the Palace Station project has seen $80mm of $191mm in costs incurred and is expected to be completed by the end of 2018. The Palms project has recently been expanded, with just $77mm of a total of $620mm incurred. The first phase is set to open in Q2 2018, with the remaining two phases completed throughout 2019. This is the number one reason, in my opinion, that Red Rock Resorts is trailing the share price returns of Boyd Gaming (BYD) and Eldoardo Resorts (ERI) since going public. I’ve seen this time and again in the space, with most market participants ignoring the likely EBITDA contribution that is down the pipe for these firms versus companies with stable asset bases.
There are two important things to remember with these remodels. Number one is that there is no additional competition being built off-strip. Any and all spending acceleration by locals is going to flow through the current casino base. This is unlikely to change, as there are a fixed number of licenses, and the Nevada Gaming Commission is known to be aggressively stingy with issuing new ones. Outside of the Strip, there are three sites currently approved for gaming. Red Rock Resorts owns all three. There is absolutely no new supply on the way in the form of new builds. Number two is that management is targeting mid-teens return on investment at Palace Station and the Palms. While a lot of capital still needs to be spent and leave the balance sheet, the Palms is working it’s way towards having a $120mm EBITDA exit rate in 2019 in my view ($35mm EBITDA at acquisition, mid-teens return on $500mm investment above the acquisition price, tailwinds from the Las Vegas market in 2018 and 2019). That a major contribution, and while it does have execution risk given the size and scope of the project, the management team at Red Rock Resorts has a stellar track record.
Same store sales are incredibly important. Same store comps, which ignore fluctuations from the above assets under construction, came in in the mid-single digits in Q3/Q4 of this year. This should not be a surprise given the acceleration seen in a lot of statistics regarding demographic health in the market. Because of the high margins on slots (which generate most of revenue in the locals market versus table games) and low gaming taxes in Las Vegas, flow through of generally results in realized EBITDA margin is roughly double that of the consolidated operation due to the fixed cost base. In other words, backing out the noise in from construction costs, the legacy business was comping extremely well in the latter part of the year versus prior period. That’s absolutely massive and it’s going to be a major tailwind as the Las Vegas market sees considerable growth over the next few years. This ties back into the macro; remember that a lot of Las Vegas locals are going to get out from under housing debt and fresh retirees moving from California likely will be flush with cash from downsizing. 90% of current Las Vegas residents live within five miles of a Red Rock Resorts casino. I see 5-6% same store sales comps as a reasonable expectation next year.
2017 To 2020 EBITDA Walk, Valuation Takeaway
Red Rock Resorts exited 2017 with $498mm in EBITDA. Sell-side analysts expect just $502mm this year and $570mm in 2019. While there are some negative impacts likely this year, I think this is a major mistake to assume that Red Rock Resorts sees such a poor year when it comes to earnings power. The expiration of the management agreement at Gun Lake is likely to be a $15mm EBITDA hit for the year and there is not expected to be any contribution from Palace Station and the Palms above 2017 levels. I see $55mm in same-store Las Vegas operations revenue growth, which should contribute $25-30mm in EBITDA net of cost increases across the entire portfolio. Sell-side analysts, expecting just 1% revenue growth year over year, have the story completely wrong in my view. Coupled with a few other tailwinds (e.g., removal of lease payments on land at Boulder and Texas Station, higher management fee rate on Graton Resort), I see $520mm in EBITDA next year. The big driver will be in 2020, when Palace Station is no longer disrupted (current $10mm EBITDA impact), renovations will be contributing, and the Palms will be fully operational. These two projects will drive $150mm in EBITDA contribution in 2020 together, and I don’t view my expectations of $750mm in EBITDA by 2020 as outlandish for investors that have faith in this management team. That doesn’t factor in some outlying benefits, such as the North Fork Project or the value of undeveloped real estate. While the S-1 filing mentioned an independent valuation of roughly $175mm for these assets, given the strong outlook for Las Vegas that has developed since that third party appraisal, carrying value is likely much higher now.
Red Rock Resorts will have to borrow to fund its capital needs to finish these projects, but financing is already lined up. There is $747mm in borrowing availability under the Revolving Credit Facility – enough to fund capital needs – and leverage covenants would permit tapping that capital. Maximum consolidated total leverage ratio is 6.5x today (stepping down to 5.25x by end of year 2020). At the end of the year, that leverage ratio was a hair below 5x. On the net, I don’t see the capital structure as a limited factor here, and even below average execution on Palace Station and the Palms, which I find unlikely, should not risk any violation of covenants. Management recently received approval for an at-the-market (“ATM”) facility for common stock issuance, which could be an outlet for some incremental capital raising if share prices make a material move higher.
Red Rock Resorts currently carries a $3,800mm market cap. Off of that $750mm in EBITDA in 2020, $150mm will be eaten by interest costs and I peg maintenance capital expenditures on the fully completed asset base at $130mm conservatively (management has referenced $100mm in the past pre-Palms). Unlike the glitz and glam of the Las Vegas Strip, constant upgrades to maintain relevance are not as necessary out here. The company is unlikely to be a material cash tax payer in 2020, but normalized cash taxes assuming the above is around $90mm given the new tax rate. Investors today are essentially buying what will be a 10% free cash flow yielding firm with a great growth outlook as the Las Vegas market likely continues to accelerate. I believe a share price in the lower $40s per share is justifiable.
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Disclosure: I am/we are long RRR.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.