MGM Turnaround Story: Can the Stock Rise 2x?

MGM reported Q4 and FY 2010 results on February 14, 2010, which were short of street estimates.  2010 was not a good year for the company as it generated approximately $1 billion of EBITDA, which is down from over $2 billion of EBITDA at its peak in 2006 and 2007.

With the 2010 results out of the way, my attention turns to MGM's multi-year turnaround story.  After the company's financial performance suffered during the recession of 2008 and 2009 and its aftermath, MGM is experiencing some problems, but now showing positive signs for future growth.

With only $1 billion of annual EBITDA, MGM has a free cash flow problem.  Annual CapEx is in the $200-$300 million range.  Furthermore, MGM has $11.5 billion of net debt, plus 50% of the CityCenter and MGM Macau of approximately $2 billion. Its interest expense for 2010 was $1.1 billion, excluding interest at CityCenter.

However, MGM is in the process of a turnaround and its EBITDA should grow from $1 billion back up to the pre-crisis range of $2 billion. EBITDA growth will be driven mainly by an improving economy, which will bring vacation and convention visitors back to Las Vegas.  Given MGM's operational and financial leverage, the company is an attractive play on the rebounding economy.

Furthermore, MGM launched two new operations since the last peak that should generate significant EBITDA and shareholder value.  In late 2009, MGM launched CityCenter, a mammoth new casino and resort project in Las Vegas.  CityCenter generated $840 million of revenue and $70 million of EBITDA in 2010, its first year of operations.  When it reaches its full potential, it should generate over $1 billion of revenue with a >25% EBITDA margin (Bellagio alone generated over $1 billion of revenue and $270 million of EBITDA in 2010).  Additionally, MGM is in the process of doing an IPO for MGM Macau, which should generate shareholder value in the short term.

Importantly, on the recent conference call MGM's management gave positive guidance and expectations for 2011.  The following are a few quotes from the call:

Positives

• Visitor Growth (I) - "Visitor growth was about 3%, and for [2011] the LVCVA is predicting another 3% increase. We think there is upside to those numbers based on increased scheduled flights into Las Vegas, a stronger convention calendar, and the early booking pace that we are seeing already this year, particularly in the year for the year."
• Visitor Growth (II) - "On the Casino side, we continue to see strength in the international play. In fact, we had another all-time record in the city and for our Strip properties in 2010 including ARIA in terms of international volume."
• Visitor Growth (III) - "We're in the tail end of Chinese New Years and we've seen very strong volumes here in Las Vegas. In fact, in one metric we're looking at -- we flew about 15% more customers into Las Vegas this year than last, all of our suite product has been fully occupied through the whole period with high-volume and high-value guests."
• Conventions - "Looking at it for the full year, we have approximately 1.6 million convention room nights on the books [NOTE: MGM has ~12 million annual room nights] which is a double digit increase from the same time leading into last year. And we're still seeing strong bookings, as I said, for in-the-year, for-the-year."
• RevPAR (I) - "And the convention mix helps us drive much better revenue, and reason why we believe REVPAR will be up all year in 2011 for our company."
• RevPAR (II) - "Our strip REVPAR in the quarter was down 2% excluding resort fees. Had we included resort fees in the quarter, our REVPAR would have been up approximately 2% in the quarter."
• RevPAR (III) - "Beginning in the first quarter, we will be including resort revenue which is a change for us in our hotel revenues, ADRs and REVPAR to be consistent with industry practice, and to give you a sense for where we are forecasting our REVPAR for the first quarter, we believe that REVPAR will be up at least 10% in the first quarter including resort fees."
• RevPAR (IV) - "I don't think, for example, we could have deployed the resort fee strategy two years ago and be as successful as we are right now. That effectively is a price increase and it has been very well-received and has had a big impact on revenue for us and will this year."

Negatives

• Spend - "One area that was challenging last year is customer spend, though even there, we're seeing some improvements at least in the luxury segments. We're beginning to see convention customers actually renting out some of our other amenities like nightclubs and restaurants and the Beach at Mandalay Bay and even the MGM Grand Garden. That has not occurred since back in 2008. In addition, we see that improved customer spend around our other special events like fights and concerts and holidays, which also bodes well for improvement this year."

On the positive side, MGM is expecting over 3% growth in visitors to Las Vegas and, as the largest hotel and casino company in Las Vegas, MGM should experience a similar increase.  Not only will visitation increase, but conventions bookings are up, which is a boost to both occupancy and rates.  Furthermore, MGM has seen an increase in RevPAR, due, in part, to the launch of its resort fee, which is effectively a price increase.  

