A Cautionary Tale: Trump Hotels & Casino Resorts (DJT)

August 19, 2016 No Moat 8 Comments

From June 7, 1995 to September 27, 2004, Trump Hotels & Casino Resorts (DJT) was a publically traded corporation listed on the NYSE.  These 10 years were not particularly auspicious.  After a decade in which it never earned a penny, on November 21, 2004, the company, led by chairman of the board and majority shareholder Donald J. Trump, filed for relief under chapter 11 of the United States Bankruptcy Code.  In bankruptcy, each share, which cost $14 at the initial public offering, got 88 cents in a cash distribution and one-thousandth of a share in the new company. Shareholders also got warrants to buy new shares at $14.60. If they exercised the warrants, they experienced additional losses.  All told, ignoring the warrants, a shareholder who invested $10,000 in DJT when the company went public in 1995 would have about $636 when the bankruptcy settlement became final.

DJT1

Along the way, though, the company was able to lure in prominent investors like Mario Gabelli and even received a positive write up on the Value Investors Club in 2002.[1]

With the benefit of hindsight, what lessons can be learned from the short history of DJT?  Can this case study help us distinguish value investments from value traps?

BACKGROUND

  • Trump’s involvement in the gaming industry began in 1984. That year, Trump opened, in partnership with casino operator Harrah’s and its parent company, Holiday Inns, the 39-story Harrah’s Trump Plaza hotel and casino in Atlantic City, New Jersey.[2]
  • In June 1985, Trump opened Trump’s Castle, a second hotel-casino in AC.
  • In 1989, Trump purchased the Atlantis Hotel & Casino and renamed it as the Trump Regency (it was later renamed again as the Trump World’s Fair).
  • In 1990, Trump built the more luxurious Trump Taj Mahal, a fourth hotel-casino in AC.
  • Then, in June 1995, with the risk of being forced into bankruptcy just weeks away, Trump transferred ownership of the Harrah’s Trump Plaza (now renamed “Trump Plaza”) casino to a new, publicly traded company: Trump Hotels and Casino Resorts with the ticker symbol DJT.
  • In 1996, the public company issued more stock and sold $1.1 billion in junk bonds. The company also bought the Trump Taj Mahal and Trump Castle — soon renamed the Trump Marina.
  • Trump World’s Fair closed in the fourth quarter of 1999. Management explained that the hotel-casino “was situated in a twenty year old structure with a casino on three levels and lacked a parking garage and was inefficient to operate.”
  • DJT also owned a riverboat casino in Gary, Indiana – approximately 25 miles from Chicago.
  • From 2002 to 2004, DJT managed but did not own the Trump 29 Casino near Palm Springs under an agreement with a Native American tribe. Under the terms of the agreement, DJT received 30% of the revenue from the casino.[3]
  • By 2004, DJT had debt of approximately $1.8 billion in 2004 with an average interest rate of 15%. It held four hotel – casinos:

DJT2

  • On November 21, 2004, Trump Hotels & Casino Resorts, Inc. (“THCR,” or the “Company”) and certain of its subsidiaries (collectively, the “Debtors”) filed voluntary petitions for relief under chapter 11 of the United States Bankruptcy Code

Trump Hotels and Casino Resorts, Results of Operations, 1996-2004

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THE US GAMING MARKET, 1995-2004

During the period in question, the US gaming industry experienced strong growth with an increasing part of the population visiting casinos.  US consumer spending at casinos nearly doubled from 1995 to 2005, going from $16 billion to $30 billion.

US Consumer Spending on Commercial Casino Gaming, 1995-2005

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To be sure, Atlantic City lost its monopoly on legalized gambling on the East Coast. First came the casinos on Indian reservations in Connecticut, in the nineties, and then, in recent years, the advance of gaming across state lines, in Pennsylvania, Delaware, Maryland, and upstate New York. Yet, AC remained the #2 casino market in the US.

DJT5

DJT’s AC properties traditionally had a 25-27% market share.

