Palace station hotel casino. Passing On Red Rock Resorts - Red Rock Resorts (NYSE:RRR), Seeking Alpha

Summary

RRR is an interesting play on the Las Vegas market, whose recovery started later than that of the rest of the country. Station casino.

Growth figures look stronger than most U.S. peers, and tribal gaming management agreements have provided support of late as well.

But RRR also trades at a premium to the space, including Las Vegas locals peer Boyd, and at a multiple that looks a bit stretched.

Margin expansion looks difficult, without it, it will be tough to support even the current valuation.

At Thursday's close of $22.72, shares of Red Rock Resorts (NYSE: RRR ) are up almost 17% from its $19.50 IPO price at its offering in April. There's some reason for optimism: The recent acquisition of the off-Strip Palms, a solid Q2 report last month, and nearly pure-play exposure to a Las Vegas economy that has bested national averages over the past few quarters.

There's also, naturally, some room for concern, most notably, RRR is priced at a premium to pretty much every peer in the gaming space. The structure of the IPO was suboptimal, between RRR providing only minority ownership of a holding company, a tax receivable agreement with the previous owners, and a couple of questionable pre-IPO maneuvers. The focus on Las Vegas' local populations - the Vegas business generated 84% of trailing twelve-month segment-level Adjusted EBITDA - is a double-edged sword, given how macro-sensitive that economy remains (even as the city works to diversify).

From my standpoint, there's just enough reason to stay cautious with the stock above $22. Investors have given a premium to stocks like RRR, Boyd Gaming (NYSE: BYD ), and Eldorado Resorts (NASDAQ: ERI ) that offer exposure to faster-growing markets (which are hard to find, at least in 2016). But even with a solid end market, I'm still not sure what catalysts Red Rock really has in terms of both revenue growth, and more importantly, margin expansion. And if anything goes wrong here, the downside could be significant.

Red Rock owns about 35.6% of Station Casinos, whose portfolio includes nineteen locations in Las Vegas (the Palms will be the 20th). For the most part, Station is a locals-targeted business. Impressively, per the S-1, nearly half of adults in Las Vegas who are members of the company's loyalty program have visited a Station property in the last twelve months.

So the bull case here is based in large part on a continued recovery in the Las Vegas metro economy. The area was one of the hardest hit in the 2008-09 financial crisis, and was slow to recover, but RRR emphasized recent economic strength in the area in both the S-1 and recent presentations. With the Vegas area seeing more diverse businesses entering the market - and the retiree population in the area increasing - the pro-Vegas argument includes more than just a cyclical rebound.

Indeed, Boyd Gaming, the other major player in Las Vegas locals, in making a similar bet, spending over $600 million to acquire three casinos on the northern side of the city. And for the most part, the market has been receptive (although BYD has dipped a bit since announcing the two purchases): RRR, BYD, and Eldorado Resorts, which before its purchase of Isle of Capri (NASDAQ: ISLE ) had a strong growth story in Reno, all have higher multiples than regional pure plays like ISLE (before it agreed to the takeover), Penn National Gaming (NASDAQ: PENN ), or Pinnacle Entertainment (NYSE: PNK ).

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Growth figures support that divergence: RRR has grown Adjusted EBITDA over 9% in the first half, while Boyd's profits declined outside Las Vegas, Isle's Q1 profits fell, and Penn's first-half growth has been limited save for the addition of a new property near Boston.

At its heart, RRR is a bet on the Las Vegas economy. On a relative basis, that seems to justify some level of premium to regional players and BYD (who still gets over half of profits outside its Las Vegas Locals and downtown Vegas businesses). There seems more upside left in the Vegas recovery, and a steady exodus into Nevada from California should continue going forward. Relative to mature regional markets like Mississippi and Iowa, Las Vegas seems more attractive - both on Strip and off.

Beyond the legacy business, there are some interesting catalysts as well. Station has seven undeveloped parcels: five in the Vegas metro area, and two in Reno. The S-1 cites a carrying value of $163.7 million, backed by a third-party appraisal - about 6% of the market cap. But the most interesting is the Wild Wild West property, site of a casino and Days Inn just off the Strip.

That property is a potential site for a 65,000 seat domed stadium in Las Vegas, proposed as part of a bid to bring the NFL's Oakland Raiders to the city. Regardless of whether the site is used for that purpose, the property clearly has potential to be upgraded (I actually stayed at the Days Inn there about six years ago on the road - it's not a nice place, at all) and other casino-zoned parcels could allow Station to build out its portfolio.

Meanwhile, Station also manages two tribal casinos, one in Michigan and one in California, which are showing substantial growth. Adjusted EBITDA increased over 40% in the first half after doubling between 2013 and 2015. Both properties have expansions on the way as well: The Graton Resort &, Casino in California is adding a hotel and convention center, to be completed this fall, while Gun Lake in Michigan has a project of its own that should be finished next summer. Meanwhile, Station has worked with the Mono tribe on a casino near Fresno, that project cleared a " major hurdle " earlier this month and, after a decade, finally may become a reality.

So there's an argument that RRR's premium to peers is justified both due to the Vegas opportunity and the smaller, but still material, growth potential from tribal casino growth and potential asset development. Discounting back $35 million in annual EBITDA from the Mono project at a 9x multiple (assuming a level equal to average profits from the two existing agreements) at 8%, a 2020 opening would have a net present value of about $230 million. That plus the land (at carrying value) implies in the range of $400 million in incremental value.