In a recent investor presentation from February 16, 2010, MGM explained its operating leverage and how such increases translate into EBITDA.  Assuming 90% occupancy:

• 1% increase in occupancy = Approximately $40 million of EBITDA
• $1 incremental rate increase = Approximately $10 million EBITDA
• $5 increase in RevPOR = $40 million EBITDA

Therefore, a 3% increase in occupancy could generate an additional $120 million of EBITDA.  A 10% increase in RevPAR could generate another $100 million of EBITDA (RevPAR is in the $50-$200 million range depending on the property, so a 10% increase on $100 of RevPAR would generate an additional $10 of RevPAR, which translates into $100 million of EBITDA).  The rate increase would likely happen gradually over the year, so the final result may be a bit less.

These are rough estimates, but based on management's projections, MGM could add $200 million of EBITDA in 2011, before additional increase in EBITDA from CityCenter and MGM Macau.  So, 2011 EBITDA could reach at least $1.2 billion and likely higher (over 20% growth y-o-y).  I believe that over the next 3-5 years, EBITDA will continue to grow and approach $2 billion.

MGM's balance sheet and valuation still remain an issue.  Currently, the company has $11.5 billion of net debt, plus approximately $1 billion of its share of off-balance sheet debt (mostly from CityCenter and MGM Macau).  With $1 billion of EBITDA, the company is not generating enough free cash flow to pay down debt because interest expense is over $1 billion annually and CapEx is in the $200-$300 million range.  However, if MGM reached $1.2 billion of EBITDA in 2011, I expect it to be in a position to generate free cash flow to pay down debt in 1-2 years.  Having restructured its balance sheet in 2010 (and CityCenter's balance sheet), it is not facing near term debt maturities and has time to grow its free cash flow.  

Furthermore, MGM has two short term liquidity opportunities.  It is in the process of selling its share of the Borgata in Atlantic City.  Already, the trust controlling MGM's Atlantic City holdings has almost $200 million and the amount will increase with the proceeds of the Borgata sale.  In total, MGM should receive a few hundred million from Atlantic City.  Additionally, the IPO of MGM Macau should generate some liquidity for MGM Macau and potentially MGM.

Still, valuation remains an issue.  The stock is trading at approximately $14 per share. With 489 million shares, the market capitalization is $6.8 billion.  Add to that $12.5 billion of net debt (including off balance sheet), the TEV is $19.3 billion, which equals 19.3x 2010 EBITDA of $1 billion and 16.1x EBITDA of $1.2 billion.

However, assuming MGM can generate $1.5 billion of EBITDA, which should be achievable in 2012/2013 and a 13x multiple and pay down $1 billion of net debt, the shares should trade up to approximately $16.50 (18% increase).

Looking further into the future (3-5 years), MGM could generate $2 billion of EBITDA and reduce net debt to $10 billion.  In this case, even a 12x TEV / EBITDA multiple would generate a stock price of $28.50, which is 2x the current share price.

MGM continues to face challenges, but over time its performance should improve.  Any improvement will be highly sensitive to the general economy, for better and for worse.  MGM's operational and financial leverage provide an attractive play on the economic recovery with a potential for a 2x return in 3-5 years.

Portfolio Review - February 16, 2010

Welcome to the Soha blog.  I am launching this blog to add another layer to my investing process for the portfolio that I established two years ago.  In general, I write detailed reports on the companies that I invest in, but also want to write about these companies on a less formal and ongoing basis.  Over time I will incorporate more of my detailed analysis in this blog, but I am beginning with a general overview of my current portfolio.

Blueknight Energy Partners (BKEP)

Blueknight is my largest position, representing 19% of the portfolio.  The company is a midstream oil and gas company that operated pipelines and storage facilities, mainly in Cushing, Oklahoma.  Blueknigh is undergoing a recapitalization after experiencing several changes in the past two years.  Blueknight was formed as a public subsidiary of Semgroup LP with the intention of Semgroup dropping down assets into Blueknight.  However, when Semgroup LP filed for bankruptcy, it lost control of Blueknight's GP.  These events led Blueknight to a technical default on its credit agreements and the loss of significant revenue generated by agreements with Semgroup LP.  More recently, Vitol acquired Blueknight's GP and the company has been working on stabilizing its business.  In late 2010, Vitol sold half of the GP to Charlesbank, a private equity fund, and together with Charlesbank proposed a series of recapitalization transactions.  The terms of the recapitalization were contested by three funds that own approximately 40% of the common units on the grounds that the deal was unfair to the common unit holders.  I fully agree with this view.  My investment thesis is based on the company completing its recapitalization, on modified terms, and continuing to improve its business to regain lost revenue.

Proshares Short S&P 500 (SH)

My second largest position is an inverse (or short) ETF on the S&P 500.  This position represents 16% of the portfolio.