Over all, an index of casino stocks rose 160%  from the date of the DJT IPO to May 20, 2005. DJT badly under-performed the broader market, dropping 89%.

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THE ECONOMICS OF THE GAMING INDUSTRY

On the surface, the gaming business would seem to be a very profitable business.  After all, the form of entertainment they provide is intended to separate customers from their money for fun.  Often these customers are addicted to the service as well and cannot stop spending money even when they would like to.  Yet, the industry faces six key challenges:

  1. High Capital Expenditures – Significant capex is required to maintain, expand and differentiate facilities.
  2. Labor-Intensive – Large number of service employees are required to staff a casino. In both AC and Las Vegas, the labor force is largely unionized causing more complications.
  3. Cyclical – Gaming is highly sensitive to ups and downs in the economy.
  4. Regulation – Gaming is a highly regulated industry where unpredictable changes in laws, taxes, licensing or zoning can have an outsized impact on a business
  5. Competition – Absent regulatory restrictions, gaming is an industry with low barriers to entry. It is difficult for incumbents to develop durable competitive advantages because gaming is largely commoditized.  Brand loyalty, when it is developed, can be fleeting and subject to trends.
  6. High Marketing Expense – Because brand and image are important differentiators for gaming companies, they tend to have very high marketing expenses.

Revenue and Profit Drivers

There are three main approaches to increase revenues and profits for a company in the gaming industry:

  1. Increase revenues at an existing location. The Company can enhance their marketing programs to attract and retain customers. This includes maintenance programs that encourage customers to spend additional money and make return trips. For the hotel component of revenues, a company can look to improve Revenue per Available Room (RevPar) by increasing occupancy rates or average room rates.
  2. Increase revenues by opening a new location. Many of the large gaming companies own hotel-casinos in more than one of the legal gaming markets; an approach that provides the benefit of not having all revenues tied to one market.
  3. Increase revenues by making an acquisition. An acquisition in the gaming space can be a faster mode of entry into a market versus building a new casino from the ground up.

Moats

As stated above, in general, it is difficult to create a moat in the gaming industry as casinos provide a commoditized service.  After all, one crap game looks pretty much like any other.  Similarly, consumers experience no switching costs if they decide to play the slots at one casino versus another.

Nevertheless, a narrow moat can be created via two sources:  brand and regulation.

Certain hotel-casinos have been able to build a brand that makes it difficult for competitors to woo their customers.  For example, Wynn Resorts (WYNN) has established a brand synonymous with high quality.  This image allows WYNN to focus on the high-end luxury segment of the casino industry and drive very high revenue per square foot.

The second potential source of a moat is government regulation.  Governments typically limit the number of licenses awarded to casino operators.  This regulatory barrier places an artificial limit on the amount of competition and leads to monopolies or oligopolies.  For example, in Macau, there are only six gaming licenses – thereby limiting supply well below demand.  A casino with a captive audience can certainly be a money maker.

Regulatory barriers were present in AC during this era.  The New Jersey Casino Gaming Control Commission deliberately controlled the pace of casino development Atlantic City. This resulted in new casino development only being permitted when the commission was confident of a net improvement in total taxation. That is, the government sought to ensure that any new development would not result in long term redistribution of existing revenues. Rather, new casino developments had to generate net accretion of taxation to New Jersey.

LESSON LEARNED

Be Wary of Leverage

Before making an investment, an analyst should be able to answer the most fundamental of questions:  “Does the company have the ability to develop revenue, profit, and cash flow to cover expenses?”

Given the firm’s highly leveraged balance sheet, it is difficult to see how this question could be answered in the affirmative.

A basic measurement of liquidity is to look at the ratio of operating income (aka EBIT) to interest expense.  For DJT, this ratio never reached 1.  A DSCR of less than 1 means negative cash flow. A DSCR of .95 means that there is only enough net operating income to cover 95% of annual debt payments. For example, in the context of personal finance, this would mean that the borrower would have to delve into his or her personal funds every month to keep the project afloat. In general, lenders frown on a negative cash flow, but some allow it if the borrower has strong outside income.

