Caesars’ quest for balance sheet stability hones in on cyberspace

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A legislative groundswell to legalize internet gambling could transform Caesars Entertainment from an over-levered cash burner into a gaming credit with a growth story and realistic IPO prospects, Debtwire reports. But before the Apollo-owned casino and hotel operator’s management team can roll out electronic dice, state and federal lawmakers need to agree that online gaming can be properly regulated and taxed, according to four hedge fund analysts and two sellside gaming analysts.

The political debate gained traction earlier this year in April following a Department of Justice sweep of online poker websites for violations of the Unlawful Internet Gaming Enforcement Act of 2006 and the Wire Act of 1961. The website shutdowns created a void for online consumers, and spurred officials to pursue legislation to legalize internet gaming on grounds that it will bring much needed tax revenues to fill municipal budget gaps. In late December, the DOJ itself issued a favorable legal opinion on the right of states to sanction online gaming.

Congressman Joe Barton (R-Texas) last June introduced an online poker bill, HR 2366, which would put the power to grant corporate gaming business licenses for poker in the hands of states provided they adhere to federal guidelines. The bill is stuck in the House Committee on Manufacturing and Trade, though a wider legislative hearing could be held this month, said a government source. However, industry analysts believe no real movement will take place until after the 2012 elections.

While online gambling proponents cite tax revenue upside as justification, detractors bemoan the moral risks of making gambling so readily accessible, the analysts noted. Critics also argue that legalization could create a host of new regulatory headaches, such as monitoring online activity that crosses state borders.

Shuffling the deck

Moral, political and tax debates aside, the online gaming debate is critical for Caesars because it could be a catalyst for right-sizing its top-heavy capital structure and advancing Apollo’s IPO aspirations, the analysts said.

To steer traditional earnings growth, the Las Vegas gaming giant is aiming to expand its hotel franchising business and open new casinos in nascent gaming jurisdictions. But with leverage sky high – as of 3Q11 Caesars’ operating entity carried 5.6x first-lien leverage and its property company carried roughly 10x leverage through its mortgage-backed notes —the broad consensus is that these physical expansion projects won’t have the dramatic impact needed to ensure financial stability, according to the sources.

The real potential earnings driver could be floating out in cyberspace, and management has set up an online segment called “interactive operations” for if, and when, online poker becomes legal. The company has guided that the segment could achieve an estimated run-rate EBITDA of USD 300m–USD 400m, which would go a long way toward addressing Caesars’ looming debt maturities and reversing its cash burn trend, the sources said.

Those projections are no sure thing since the universe of potential online competitors has not yet been defined. Nonetheless, the prospects are enticing. The government source maintained studies have shown the online gaming industry could generate anywhere from USD 3bn to as much as USD 40bn over the next 10 years.

Assuming a new online gaming world takes off, Caesars Interactive’s could gain a competitive edge by leveraging its World Series of Poker brand against joint ventures that have been started up by the likes of MGM Resorts and Google, the analysts said. Caesars also has acquired a 51% stake in online game developer Playtika, which has a presence on Facebook, according to SEC filings.

Another strategic edge for Caesar’s could come from the fact that guidelines for HR 2366 propose giving current gaming licensees a two-year head start before anyone else could apply for a license. So Caesars would have a large time window to build up its poker business before the likes of Google can enter the arena.

Some investors believe the best and most direct way for Caesars to monetize an online venture would be to spin off the interactive unit as a start-up vehicle, using proceeds to fix balance sheet ills at the parent, the analysts noted.

Over the LTM period ending 30 September, Caesars generated negative USD 175m of free cash flow, said one flow desk analyst. However, liquidity is still robust at USD 2.23bn, split between USD 1.15bn in cash and USD 1.08bn available under a revolving credit facility.

On the maturity front, the B- rated Caesars tried to clear its closest maturity wall last May when it launched a three-year amend-and-extend proposal to holders of its USD 5.8bn L+ 300bps term loan due 2015. However, a majority of lenders were not willing to move to the back of the levered credit’s maturity curve, as only USD 800m of the credit facility agreed to roll.

The extended L+ 425bps TL due 2018 traded at 82.3/83.3 today for a spread to maturity of L+823.1bps, while the non-extended TL is quoted at 87.5/88.3 for a spread to maturity of L+ 758.3bps, according to Markit.

While high leverage and wide secondary trading spreads imply that a traditional refi of Caesars will be costly -- if not a significant longshot -- recent transactions show that when the timing is right, the primary market will gamble on levered casinos. In January 2011, the B rated CityCenter refinanced its USD 2bn credit facility at 8x first lien leverage and 11.8x total leverage, pricing a USD 900m first lien term loan at L+ 650bps, a USD 500m 7.625% first lien bond and a USD 600m 10.75% second lien note. The second liens last traded at 100.5 on 1 December, while the term loan trades at par, according to MarketAxess and the flow desk analyst.

Although Caesars is more than two turns less levered through its bank debt compared to its peers, analysts expect the company would currently have to pay wide of CityCenter since the latter is a relatively new single-site Las Vegas property with a growth story. For its part, Casear’s is a sprawling network of properties competing in mature markets, the analysts noted.

Irrespective of all internet hype, Caesars could muster up moderate refi momentum through pending expansion ventures in Ohio and Las Vegas that could add USD 125m of incremental EBITDA, the analysts said.

The company is also planning to expand with projects in Baltimore and Massachusetts. However, analysts are reluctant to project financial earnings for these two properties because Caesars will likely require a joint venture partner to finance construction, leaving the company with minority stakes and management fees.

Officials from Caesars declined to comment.

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