River Rock Entertainment Authority 768369AF7
March 05, 2013 - 9:20am EST by
GideonMagnus
2013 2014
Price: 61.50 EPS $0.00 $0.00
Shares Out. (in M): 87 P/E 0.0x 0.0x
Market Cap (in $M): 54 P/FCF 0.0x 0.0x
Net Debt (in $M): 202 EBIT 0 0
TEV ($): 0 TEV/EBIT 0.0x 0.0x

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  • Casino

Description

I recommend buying River Rock Entertainment Authority’s 9% Series A Senior Notes due 11/1/18 (CUSIP 768369AF7). At a current offer price of 61.5, the bond
has a yield to maturity of 20.9%. However, a very strong amortization covenant on this issue will likely result in an IRR closer to 28% through to redemption.
 
Note: The general analysis below also applies to River Rock’s 8% Series B Tax-Exempt Notes due 11/1/18 (CUSIP 768372AA2), however, they are less liquid
and at recent trading prices around 85-90 they offer a much lower IRR of 11-13%. This might be a reasonable pick for a tax-exempt mandate, but the taxable
notes are much more attractive at this time.


Background

River Rock Entertainment Authority operates the River Rock Casino on the Dry Creek Rancheria Band of Pomo Indians reservation in Sonoma County, CA.
Right now, it’s hard to find a more unloved investment sector than Native American gaming operator bonds. That sentiment has plenty of justification, as a
number of over-leveraged operators defaulted on bonds that have come due since the recession. A significant complicating factor in this sector is that many
Native American tribes in the U.S. are recognized as sovereign nations and, as such, are not subject to U.S. bankruptcy law and can only be sued with a
tribe’s consent. To reduce concerns about this, tribes often waive their sovereign immunity with respect to specific contracts with investors, suppliers, and
developers. Nonetheless, uncertainty remains as to whether a court would accept jurisdiction of a tribe’s bankruptcy or instead declare that tribal law be
followed. Neither the tribes nor the investors in defaulted bonds want to test those uncharted waters, so the typical result has been to exchange defaulted
bonds with new debt, often with a long delay and a significant haircut to principal.
 
River Rock was, in fact, one of the operators that defaulted on its debt due 11/1/2011. However, the result for bond investors was materially different than
what happened to many others. River Rock had more than sufficient cash flow to cover the debt burden but could not come to an agreement with investors
on new bond terms in time to refinance (they were working to issue three bonds at the same time). An exchange offer on the defaulted bonds was made
shortly after maturity and included the following.
  • No haircut to principal
  • Extension of maturity date to 11/1/2018
  • A choice between two pari passu Series of Senior bonds - a taxable bond (Series A) with a modest reduction in coupon from 9.75% to 9.0% and a
    tax-exempt bond (Series B) with an 8% coupon (initial offering documents show a 7.5% coupon, but it was bumped up)
  • Existing notes due in 2011 were subordinated to the new notes
  • Very strong covenants including:
    • 100% of excess cash flow will be used to pay down debt at each semi-annual coupon period!
    • Limitation of additional debt to $5 million, which cannot be used to pay principal or interest on existing debt
    • CapEx is limited to $5 million per year (with some exceptions)
    • Limitations on distributions to the Tribe (as detailed below in “Covenants” section)
    • Senior Notes are secured by a first priority lien on the Authority's revenues and substantially all of its existing and future real property and
      tangible and intangible personal property
    • Waiver of sovereign immunity

The full offering documents can be found here

River Rock used to file with the SEC, but ceased doing so after the bond exchange to save money. You can review past SEC filings here.

River Rock continues to produce financial reports which can be retrieved from the casino’s website (https://www.riverrockcasino.com/investors/login.php). You
will need to request a login and then wait perhaps a day or two for it to be activated. All information in those reports is considered confidential, so below I will
rely solely on information that is in the public sphere. For your own cash flow modeling, of course, you will want to get the most recent information.


