Question of the Day - 17 April 2020

[Editor's Note: This opinion piece was submitted by Steve Heston in response to our QoD last week that took a hindsight look at the MGM doing leaseback deals with Bellagio, Mandalay Bay, and MGM Grand and Caesars doing one with the Rio. Steve is a deep source for us who comes into the light from time to time. His CV is long and impressive: a Ph.D. in finance from Carnegie Mellon, professorships at Yale, Columbia, Washington U. (St. Louis), and nearly 20 years at U. of Maryland (currently), with a stint as VP of Arbitrage at Goldman Sachs. He's also a gambling-math guy par excellence; he's one of the co-authors of our poker book Kill Everyone, he contributed to Kill Phil, and he's "the Professor" who assisted Anthony Curtis and Frank B in developing Mattress Mack's hedge strategy on the Houston Astros in last year's World Series. Phew. Naturally, we thought you'd all be interested in reading what he has to say about the MGM and Caesars leaseback deals.] 

A casino can borrow money to buy land. Then it can deduct the interest and pay less tax. Alternatively, a real estate investment trust can borrow to buy the land and pass the savings to the casino in the form of a favorable long-term lease. These are functionally quite similar and many corporations recognize “capitalized leases” on their balance sheets.

In a prolonged economic contraction, many casinos will go bankrupt and default on their debt. Other casinos will default on their leases.

There's an old saying, “If you borrow a million dollars, you have a creditor. But if you borrow a billion dollars, you have a partner!”

Similarly, billion-dollar lessors are no longer just  landlords. In the current economic environment, they're effectively partners with the casinos. The shareholders and employees probably don’t care whether the casinos default on debt or default on leases. Ultimately, all payments and long-term deals will be renegotiated. After this shakeout, the profitable properties will find a structure to continue.

So, the choice of borrowing versus leasing depends on which provides the cheapest, smoothest transition after default, and which saves the most taxes. But they are functionally equivalent, and neither option can prevent losses in a bad recession.

It's not management’s money, it's shareholder money.  If shareholders were bullish on Vegas real estate, then they could have purchased the REITs.  If so, they're largely unaffected by the decision to sell-off.

The idea that Caesars/MGM are unlucky because they have long-term leases is silly, because they will renegotiate. Donald Trump routinely did risky deals. In good times, he made huge profits and in bad times, he threatened corporate bankruptcy. It's part of the game. 

Readers are commenting that casinos should be diversified. No, the shareholders should be diversified. If a company has expertise in gaming and hospitality, then it should focus on this comparative advantage. As an investor, I can buy separate companies that compete profitably in their niches. This is better than building an inefficient conglomerate empire. Remember when Steve Wynn wasn’t worried about earnings and just wanted to bask in the historic glory of dolphins and Siegfried and Roy? The stock price tanked and MGM acquired Mirage.

Shareholders do not want companies that are safe, comfortable, and slightly profitable; they want big profits now!

Vegas has good weather, permissive laws, and a good airport. The casino chains are competent at vacations and conventions. They should accept that it is a risky, cyclical, business environment and they cannot change that. Gary Loveman showed Caesars how to market and squeeze out profits in good times. No one can make money in bad times. A casino that held onto cash and didn't sell off can burn this cash for a few extra months. Maybe they can hold onto unnecessary workers or pay their debts and leases. But shareholders would much prefer to receive that cash in dividends and abandon the business in a crisis.