Description

Summary / Valuation Overview:

Recently, an analyst covering Sphere Entertainment Co. (“SPHR”) maintained his neutral rating and cut the price target on the stock to $25/share from $59/share.  While a headline such as this often comes after an enormous earnings shortfall or significant deterioration in the business fundamentals, we think this can be attributed to a good old-fashioned error in valuation following a spin-off of assets. 

SPHR holds the assets remaining after the spin-out of Madison Square Garden Entertainment Corp. (“MSGE”), which owns Madison Square Garden Arena, Radio City Music Hall, Beacon Theater and London Theater. SPHR has several assets which are described in detail below, but the predominant driver of value is a large entertainment complex in Las Vegas, called MSG Sphere or the “Sphere”, that is set to open in the fall.  The company is expected to spend $2.3 billion to build the Sphere, but we believe investors can buy it today at 20 cents on the dollar.   

We believe this opportunity is available today because of an incorrect reading of SPHR’s financial statements.  First, the capital structure is incorrect on Bloomberg, as the balance sheet on Bloomberg has not yet been updated to reflect the spin-out of MSGE, which took place after the quarter ended.  Second, a large tranche of debt is non-recourse to SPHR, which can impact SPHR’s stock price by approximately 75% if not correctly accounted for. For example, JP Morgan’s June 7, 2023 note, titled “Still Unclear on the Sphere; Staying at Neutral and Establishing a Dec-24 PT of $25”, is making a significant mistake. As can be seen in the note (table below), the analysis ascribed an enterprise value of $190 million to MSG Network (“MSGN”, a regional cable and satellite television network) while using a debt balance of $1,088 million for SPHR as a whole. However, $950 million of that debt sits with MSGN and is non-recourse to SPHR. Hence, the analyst’s price target applies more than $22 per share of negative value to SPHR due to MSG Network’s debt, which SPHR has no obligation to satisfy. 

While SPHR appears to be a heavily levered entity that burns cash, we believe the capital structure is reasonable and SPHR should be in position to generate cash shortly after MSG Sphere’s opening.  Ultimately, we believe one does not have to underwrite much to generate a 75% return, valuing Sphere at 50% of replacement cost. The market is currently pricing in enormous capital destruction from the construction required to build the Sphere, and we think there is 200% upside if the stock was valued based on the very recent capital that SPHR has deployed to create the business.

Asset Overview:

SPHR is the holding company for three key assets. First, MSG Sphere is a $2.3 billion (all in construction costs) one-of-a-kind venue in Las Vegas. Second, SPHR owns 17.1 million shares of Madison Square Garden Sports Corp (“MSGS”) that we believe is worth approximately $18 per share to SPHR after tax. Third, SPHR is the sole owner of MSGN, a regional network that we value at zero. While it is not factored in our estimate of SPHR’s intrinsic value, we think it plays a huge role in errors that the sell-side is making in calculating SPHR’s intrinsic value. JPMorgan is not the only one making that mistake. The Morgan Stanley Initiation titled “Madison Square Garden Companies: From New York to Vegas – Initiate EW MSGE, Lower Outlook for SPHR, and Raise PT at MSGS (26 May 2023)” is making the very same mistake. Ultimately, given the non-recourse nature of MSGN’s debt to SPHR, we believe this is an incorrect and material error in valuation. In addition to the assets described above, SPHR has some additional smaller holdings (e.g., land located in London) that do carry some value, but we have not factored this into our calculations for simplicity.

MSG Sphere Overview:   

MSG Sphere broke ground in 2018 and is expected to open in the Fall of 2023 for the first show of U2’s residency there on September 29th. When completed, the venue will be able to sit nearly 18,000 people and will be the largest spherical structure in the world, measuring 516 feet wide by 336 feet tall. The Sphere will be home to concerts and shows utilizing 16K wraparound LED displays and over 160,000 speakers with 4D capabilities. The indoor screen is larger than three football fields. Additionally, it will include 23 luxury suites and an approximately six million cubic feet grand entry in the main atrium. Outside the Sphere is an approximately 160,000 square foot 16K LED display that we think will dominate the Vegas night skyline.