Lenders will routinely assess a borrower’s DSCR before making a loan. If the ratio is less than 1, the borrower is unable to pay current debt obligations without drawing on outside sources—without, in essence, borrowing more. If it is too close to 1, say 1.1, the entity is vulnerable, and a minor decline in cash flow could make it unable to service its debt. Lenders may in some cases require that the borrower maintain a certain minimum DSCR while the loan is outstanding. Some agreements will consider a borrower who falls below that minimum to be in default.

Trump Hotels and Casino Resorts, Debt Service Coverage Ratio, 1996-2004

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Here, it is hard to see as a matter of arithmetic how the company could generate enough cash flow to cover its interest obligations.  Therefore, to avoid a potential bankruptcy, everything would have to go perfectly.  Given the three drivers of revenue and profit described above, the Company had limited options.  Seemingly, it would have to dramatically out-perform past results at existing casinos while expanding into new markets – and all without the benefit of any free cash flow.  The probability of this happening seems very low.  A potential investor would have to be incredibly optimistic to see how this could happen with interest payments crowding out all other forms of investment.  (Note that I am not trying to justify the $14 price per share at the time of the IPO or even the $2.40 share price at the time of the VIC write-up.  I am just trying to see how the company could stave off bankruptcy.)

Further complicating matters, the company was not only responsible for paying interest on the loans but repaying principal when it came due as well.  If the odds of paying interest seemed low, the odds of paying off debt when it matured seemed even more remote.  As a result, it would be forced to rely on the continuing generosity of banks to refinance the debt when it came due.  The company was realistic about this possibility from the get-go:  “Management does not currently anticipate being able to generate sufficient cash flow from operations to repay a substantial portion of the principal amount of the (debt). Thus, the repayment of the principal amount of the (debt) will likely depend primarily upon the ability to refinance the (debt) when due.”[4]  If the credit markets insisted on much higher interest rates when refinancing the debt or simply lost patience altogether, DJT was in big trouble.

Competitive Analysis

This case study reinforces our belief that it is important to (1) identify sources of competitive advantage and support them with qualitative and quantitative data and (2) determine whether supply in the industry is growing or contracting.

Management believed it had two source of competitive advantage.

First, DJT believed it had a powerful brand.  In its prospectus for a second share issuance in 1996[5], the Company wrote:  “The Company capitalizes on the widespread recognition of the ‘Trump’ name and its association with high quality amenities and first class service. To this end, the Company provides a broadly diversified gaming and entertainment experience consistent with the ‘Trump’ name and reputation for quality, tailored to the gaming patron in each market.”[6]

Unfortunately, whatever positive qualities may be associated with the Trump name, they were not reflected in the income statement.  This was evident at the time of IPO by looking at the historical results of the casinos and at any time following.

Second, DJT believed they could use these regulatory barriers both in New Jersey and elsewhere to their advantage.  Specifically, they believed that their superior scale, reputation and experience would give them a leg up with regulators.  “The Company also benefits from the ‘Trump’ name in connection with its efforts to expand and to procure new gaming opportunities in the United States and abroad, as well as to explore opportunities to establish additional gaming operations, particularly in jurisdictions where the legalization of casino gaming is relatively new or anticipated.”

Again, the company was never able to capitalize on these advantages if they did in fact exist.  DJT never expanded beyond the four properties it held at the time of the IPO and, in fact, contracted.

Likewise, this case study reinforced the importance of determining whether supply is increasing or decreasing in the industry – as the great book Capital Returns demonstrates.  After all, if I had been analyzing DJT in 1999 or 2000 or whenever, I would have no great ability to forecast consumer demand for gaming activities in AC.   But, I could pretty clearly see that the supply of gaming activities was increasing both in AC and around the country (as described above).  This could only be bad for DJT.[7]

FOCUS ON MANAGEMENT & STEWARDSHIP OF SHAREHOLDER CAPITAL

There are numerous instances of self-dealing and conflicts of interest over the brief history of DJT.  The disclosure of related party transactions in the 1996 S-1 goes on for 7 pages.  These events should have served as red flags to potential investors.

