Rewarding the Patient Investor: Red Rock Resorts

By Aaron Monroe, CFA
May 2018

Every casino patron knows that The House holds the upper hand and the longer you play, the more likely The House will win. As long-term, value investors, we look for key attributes in businesses which improve our odds of earning good returns on our capital and reward our patience. With a strong economic moat, aligned interests, long-term thinking, and opportunities to utilize capital effectively, Red Rock Resorts, Inc. holds these attributes in spades.

Red Rock (previously listed as Station Casinos) is the market share leader in the Las Vegas Locals regional market in what has consolidated to nearly a duopoly. The company owns 20 properties across the valley at varying quality levels and 90% of the population lives within five miles of one of Red Rock’s facilities. The company also manages the top-rated loyalty program in Las Vegas that touches 50% of the adult population within a 12-month period.

RED ROCK RESORTS: SIGNIFICANT DISTRIBUTION & SCALE

Red Rock Resorts Significant Distribution and Scale
Source: Red Rock Resorts Investor Presentation March 2017

One unique attribute to gaming in the state of Nevada is a substantial restriction on where casinos can be developed due to legislation passed in 1997 (Senate Bill 208). This bill restricts development in all areas excluding the Strip. Since the bill’s passing, Red Rock has consolidated much of the market and has purchased the majority of the viable plots for gaming development. Consequently, it possesses the broadest market penetration with the largest market share and the best loyalty program, while also controlling supply. These characteristics have built a very defensible moat for the business.

In addition to strong company fundamentals, Red Rock also has an aligned management team with a long-term focus. The Fertitta family founded Station Casinos in 1976 and currently owns over 40% of the economic interest and controls nearly 90% of the voting rights. Some investors find a controlling stakeholder to be disconcerting; however as investors with a business owner’s mindset, we find their position refreshing. Casinos are inherently long-timeframe investments, so for the patient investor it adds substantial value to have a management team that is free from delivering quarterly results to The Street or answering to activists focused on the short term, which can wreck a business for near-team profits. Therefore, we view it as a strong positive for the business to have owners Frank and Lorenzo Fertitta actively involved with the company and maintaining its long-term focus. I believe their current investment in The Palms speaks to their time horizon. After purchasing the property for a reasonable price in late 2016, they could have easily delivered the immediate synergies and produced a good return, but have decided to triple their investment in a completely re-envisioned facility. This process will not be completed until the end of 2019 and disrupts earnings in the near term, but can significantly enhance the returns to all shareholders over the longer term.

The Palms is just one of the recent capital opportunities. As mentioned previously, Red Rock purchased many of the viable development sites in the Las Vegas market. The company controls a land bank of over 400 acres, providing future opportunities to deploy capital while also mitigating competition. Combined with the economic strength of Las Vegas, the patient investor should be well-rewarded.

As for potential risks to our investment, given the company’s concentration in one geography, any market-specific weakness will substantially affect the company’s position. This was the case during the last recession as Las Vegas home prices fell more than 60%, unemployment spiked to 14% as tourism and conventions evaporated, commercial construction ceased, and the housing crisis ensued. These events forced a restructuring of Red Rock’s business in 2011 as leverage levels reached over 9x EBITDA. With that said, the market intelligence gained from years of geographic focus, as well as the legislative development restriction, make the regional concentration a risk with substantial payoff. Additionally, the Las Vegas economy is now meaningfully less reliant on construction and homebuilding than it was a decade ago prior to and during the Financial Crisis.

LAS VEGAS EMPLOYMENT BY CATEGORY: PEAK TO CURRENT (IN THOUSANDS)

Las Vegas Employment by Category
Source: Red Rock Resorts Investor Presentation March 2017

Despite previous challenges with leverage, the company continues to operate with a slightly elevated leverage target at 4-5x and will probably drift above this due to the near-term EBITDA disruption from The Palms and Palace Station renovations. Some comfort is found here with the support of the significant tangible assets the company owns. Plus, having gone through bankruptcy previously, it is our belief that management will remain grounded.

In conclusion, we believe these strong attributes outweigh the risks and put the odds in our favor to earn good returns with our ownership in Red Rock Resorts. As we’re sure many casino patrons can agree, it is best to own The House.

As of April 30, 2018, Diamond Hill owned shares of Red Rock Resorts, Inc.

Originally published on May 22, 2018.

The views expressed are those of the research analyst as of May 2018, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

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