Debt Structure

Upon completion of the bond exchange, River Rock had the following bonds outstanding:

Issue                                                            Par Value                             Date

Series A 9% 2018 Senior Notes                   96,662,000                     12/21/11

Series B 8% 2018 Senior Notes                    93,302,000                     12/21/11

Senior Subordinated 2019 Notes (1)            27,600,000                     12/21/11

Subordinated 2011 Notes  (2)                       3,607,000                       12/21/11

TOTAL                                                            $221,171,000

 

(1) The Senior Subordinated 2019 Notes were issued to Merrill Lynch to repay existing debt of the Tribe. These notes pay interest in additional bonds
(Pay In Kind) as long as the combined par value of Senior Notes remains above $100 million, providing additional security to the Senior Notes for a number
of years.

(2) The Subordinated 2011 Notes are holdouts from the exchange and are now at the bottom of the structure and stripped of most of their covenants; all
interest and principal is deferred while the Senior Notes remain outstanding. However, they can be exchanged at any time for Series A Senior Notes, so a
conservative approach would be to assume that they will all be exchanged.

Redemption Notices provide updates to most of this information. $11,014,000 of the Senior Notes were redeemed on 11/1/12, representing 6.08% of the
outstanding bonds (http://emma.msrb.org/EP706596-EP548929-EP949997.pdf).

$1,223,800 of the Senior Subordinated Notes were redeemed on 11/1/12 (http://emma.msrb.org/EP706596-EP548929-EP949998.pdf). It does not specify
the outstanding balance, but if you work through the math on how many bonds would be issued with the PIK and assume that none of the Senior Subs were
redeemed on 5/1/12, you arrive at a maximum estimate of the outstanding par value.

Issue                                                         Par Value                             Date

Series A 9% 2018 Senior Notes                87,253,000                      11/1/12

Series B 8% 2018 Senior Notes                82,992,000                       11/1/12

Senior Subordinated 2019 Notes (1)        max of 28,199,353           11/1/12

Subordinated 2011 Notes  (2)                   3,607,000                       12/21/11

TOTAL                                                       $202,051,353

As you can see, 10.4% of Senior Note principal was paid down in the first year after the exchange (total debt decreased by at least 8.6%). This rapid
paydown at par value is what turns an ordinary high yielding bond priced at 62 into a VERY high return bond. If you compare the Series A YTM of 20.9%
and Series B YTM of about 10.0%, it appears that the difference is explained solely by the tax factor; the market appears to be completely ignoring the
early redemptions into the pricing of these bonds!

There are three other off-balance sheet liabilities to note.

  1. Priority Tribal Distributions are monthly payments to the Tribe that are effectively senior to the Senior Notes since distributions will be made even
    if debt is in default. The distributions are, however, tied to the cash flow of the casino so weak results will reduce this amount (as detailed below
    in “Covenants” section).

  2. River Rock has a lease agreement with the Tribe on the Bellacana Property (f.k.a. Proschold Property) for $232,000 per month through July 1, 2016,
    after which it drops to $12,000 per month. These payments are not expensed but instead are considered distributions to the tribe in River Rock’s
    financials.

  3. River Rock currently pays Sonoma County $3.5 million per year for use of services such as police and fire departments; these payments are expensed
    as they are paid. An initial Memorandum of Agreement made in 2008 pegged the total payments to equal $75 million through 2020, but a portion of
    that was based on River Rock’s expansion plans which were put on hold in early 2009. The current $3.5 million payment was renegotiated from a
    higher amount due to the change in plans, but River Rock would have to make up for it if/when a new resort facility is built. If the expansion plans
    don’t happen by late 2020, I estimate that River Rock will still owe the county $29.7 million per the agreement. Presumably though, that number
    would be renegotiated to a substantially smaller amount in those circumstances, maybe even zero. The Tribe appears to be on good terms with the
    county.