Makhteshim Agan Industries (MAIXF)

Makhetshim Agan is an Israeli producer of generic crop protection products.  This position represents 12% of the portfolio.  The company recently received an offer to take the company private for approximately NIS 20 per share, which translates into $5.43 per share based on the current exchange rate.  The deal is expected to close in one or two quarters.  Given the uncertainty regarding the deal (the price was already reduced once) and the uncertainty in the exchange rate, I am looking to sell the shares at a small discount to $5.43; however, with the stock at $5.01, the discount is too large and I am waiting for the stock to reach the $5.20 range.

Macquarie Infrastructure Company (MIC)

Macquarie Infrastructure Company, which represents 10% of the portfolio, is a listed infrastructure fund.  MIC has emerged from the troubles it had during the financial crisis in 2008/2009 when it was caught with too much debt and a cyclical downturn in its aviation services business as air travel volumes declined.  However, the company has benefited from strength in its oil storage business.  When the downturn began, the company suspended its distribution; however, I expect the company to resume distributions, at lower levels, in the next one to two quarters.  The ongoing deleveraging, resumption of distributions and growth of the distributions as the aviation services business continues to rebound will provide catalysts for the stock.  Importantly, the resumption of the dividend should bring back investors that look at MIC as a yield play, which are an important constituency for infrastructure stocks.

Semgroup Corp (SEMG)

Semgroup Corp, a midstream oil and gas company that recently emerged from bankruptcy, represents 10% of the portfolio.  As mentioned above, Semgroup Corp (formerly, Semgroup LP) filed for bankruptcy two years ago.  The bankruptcy was triggered by the trading activities of the management team, which has since been replaced.  Semgroup primarily is a midstream oil and gas company and trading was never a core part of its operations.  The company emerged from bankruptcy and began trading in November 2010.  I believe that the company was priced at an attractive level when it emerged from bankruptcy.  Post bankruptcy companies are often under-priced and under-followed, which can create opportunities for gains.

MGM Resorts International (MGM)

The Las Vegas casino operator, MGM, represents 9% of the portfolio.  MGM's business is correlated to the general economy and is not immune from recessions, as casinos may have been in the past.  MGM is the largest casino operator in Las Vegas and its financial performance declined significantly during the recent recession as fewer visitors vacationed in Las Vegas and businesses cut back on convention spending.  Furthermore, MGM is highly leveraged and faced liquidity issues.  At this point, MGM's balance sheet is improved after debt recapitalizations, equity fundraising and asset sales.  Although management has cut expenses significantly, its EBITDA for 2011 is projected to be 62% of peak EBITDA in 2006.  However, at this point in the cycle, MGM looks attractive.  The economic recovery has begun and trends in Las Vegas are less negative than in the past two years and are starting to turn positive.  Furthermore, after a period of significant new construction in Las Vegas, including by MGM with its CityCenter project, hotel room capacity  growth has slowed significantly, which should be a positive for the existing players in Las Vegas, especially MGM.  The investment thesis is based on a cyclical uptrend of the next couple of years which should increase EBITDA to pre-recession levels.  The high leverage will benefit shareholders as the company's performance improves.

General Motors Preferred (GMPRB)

When General Motors went public in 2010 after emerging from bankruptcy it issues preferred stock in addition to common stock.  The portfolio's position in GMPRB represents 9% of the total and I established this position shortly after GM's IPO.  The preferred shares are convertible into common and provide downside protection while also offering a dividend.  Based on my purchase price, the yield is greater than 4%.  GM is a play on an improving domestic economy and the company's strong position in the Chinese market.  Furthermore, I suspect that the IPO was a bit underpriced because of the large offer size, messy history and the government's desire to sell more in the aftermarket.  The GM preferreds provide a less risky way to play GM's upside and possible IPO underpricing.

Diana Containerships  (DCIX)

Diana Containerships was recently formed through a spinout from Diana Shipping (DSX).  I established the position in Diana Containerships after the spinout and it represents 6% of the portfolio.  Diana Containerships owns 2 containerships and intends to purchase additional vessels.  Diana Containerships is managed by the same team that manages Diana Shipping.  The management team is experienced, conservative and prudent and made appropriate decisions through the ups and downs of the dry bulk cycle.  Diana Containerships is a play on the recovering trends in the containership market (which are more promising than the dry bulk market) and management's ability to make prudent acquisitions.  Furthermore, currently the stock is trading at approximately a 10% discount to the NAV of its vessels (which were acquired as newbuilds in mid 2010) and pricing has come down from previous highs, so the downside in the stock should be limited.

Cash

The portfolio has 8% of its value in cash.


DISCLOSURE: I AM LONG BKEP, SH, MAIXF, MIC, SEMG, MGM, GMPRB, DCIX.