In sum, even when putting the facts in the best possible light, it is hard not to see the IPO itself as simply a scheme to shift Trump’s personal debt on to the shareholders.  The transactions surrounding the World’s Fair are one good if convoluted example:

  • As stated above, in June 1989, a partnership wholly owned by Trump acquired the Atlantis. Trump later re-named it the Trump World’s Fair.
  • In August 1990, another Trump entity, Plaza Associates, leased the property and operated it as a non-casino hotel. They proceed to lose $14 million on this venture.
  • In September 1992, a bank took over ownership of the hotel and Plaza Associates issued it a note for $17 million for back rent.
  • In December 1993, the bank granted Trump an option to purchase: (1) the World’s Fair and (2) promissory notes totaling $65.8 million, including one issued by Trump personally for $35.9 million in 1987. This last loan is referred to as the “Trump Note.”  The notes were secured by certain real estate assets in New York wholly unrelated to the AC gaming ventures.
  • In June 1995, using proceeds from debt issued in conjunction with the IPO, Trump paid off the $17 million note for back rent.
  • Also in June 1995, using proceeds from the IPO, Trump acquired the World’s Fair for $58 million and transferred title to Plaza Associates. The S-1 then drily adds that in connection with this transaction “the Trump Note was canceled.”

It’s difficult to understand how repayment of Trump’s personal debt was justified as a use of Company funds.

Beyond that, is really the type of management you would want to do business with?

“JUST A TECHNICAL THING”

In the end, DJT’s chairman of the board was able to dismiss the bankruptcy of the company he led as mere financial engineering and paper-shuffling.  Trump told CBS News at the time that “I don’t think [the bankruptcy]’s a failure, it’s a success. In this case, it was just something that worked better than other alternatives. It’s really just a technical thing, but it came together.”  One wonders whether his fellow shareholders were so blasé about it.

For those of us viewing the history of DJT with the benefit of hindsight, the case study provides useful guidance for avoiding so-called “value traps.”  Just because shares are selling for 6 times EBITDA (the approximate ratio at the time of the bullish VIC write-up) does not mean they are a good investment.

 

 

[1] Gabelli is disclosed as owning 9.1% of the outstanding shares in 1997, 7.2% in 1998, and 6.2% in 1999 per the annual Form 10-K.

[2] The joint venture, with the hotel-casino built by the Trump Organization on Trump land but with Holiday Inns’ money, collapsed  two years later.  Trump antagonized his joint venture partners by building the Trump Castle directly across the street from Harrah’s Marina hotel in Atlantic City. In 1986 Mr. Trump bought Harrah’s half-share in Trump Plaza (Harrah’s name had been removed) for $59.1 million.

[3] For a look at the colorful history of Trump 29 see here.

[4] 1996 Form S-1, page F-11.

[5] The prospectus for the IPO is not on the SEC website and I cannot locate a hard copy.

[6] The association of the Trump name with first class amenities would certainly come as a surprise to anyone who actually visited one of the casinos.  I visited the Taj Mahal in 1997.  “First class” was not the first thought that came to mind.

[7] Somewhat paradoxically, the Company and the bulls believed that  the company would benefit from more competition.  That is, the AC gaming industry was being artificially constrained by a shortage of hotel rooms.  Therefore, as competitors increased their hotel capacity, all AC casinos would benefit.  Besides being comical on its face, this assertion also ran counter to the Company’s own very recent experience.  From the 1996 S-1: “ In 1990, the Atlantic City casino industry experienced a significant increase in room capacity and in available casino floor space, including the rooms and floor space made available by the opening of the Taj Mahal. The effects of such expansion were to increase competition and to contribute to a decline in 1990 in gaming revenues per square foot of casino floor space. In 1990, the Atlantic City casino industry experienced a decline in gaming revenues per square foot of 5.0%, which trend continued in 1991, although at the reduced rate of 2.9%.” (Emphasis added.)