 “There is a culture of collaboration between the county and the tribal board of directors,” said Sonoma County Supervisor Mike McGuire, whose district includes
the casino. “I heartily appreciate — and sincerely mean this — how accessible the tribal board of directors has been on issues.”
(
http://www.pressdemocrat.com/article/20120915/ARTICLES/120919690?p=3&tc=pg)

 

Covenants

There are two sets of covenants particularly relevant to the cash flows.

 

  1. The amount of Priority Tribal Distributions are determined based on River Rock’s “Cash Flow” (essentially EBITDA plus the payments to Sonoma
    County – see full definition in offering docs; also note that River Rock does not pay income taxes) as follows.

    If trailing four quarter Cash Flow (CF) is:
    1. CF ≤ $40 mil, distribution is $500,000 per month
    2. $40 mil < CF ≤ $45 mil, distribution is $583,333 per month
    3. $45 mil < CF ≤ $50 mil, distribution is $666,667 per month
    4. CF > $50 mil, distribution is $750,000 per month

 

2. Paydowns of principal on the Senior 2018 Notes and Senior Subordinated 2019 Notes are determined by River Rock’s “Excess Cash Flow” (essentially
free cash flow less distributions to the Tribe – see full definition in offering docs) as follows.

 

If trailing four quarter Excess Cash Flow (ECF) is:

  1. At least $50 mil, 90% of ECF is applied to Senior Notes (pro-rata between Series A and B) and 10% is applied to Senior Subordinated Notes.
  2. Less than $50 mil, 100% of ECF is applied to Senior Notes (pro-rata between Series A and B) and 0% is applied to Senior Subordinated Notes.

 

Cash Flow Modeling

Other than the general malaise about gaming bonds, why are River Rock’s bonds trading so cheaply? The reason is that a large new competing casino is
expected to open by year end at Rohnert Park, about 30 miles south of River Rock Casino. This casino will be closer to San Francisco and will certainly
draw away some of River Rock’s customers due to the shorter travel distance. In one of Standard & Poor’s last reviews of the defaulted bond, its analyst
anticipated a mid to high 30% drop in EBITDA due to the new casino, while management believed it could be less than 30%.

Despite this, a stress test of River Rock’s cash flows shows that there is still likely to be a comfortable cushion in covering interest payments and paying
down principal. I assume a Base Case 35% drop in EBITDA in the first quarter of 2014. The last full calendar year that River Rock filed with the SEC was
2010, so I will use some historical values from then in combination with known information from other SEC filings to present an illustration of how well
River Rock can handle the drop in EBITDA. CapEx is assumed to be the maximum permissible $5 million each year. Principal payments occur every six
months (5/1 and 11/1), based on financial calculations ending with the preceding quarter.

 

THE FOLLOWING ILLUSTRATION IS NOT BASED ON THE MOST RECENT DATA!!!

You will need to review River Rock’s confidential reports over the past year to fine tune your estimates going forward.

 

ALSO NOTE: THE TABLE BELOW IS HYPOTHETICAL AND IS NOT A PROJECTION FROM RIVER ROCK’S MANAGEMENT.

All values in thousands of dollars

  Basis for initial Q1 2013 assumption Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014
Cash Flow                  
Net Income quarterly average from 2010            6,423              6,416         6,622         6,614         2,225          2,218          2,341         2,333
 + Interest Expense using par values from "Debt Structure" section of this write-up            4,081              4,089         3,882         3,890         3,679          3,687          3,564         3,571
 + Depreciation quarterly average from 2010            2,462              2,462         2,462         2,462         2,462          2,462          2,462         2,462
 + Sonoma MOA Payments per current MOA                875                  875            875            875            875             875             875            875
TOTAL            13,841            13,841      13,841      13,841         9,241          9,241          9,241         9,241
Annual            55,365            55,365      55,365      55,365      50,765       46,165       41,565      36,965
                   
