River Rock Gaming Authority Bonds are a Good Bet

November 3, 2010

I am pleased to report that my habit of finding investment opportunities that come in pairs is running true to form. I recently recommended the bonds of the Mohegan Tribal Gaming Authority, and now I can follow it up with the bonds of the River Rock Entertainment Authority, which runs a casino in Sonoma County, California, which offer reasonable safety and an unbelievably high yield.

The bonds currently trade at around 84, with a coupon of 9.75%, current yield of 11.7%, and fall due in November of 2011, offering a yield to maturity of roughly 30%. The bonds’ credit rating is B+, ostensibly an improvement from the CCC+ debt that I normally seem to find. The bonds are River Rock’s only long term debt, which prevents us from worrying about issues of subordination or secured versus unsecured. As stated in Steven Moier’s Distressed Debt Analysis, a vitally useful book for investors in junk debt, if there is only one bond issue it is automatically senior and secured.

The issue size is $200 million, and at current prices has a market value of $170 million. The question, then, for the bond investors, is simply whether the entire casino is worth less than the value of these bonds. As we shall see, the financial statements of River Rock indicate that this question is ludicrous.

Revenues at the casino have been on the decline as the economic troubles have been underway, but seem to have stabilized. The casino’s operations have not only covered their interest requirements by a significant margin, but have also allowed the generation of a substantial profit.

In 2007, income was $139 million, operating expenses net of depreciation were $88 million (including an $11 million “credit enhancement fee” to their developer, an obligation that has since been extinguished), producing operating income of $51 million. The gap between depreciation and capital expenditures was $3 million, creating estimated free cash flow of $54 million. Their interest requirement of $21 million was thus covered 2.57x, a safe margin considering the rating of the bonds.

In 2008, income was $140 million, operating expenses net of depreciation were $76 million (the fee owed the developer is conspicuously absent), producing operating income of $64 million. The gap between depreciation and capital expenditures was $4 million, producing operating income of $68 million, which covered their interest requirement by 3.3x. This level of interest coverage is may actually be found in the lower levels of investment-grade debt.

In 2009, income was $124 million, operating expenses net of depreciation were $70 million, producing operating income of $54 million. The gap between depreciation and capital expenditures was $4 million again, producing estimated free cash flow of $58 million. Their interest requirements were covered 2.76x despite what was apparently a difficult year.

In 2010 year to date, income was $65 million for the first two quarters, with operating expenses of $35 million, producing operating earnings of $30 million. Plus a $1 million gap between depreciation and capital expenditures, we have $31 million in operating incomes, with interest covered 2.95x.

You can see what I mean by the absurdity of the question of whether the entire casino is worth less than the bonds. In its worst year, the casino could boast $58 million in free cash flow to the firm. The value of its debt, $200 million, then, is less than four times its yearly free cash flow, a remarkably safe proposition. (By way of comparison, Bon-Ton department stores bonds, another junk bond I liked, had a debt/free cash flow ratio of about 10 when I bought it).

So, then, what is the source of the market’s skepticism? Most value investors have given up on determining why the market does what it does, but identifying the factors is still worth considering. First of all, there is a proposal to build a new casino between River Rock’s current location and the San Francisco Bay Area. River Rock reports that this casino is still in the planning and permitting stage, but if it is ultimately approved and built, it would perhaps affect River Rock’s profitability in a few years’ time. This fact might make it difficult for River Rock to refinance its bonds in November of 2011. Furthermore, River Rock reported in its 2009 10-K that its plans to renovate and expand have been put on hold for want of financing, which no doubt is weighing on the market perceptions as well. Also,  the casino transfers at least $11 million to the Tribe every year, and these payments, although they rank below the bonds in priority, might well be regarded as sacrosanct. However, this distribution is well covered by the casino’s operations after interest.

I think the main reason, though, is that the balance sheet is apparently not in good shape, containing a large entry for “construction in progress” and showing hardly any equity at all even taking the construction in progress into account. However, earnings power should guide the balance sheet, not the other way round. The casino also has $35 million in cash on the books, so it may be that River Rock will not have to roll over the full amount.

Moreover, in the unlikely event that River Rock were unable to refinance these bonds, the market would be in uncharted territory, as no Indian casino has ever tested the bankruptcy courts. Obviously, the traditional workout of the bond holders stepping up to become new equity holders is unavailable because only an Indian tribe can hold an interest in an Indian casino. However, the alternative of foreclosure and liquidation is not feasible, because the property is useful only as a casino, really, and given its current profitability there would be no reason to pursue this course. So, as no stakeholder in the casino has any reason to see its operations terminated, even in the unlikely event that the debt could not be rolled over, a workout would ultimately be fairly painless.

So, based on the above figures I can state that River Rock gives every appearance of being able to handle the interest on its current bonds and give assurance to the new debtholders when the time to roll the issue over comes that they can service their debts. As a result, I think the large discount and consequent high yield to maturity are a market anomaly that will likely be corrected, to the profit of everyone who buys at the current price.

9 Responses to “River Rock Gaming Authority Bonds are a Good Bet”

  1. By coincidence, I stumbled upon your website today while continuing my research of River Rock Gaming Authority. I just got my first interest payment after paying $88 on 10-19-10.

    Looking forward to sharing ideas with you anytime, I’m also a consumer lawyer.

  2. Just for follow up, the price of these bonds is now at 94 as of 11/23/10. The yield is still at 17%, but clearly these bonds were undervalued as is evidenced by the 12% increase in price in 3 weeks.

    Very timely article and nicely done.

  3. What are you thinking of these bonds now? They have just been downgraded and the other casino that is proposed is 40 minutes closer to San Francisco. I called investor relations and they said that they were going to talk about the refinancing when they announce earnings later this month. Moody’s downgraded due to lack of progress on the refinancing and the potential for the new casino operator to the south that is backed by Stations Casinos.

    Love to hear your thoughts as I own these bonds.

  4. What do you think of the bonds now given the recent downgrade and news that the competitive casino 45 minutes closer to San Fran is making progress? I hold these bonds and am hoping for good news regarding the refinancing.

  5. I am not particularly concerned about the downgrade as such, although I would be interested to read River Rock’s annual report when they finally release it. I have commented further in a new post.


  6. Excuse me!

    Interest covered 2-3x? This outfit has 1.6 billion debt total mostly in bank loans (the bond issue discussed here is mere 200 million) and they are clearly not worth even a fraction of that if they go under.

    Besides there is at least one another bond, 11.5% second lien secured see their 1q11 report . Not clear to me the bond discussed here is of the seniority.

    Very irresponsible discussion by the author.

  7. I’m afraid you’re talking about a different casino.

    First, according to the latest released balance sheet of the third quarter of 2011, there is no mention made of any bank debt at all, not even a revolving line of credit.

    Second and more importantly, the first quarter of 2011 for River Rock’s fiscal year isn’t even over, so there could be no such report.

  8. Stand corrected, thanks, my bad. 1.6B debt was from 1Q11 report of Mohegan Tribal Gaming Authority another tribal casino you covered recently.


  9. The conference call was a mess. These guys have a ton of off balance sheet liabilities that are at the tribal level..BUT.. it appears that they can push them down on to the casino. There is 75 million that they owe to the city and another 50+ million that the tribe has taken for who knows what. It is going to be tough to refinance the bonds and the market is now clearly telling us that. I’ve lost lots on them and am not sure what to do now…

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