That's almost 20% of the current market cap, and brings the pro forma EV/EBITDA multiple down to 9.5x. (Note that my calculation of enterprise value includes the carrying value of the tax receivable agreement, and EBITDA backs out stock-based compensation for both RRR and peers.) Given tribal growth from the two properties, and assuming the Vegas story stays intact, that modest premium to peers doesn't seem particularly onerous. A lower debt profile than some peers (a pro forma leverage ratio of about 4.6x, per the Q2 conference call ) helps the cause as well. There is an intriguing fundamental case here, overall.

But there are just enough reasons for me to pass on RRR. Admittedly, I'm a bit bearish on the space as a whole, the industry still is struggling to attract millennials and revenue (both in Vegas and nationally) has been choppy since lower gas prices were lapped early this year. But I'm not sure the Vegas growth story isn't quite as strong as Station presents it.

The S-1 cites a 5.1% increase in the Las Vegas regional market (excluding the Strip, Downtown, Mesquite, and Laughlin), per state figures, from 2010 to 2015: a 1% CAGR. Station already has a huge share of the market, making it difficult to drive incremental share.

Station casino jobs

More troublesome is potential margin expansion, which has driven much of the strength in U.S. gambling stocks over the past two years. First-half Adjusted EBITDA margin already is at 34%, a huge number in the space. (Boyd's figure is under 28% over the same period.) Station has improved that number nicely of late, but its ability to do so going forward looks like it might be limited.

As SA contributor Richard Evans detailed earlier this month, employees at RRR's Boulder Station recently voted to unionize, which could portend wage pressure. Lower-margin F&,B sales have grown at a quicker pace than casino sales of late, on the hotel side, RevPAR increased nearly 20% between 2013 and 2015. But growth has slowed in the first half (7% in H1 and 5% in Q2, per the 10-Q ), and with occupancy at 95%, further gains will become more difficult to achieve.

The tribal properties can help, as the Gun Lake agreement includes a step-up to 93% of fees over $48 million (the 2015 figure was $37.7 million), and Graton's percentage of net income increases from 24% to 27% in 2018. RRR management reiterated a target of 60-70% EBITDA flowthrough on the Q2 call - and the low tax rate in Nevada is a huge help on that front - but there is a risk that the cost pressure seen in other industries will start to appear.

After all, if the Vegas economy is strong enough to drive growth, it should be strong enough to drive some labor pressure as well - and the unionization drive may add to that pressure.

There's certainly a feeling that Station Casinos is performing at a high level, and in such a cyclical space, that can be a somewhat counterintuitive negative. I'm not sure where drivers there really are beyond Mono and the development (and it's worth noting that Station has taken impairments of its land value in each of the last two years). And there are some risks relative to the Vegas macro, and even the tribal agreements, which expire in 2018 (Michigan) and late 2020 (California).

Investors interested in the RRR story should take some time to read the coverage from labor union UNITE HERE, which has maintained a website with a bearish (and admittedly biased) take on the RRR IPO. (Again, the union battle was a bitter, protracted, conflict.) One of the most interesting points made in a presentation on the site is the potential overhang from Deutsche Bank's (NYSE: DB ) stake in Station Casinos, which owned a 25% stake before the IPO.

(Station did repurchase some of those units from DB as part of the offering.) CEO John Cryan said in January that Deutsche was looking to unload those shares, and that could lead to near-term selling pressure.

UH's research also pointed out that the company bought a private jet that - per the S-1 - was transferred out of Fertitta Entertainment (the former management company). The current liability for the tax receivable agreement is carried at $44 million - ~2% of the market cap - and is likely limited by the usual D&,A shield most casinos offer. But it's another aspect in what isn't an entirely 'clean' IPO.

The minority interest likely is less of an issue, at least on a relative basis: large (albeit non-majority) stakes are relatively common, leading to de facto control or something close. But there are some interesting facts in the UH research (which should be taken with a grain of salt, given the union's interest), including that Fidelity and DB recently valued the stock (pre-IPO) at $9.19, and $5.39 per share, respectively.

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Boyd paid a bit over 10x its estimate of incremental Adjusted EBITDA for the three new properties in North Las Vegas, which might read across well to RRR. But those casinos likely require a multi-year ramp, with Boyd still expecting improvements post-2017. BYD itself has seen its multiple come down from the mid-9s to a pro forma 8.6x (including its divestiture of half of the Borgata in Atlantic City), which would seem to imply a mid-9x figure for the Las Vegas business and ~8x for the regional assets.

That multiple values RRR in the $22-$23 range (including the Palms acquisition). A free cash flow multiple of ~10x and ~7x excluding project capex similarly is a modest premium to peers, but both appear rather attractive on an absolute basis, particularly given some of the potential growth opportunities.

But I'm not sure the fundamentals are quite compelling enough, given the risks, and I'm not entirely sold on the Vegas story. (The ERI/Reno opportunity, pre-ISLE, seemed a bit stronger and to offer a bit more upside.) This certainly seems like a stock that can struggle in the near term, given potential post-IPO selling pressure and the macro-sensitive nature of the industry and its end market. If an investor believes a correction is likely over the next 3-6 months, RRR almost certainly is a stock to avoid.

I do think a discount might change my mind. The sub-$20 IPO price implies a 2016 EV/EBITDA multiple below 9x, and I do believe there should be some sort of premium here. But I also see trading risk (the January 2017 22.5 puts, at $1.30/$1.80, look somewhat attractive, though volume is limited) and not quite enough of a story.

For Vegas exposure, I'd rather have BYD, which has more room to ramp up its Local business and has seen success at its downtown properties. Red Rock has an interesting story, but I don't think the price is quite right - yet.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Posted by at 07:02PM

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