Excess Cash Flow                  
Net Income quarterly average from 2010            6,423              6,416         6,622         6,614         2,225          2,218          2,341         2,333
 + Depreciation quarterly average from 2010            2,462              2,462         2,462         2,462         2,462          2,462          2,462         2,462
 -Priority Tribal Distribution per covenant          (2,250)            (2,250)      (2,250)      (2,250)      (2,250)       (2,250)       (2,000)      (1,750)
 - Bellacana Lease Payment per August 2011 agreement             (696)                (696)          (696)          (696)          (696)           (696)           (696)          (696)
 - CapEx max allowable under covenants          (1,250)            (1,250)      (1,250)      (1,250)      (1,250)       (1,250)       (1,250)      (1,250)
 + Deferred Interest on Sub Debt using par values from "Debt Structure" section of this write-up                458                  466            457            464            454             462             459            467
TOTAL              5,147              5,147         5,344         5,344            945             945          1,316         1,566
Semi-Annual            10,294            10,294      10,492      10,689         6,290          1,891          2,261         2,882
                   
                   
9% Sr. A Notes Par Value Start using par values from "Debt Structure" section of this write-up          87,253            87,253      82,505      82,505      77,665       77,665       74,764      74,764
8% Sr. B Notes Par Value Start using par values from "Debt Structure" section of this write-up          82,992            82,992      78,475      78,475      73,872       73,872       71,113      71,113
6.5% Sr. Sub Notes Par Value Start using par values from "Debt Structure" section of this write-up          28,199            28,657      28,093      28,550      27,965       28,419       28,252      28,711
9% Sr. A Notes Cash Interest              1,963              1,963         1,856         1,856         1,747          1,747          1,682         1,682
8% Sr. B Notes Cash Interest              1,660              1,660         1,570         1,570         1,477          1,477          1,422         1,422
6.5% Sr. Sub Notes Deferred Interest                  458                  466            457            464            454             462             459            467
9% Sr. A Notes Principal Paydown                     -                4,748                -           4,839                -            2,901                 -           1,159
8% Sr. B Notes Principal Paydown                     -                4,517                -           4,603                -            2,760                 -           1,102
6.5% Sr. Sub Notes Principal Paydown                     -                1,029                -           1,049                -               629                 -                  -  
Portion of outstanding Sr. A Notes paid     5.4%   5.9%   3.7%   1.6%
Portion of initial Sr. Notes paid     5.4%   5.5%   3.3%   1.3%

 

As you can see, Excess Cash Flow drops materially from approx. $10.7 mil semi-annually in 2H 2013 to just $2.9 mil in 2H 2014. Still, this means that all cash
interest was paid on the debt and there will be $2.9 million available for retiring Senior Notes (the Senior Sub Note paydown ceases after 5/1/14 because
trailing Cash Flow falls below $50 million). Also, because less interest will be due on the notes in the future, even if operating cash flow is flat going forward,
Net Income and Excess Cash Flow will continue to rise again over time. Thus, assuming business is stable, River Rock should be able to pay down a larger
proportion of debt at each semi-annual coupon period in 2015+.

In my actual base case cash flow model (not shown due to inclusion of confidential data), I assume the 35% drop in EBITDA in 2014 followed by a
conservative assumption of zero operating cash flow growth through maturity. The following table shows the anticipated principal paydowns. As noted in
the previous paragraph, the principal paydowns fall substantially in 2014, but then begin to rise again as interest costs decline.

 

   % of outstanding principal
paid down 
 % of initial principal
(as of 3/1/13) paid down 
5/1/2013                                                                          6.7                               6.7
11/1/2013                                                                          7.5                               7.0
5/1/2014                                                                          5.4                               4.6
11/1/2014                                                                          3.0                               2.5
5/1/2015                                                                          3.8                               3.0
11/1/2015                                                                          4.3                               3.3
5/1/2016                                                                          4.7                               3.4
11/1/2016                                                                          5.6                               3.9
5/1/2017                                                                          6.9                               4.5
11/1/2017                                                                          7.7                               4.7
5/1/2018                                                                          8.1                               4.6
Total                               48.3

 

The total of 48.3 implies that of every 100 bonds you buy prior to the 5/1/13 paydown, approximately 48 of them will be redeemed prior to the debt’s maturity
date; 14 are estimated to be redeemed before the end of this year. Keen observers will notice that these paydowns are more rapid than the outdated cash flow
illustration above (hint, hint).

