Trump Bull's Pen
by Dale Wettlaufer ([email protected])

Man, I must be a masochist taking the bull side of Trump Hotels & Casino Resorts <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DJT)") else Response.Write("(NYSE: DJT)") end if %>. I mean, come on. The stock's trading symbol is made up of the initials of Donald J. Trump, whose marquee name is highlighted in the company's SEC filings as an asset. I sometimes think that at least one of the syllables in "asset" captures the essence of this throwback to the Gilded Age.

Spending time in a casino decorated in flouncy neo-crapsical Trump, throwing away money that I could otherwise be investing in great companies while being pumped full of oxygen and plied with drink doesn't sound like my idea of fun. At least not if you do it that often. But, hey, a lot of people like to do it. And being the libertarian that I am on subjects like gambling and smoking, piddling away your life's savings or your child's college education in a casino is none of my business.

Let's settle in on the point that I'm making. In what other business is a company virtually guaranteed of making money by the laws of chance? I can't really think of any. That's where the cash-cow potential in the casino world lies. If you do it correctly, you should be able to make money in this business. That's why these companies lend themselves well to debt. But gosh, Donald, too much of a good thing can hurt you, buddy. $1.8 billion in long-term debt? Oy vey, how am I am going to defend this? Well, I actually do have some non-bearish things to say.

Starting from the top, Trump has an enterprise value of $2.042 billion. That's $308 million in equity market capitalization less $140 million in cash plus short- and long-term debt of $1.868 billion. Well, that's not good. This pretty much means that the debt holders are in charge on this one if the ratio of debt-to-market capitalization is about 6:1. Let's take a look at how that compares with gross cash flow.

Cash flow, or earnings before interest, taxes, depreciation, and amortization (EBITDA) was $236.9 million in 1997. Dividing that into the company's enterprise value, we're looking at a multiple of 8.62. That's above the industry average of around 8.6, but in line with the big-10 casino average of 8.89, according to Paul Larson's excellent March 6, 1998 Industry Snapshot on casinos.

When Donald Trump says he can sell the company above $30 per share, he could be in fantasyland, because NO serious investor looks at just the capitalized equity value compared to the gross amount of cash flow a company generates. I can see the math here. At an industry average of 8.12 times gross cash flow, the company would be worth $52.84 per share with no net debt. With no change in net debt and an equity capitalization at $35 per share, the company would be valued at 12.7 times gross cash flow, quite rich compared to its peers. Sure, Trump is going to argue that the company should be valued at the same sort of multiple as the premium casino & resort companies, but that's a 43% premium to the rest of the industry with flagging fundamentals to boot.

The problem is that the margins at Trump are below par for most of the companies trading at the premium multiples, and the markets in which Trump operates are less attractive. Atlantic City just isn't going to get the same sort of winter convention crowd that Las Vegas will. The Northeast is becoming much more well-served than it used to be, with the Pequot casinos in Connecticut, central New York covered by the Iroquois, western New York being served by Canadian casinos in Niagara Falls, and slots being provided in Delaware. While Atlantic City's position in the mid-Atlantic and Northeast regions is still fine, the competition within Atlantic City is a bit fierce, to say the least. Investors aren't going to pay up for a less attractive natural growth rate in a market where competition is intense.

Why am I the bull then? Well, first of all, the whole bull/bear paradigm assumes that there MUST be a bull or a bear position with no in-between. I am not a bull, but I do see some reasons not to be bearish on the thing if the whole economy doesn't go into a recession. First, when competition in slow-growth markets gets to the point where returns on capital become uneconomic, consolidation occurs. Assuming no growth in EBITDA this year, after-tax operating return on total capital at Trump would be about 8.2%. That's not enough to send you out of the business, given that the after-tax cost of that capital is around 8%. So, consolidation might not come to Trump, but if the company's return on capital worsens, an acquisition at a lower share price could be likely. However, investors rightly fear that Trump wants to be the acquirer and not the acquired. The personal ego of Donald Trump has a lot to do with the way capital is allocated at the company.

Is ego totally bad here, though? Many successful people are egotistical -- it's what drives them to be better than others. And if Donald is paying attention to his financial people, I'm sure he's getting the message that the numbers are not better than the others. So, what does he do?

Well, you could sell off the properties, pay down the debt, manage the casinos and resorts for a management fee of 4% of revenues, run at 40% operating margins, and end up with $0.44 per share in pure cash earnings if the properties can grow their top line by 10% this year. At 20 to 30 times earnings, that's $8.80 to $13.20 per share in value. Hook up with a real estate investment trust (REIT) with the capital to handle the bricks and mortar and act as a management company. License the name to other superior operators, if the Trump name does indeed have marquee value. Or run the company more prudently. SG&A went ballistic last year, increasing 41% on a 45% increase in net revenues. Where's the leverage? Netting out extraordinary items from both years' income statements, operating income grew only 36.8% in 1997. That's negative leverage on operations. Trump has to do something about this, as interest coverage, or times interest earned, was 1.156. That's EBITDA to net debt service of 1.156 times. That leaves little margin of safety.

Will the Donald do something about this? I don't know, but he sure has made some noises about it. The difference between 8 and 9 times enterprise value-to-gross cash flow means an increase of $6.51 per share in equity value to shareholders. Having watched the Donald for a few years and having taken a hard look at his junk bonds when they were trading at a steep discount to par, I wouldn't bet against him. I noticed his high-yield bonds are trading above par these days, so the market for his debt shows either an anticipation of change in control by a higher-grade operator or that debt holders feel comfortable about their prospects.

Here's the thing. Donald Trump has never defaulted on his secured debt. Now, I don't know what his equity partners' experiences have been in private transactions, but this guy isn't going to roll over and die here. Maybe he'll pull something Machiavellian and let the equity value of the company tank so he can recapitalize the whole thing, but that's just as speculative to say as "he'll be doing a transaction on the company in the next couple months."

I believe he's looking at a number of strategic possibilities to enhance shareholder value here, and I think he wants to establish a track record of doing the right thing for his equity holders in the public markets. With such massive leverage on the price of the common stock, I wouldn't be a bear on the company and short it. I also wouldn't be a bull in the sense that this would make a good equity to purchase. I would rather be a bondholder with collateral backing the security, but that's now trading at par, leaving little risk/reward room for the more speculative investors. Nonetheless, a restructuring move or other financial engineering would gore the bear on Trump pretty quickly if he can negotiate just a slight increase in valuation premium. I wouldn't bet against the ability of Trump to get that done.

Next: The Bear Argument