Analysis

UAFRS shows this company is a classic example of how asset-based lending really works—when the market remembers, the bonds will rally

June 17, 2020

As we’ve highlighted in past reports, a strong asset backing for debt does not always guarantee a firm the ability to refinance, especially if it is already highly levered.

However, when firms limit their borrowing and maintain high-quality assets, with correspondingly robust recovery rates, financing can be attained even with weak cash flows in a restrictive lending environment.

Investors seem to be concerned about this firm’s cash flows relative to its debt, amidst the coronavirus pandemic. Given its impressively valuable assets, this firm should be able to access credit markets with ease—and it might not even need to.

Below, we show how Uniform Accounting restates financials for a clear credit profile.

Investor Essentials Daily:
Wednesday Credit Insights
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When we highlighted the credit of aircraft leasing company, Aercap Holdings (AER), in a past Investor Essentials Daily in April, we highlighted how there are two kinds of lending: cash flow lending and asset-based lending.

In that report, we dived into how master limited partnerships (MLPs), common in the oil and gas industry, and rental companies are often examples of companies with steady cash flows and strong asset backing that warrant high leverage.

However, this leverage is only warranted while access to credit is free flowing. Once credit markets freeze, as had occurred during the Great Recession in 2008 and in the oil glut of 2015-2016, this leverage can become a detriment.

Companies that became overly reliant on this consistent refinancing faced serious issues. As such, some of these “high quality” MLPs were forced to declare bankruptcy during those time periods.

While many MLPs were struggling to get access to refinancing in 2008, amidst the Great Recession, there was another company that was able to, casino powerhouse, MGM Resorts International (MGM).

MGM also used asset-based lending to refinance its debts, even in the depths of the credit crisis. The company owns some of the most valuable real estate assets in Las Vegas.

Meanwhile, because the company’s cash flows were already incredibly volatile, even in a stable economic environment, it never became as levered as the “stable” cash flow, asset-based borrowers, such as the MLPs and leasing firms.

This allowed MGM to show very strong recovery rates on its assets. High quality assets and low leverage relative to assets means in a distressed environment, a lender is likely to get its money back from the value of the assets alone.

As such, even in a severely cash-constrained lending environment, as gambling was getting crushed in the middle of the Great Recession, the firm was able to refinance its upcoming debt obligations.

Recently, as the world’s economy has been radically impacted by the coronavirus, the market seems worried again about MGM’s cash flows relative to its debt and operating obligations.

In the middle of the worst of the pandemic, as businesses were forced close across the United States, and as there was no visibility into when they could reopen, credit investors seemed to be concerned that no one was going to be able, both financially and literally, to gamble.

Yields for MGM’s debt skyrocketed from just over 3% in the middle of February to well over 10% in less than a month.

The market did not seem to realize how, for MGM, this market disruption is very similar to the Great Recession, albeit with some slight differences.

MGM still has impressively valuable assets, although not just in the U.S. anymore. It has expanded its presence globally, to hubs in Macau and even potentially in Japan, for instance. This asset base allows the firm to have a robust 160%+ recovery rate that would give it access to refinancing.

Yet, the firm may not need it. Currently, MGM has significant cash liquidity of over $6 billion.

As evident in the firm’s Cash Flow Credit Prime above, this cash on hand alone, along with modest cash flows, could cover all maturities, including debt maturities, until 2024, when the firm faces the third year of a string of material debt headwalls. Even then, the firm would only have a moderate refinancing need.

Therefore, MGM’s looks like a potentially intriguing opportunity for credit investors. Although the yields of the firm’s bonds have regressed from their peaks, they remain elevated, suggesting that the market has yet to appreciate the strength of the firm’s liquidity and refinancing capabilities.

MGM’s Significant Liquidity and Robust Recovery Rate Will Likely Lead to a Ratings Improvement

Credit markets are grossly overstating credit risk with a cash bond YTW of 6.948% and a CDS of 529bps, relative to an Intrinsic YTW of 1.798% and an Intrinsic CDS of 145bps. Moreover, Moody’s is overstating MGM’s fundamental credit risk, with its speculative Ba3 rating, three notches lower than Valens’ XO (Baa3) rating.

Fundamental analysis highlights that MGM’s cash flows would fall short of operating obligations in 2020-2022, driven by ongoing coronavirus headwinds, and each year thereafter. That said, the firm has significant cash liquidity, bolstered by recent debt issuances, which should allow it several years of runway to improve operations.

In addition, given a robust 160% recovery rate on unsecured debt and sizeable market capitalization, the firm should have easy access to credit markets to refinance its debt, if necessary.

Incentives Dictate Behavior™ analysis highlights mixed signals for debt holders. MGM’s compensation framework should focus management on top-line growth and margins, which should drive Uniform ROA expansion.

Additionally, management members have low change-in-control compensation, indicating that they may not be incentivized to pursue a sale or accept a takeover of the firm, limiting event risk.

However, the compensation framework does not punish management for overleveraging the balance sheet or overspending on assets, potentially limiting cash available for servicing debt.

Furthermore, driven by a recent management change, apart from CFO Sanders, management members are not material owners of MGM equity relative to their annual compensation, indicating that may not be well-aligned with shareholders for long-term value creation.

Earnings Call Forensics™ of the firm’s Q1 2020 earnings call (4/30) highlights that management is confident Phase 1 of MGM 2020 drove strong results.

However, they may be concerned about their new bond issuance, the challenges coronavirus presents to their operations and employee safety, and the progress of reopening in Hong Kong and China.

Moreover, they may be exaggerating their ability to free up liquidity by utilizing their stakes in CityCenter and MGP, the significance of their business to Nevada, and the progress of sports betting legalization across states.

Furthermore, management may lack confidence in their ability to sustain major-event and large company rebooking trends, continue to reduce payroll and pension costs, and remain profitable while operating under limited capacity.

In addition, they may be exaggerating their food and beverage pick-up and Japan opportunities, their focus on sports betting and iGaming, and the progress of their license renewal in Macau.

MGM’s significant cash balance, sizeable market capitalization, and robust recovery rate indicate that credit markets and Moody’s are overstating credit risk. Therefore, a tightening of credit spreads and a ratings improvement are both likely going forward.

SUMMARY and MGM Resorts International Tearsheet

As the Uniform Accounting tearsheet for MGM Resorts International (MGM) highlights, the company trades at a 80.4x Uniform P/E, which is above global corporate average valuation levels and its historical average valuations.

High P/Es only require high EPS growth to sustain them. That said, in the case of MGM, the company has recently shown a 117% Uniform EPS shrinkage.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, MGM’s’ Wall Street analyst-driven forecast projects a 1,516% growth in earnings in 2020, followed by 39% shrinkage in 2021.

Based on current stock market valuations, we can back into the required earnings growth rate that would justify $19 per share. These are often referred to as market embedded expectations.

In order to justify current stock prices, the company would need to have Uniform earnings grow by 4% each year over the next three years. Wall Street analyst expectations for MGM’s earnings growth are above what the current stock market valuation requires in 2020, but below that requirement in 2021.

Meanwhile, the company’s earning power, based on its Uniform return on assets calculation, is below corporate average returns.

However, the company’s total obligations—including debt maturities, maintenance capex, and dividends—are above total cash flows, and intrinsic credit risk is 140bps above the risk-free rate, signaling a fairly low risk to its dividend and operations.

To summarize, MGM’s Uniform earnings growth and valuation are both trading above peer averages.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research