Last but not least is the question, “How bad can it get?” Based on my cash flow modeling, the Bear Case EBITDA could drop about 52% before there is any
risk to the coupon payments on the Senior Notes. This is a very unlikely scenario and demonstrates how strong the cash flows and covenant protections are
on this bond. Realistically, it would have to get even worse than -52% because River Rock would be able to cut CapEx to boost Excess Cash Flow.

 

Risk and Return Summary

In my opinion, the biggest risk here is that the cash flow is generated by a single facility. Stressed-test forecasts notwithstanding, there is always a risk of
the unexpected that could derail the investment thesis. Clearly, I do not believe this is a reason to avoid these bonds, but it does argue for a modest
weight in a portfolio.

Despite an expectation for a dramatic decline in cash flow in 2014, it appears likely that River Rock will have little trouble meeting its interest payments and
will most likely retire a substantial portion of the Senior Notes prior to maturity. The interesting thing about the Base Case, Bear Case, and Bull Case (which
assumes only a 30% EBITDA drop and Operating Cash Flow growth of about 2% in 2015+) is that the IRR is not that sensitive to changes in outlook. The
reason is that in all three scenarios, you get the high current yield of 14.5% and you should get fairly good principal paydowns for at least the next 3 coupon
periods. Thus, even a bear on this casino should be long! My IRR estimates are:

 

Bull Case: 29.0%

Base Case: 28.1%

Bear Case: 25.4%

 

Note that the Bull Case does not even include the most bullish scenario – an early call of the bonds if River Rock can find financing to restart its expansion
plans, requiring the Senior Notes and their restrictive covenants to be retired. I can’t place a probability on this happening, but considering that they
announced the expansion plans in June 2007 and already spent $67 million in planning, there is likely to be a strong preference to get back on track sooner
rather than later if they can access the money to do so.

Since River Rock’s bonds are likely to be purchased by investors who normally buy corporate debt, a concern is likely to be the matter of default
recovery, whether due to an actual weakness in cash flow or an inability to refinance at maturity. Despite the first lien on casino assets, it is not clear what
capital and collateral can be recovered and there is no way for bondholders to take over the casino and collect future cash flows since only a Native
American tribe can run the casino.

As we know from our book learning days, there are “4 C’s of Credit”: Character, Capacity, Capital, and Collateral. While there is a potential weakness in the Capital and Collateral
areas, I believe I have shown that River Rock has more than enough Capacity. So what of the Character? History provides our first clue as the previous
bond exchange was very investor friendly.

On a forward-looking basis, there are two key factors that lead me to believe that River Rock will remain on good terms with bond investors. First is
that they would still like to go ahead with their expansion plan if financing is available, which means they can’t stiff current lenders and expect new ones
to give them money. Second, whatever the probability may be, the Tribe will be extremely reluctant to take any risk that a creditor could have the casino shut
down or cash flows to the Tribe halted. The payments the Tribe receives from the casino are simply too important; as of 2005, 38% of the tribe was
unemployed and of those employed, 1/3 were below poverty levels. Tribal members over 18 get a monthly payment of about $600, which is significant
income for many of them. Thus, I believe that River Rock’s Character to meet their debt obligations is high. (Source for various points in this paragraph are
from this September 2012 article.

Similar to most sovereign bond issues, this is primarily a bet on cash flow, not collateral. Given the impressive cash flow at River Rock, I believe it is a bet
that is likely to pay off to the tune of an IRR just under 30%.

I do not hold a position of employment, directorship, or consultancy with the issuer.
Neither I nor others I advise hold a material investment in the issuer's securities.

Catalyst

Continued principal paydowns with each coupon.
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