While the project was originally expected to cost $1.2 billion at the onset, changes in design, construction and inflation have elevated the all-in cost to $2.3 billion. Given the timing of the opening (3 months away), we believe the chance of any material changes in construction estimates are small. The building sits on land that was contributed by the Venetian Las Vegas hotel (the “Venetian”, originally owned by Las Vegas Sands Corporation (“Las Vegas Sands”), but now owned by Vici Properties Inc.). The ground lease covers approximately 18.6 acres and has a 50-year rent free lease term. In return, SPHR has agreed to share approximately 25% of its after-tax cash flows in excess of a return threshold that was agreed to at the onset of the project. While the specific percentage was redacted from the Ground Lease Agreement, we believe this return is based on the all-in cost of construction (i.e., $2.3 billion).

At this point is important to pause and recognize what investors in SPHR are buying. This is a one-of-a-kind building in the number one destination market in the world, which we think will be the #1 immersive experience in the city.  Surely something like this is worth at least 50% of its build costs to someone. In fact, the Venetian provided 18.6 acres of ground lease for free, something we believe merits further consideration. Las Vegas Sands (the Venetian’s prior owner) is, we think, one of the smartest strategic companies in the gaming space and most likely felt it could generate a better capitalization rate from contributing the property than selling it. When factoring in (a) the value of the land, assuming a 5-6% capitalization rate, (b) the fact that Venetian was comfortable foregoing any cash flow for six to seven years until the Sphere is up and running and (c) the contribution of land and forgone rent only entitles them to 25% of the cash flow after a hurdle is reached, we believe the Venetian was probably underwriting $400 million or more in EBITDA, potential annually.

With that preamble out of the way, we want to provide a basic framework of how to think about the profit opportunity for investors in SPHR. The below analysis is solely to provide a working framework of how to evaluate the key earnings streams of SPHR. Ultimately, there are many paths from here, but none of that matters, in our opinion, until the shares are at least trading at 50% of replacement value. Sphere’s three sources of income will be driven by:

1. Experiences – The first show is called “Postcards from Earth” and will be shown approximately 3 times per day with a ticket price of $60-$90 per seat. We believe that the margins at the Sphere should be better than what MSGS earns on its “Christmas Spectacular” production, the marquee show at Madison Square Garden Arena.
2. Shows / Residences – There will be approximately 60-70 shows or events a year, starting with U2’s 25 shows. We make some basic assumptions for margins and an attach rate on food and beverages. However, it is important to note that we believe the “guarantees” are provided by Live Nation and the like, and not SPHR.
3. Advertising Opportunity – With MSGE deriving $100-$150 million in advertising revenue from Madison Square Garden Arena, we believe this is a good starting spot for the opportunity of the Sphere, given size of venue, outside display area and density of the market (i.e. visitors on the strip).

MSGN Overview:  

MSGN is, in our opinion, a declining regional network. While management believes they can turn MSGN around, we don’t ascribe to that view and don’t need to do so. As noted previously, Morgan Stanley and JP Morgan value the network at an enterprise value of $150-$350mm, and after accounting for the $950 million of debt held by MSGN, both analysts are ascribing roughly $20 of negative value to SPHR because of its ownership of MSGN. The issue with this analysis is that it completely misses the capital structure construct of SPHR. MSGN’s debt is non-recourse to SPHR.

MSGN’s debt is entirely guaranteed by MSGN and not SPHR, and SPHR lays this out in SPHR’s latest 10-Q;

“Guarantors and Collateral. All obligations under the MSGN Credit Agreement are guaranteed by the MSGN Holdings Entities and MSGN L.P.’s existing and future direct and indirect domestic subsidiaries that are not designated as excluded subsidiaries or unrestricted subsidiaries (the “MSGN Subsidiary Guarantors,” and together with the MSGN Holdings Entities, the “MSGN Guarantors”). All obligations under the MSGN Credit Agreement, including the guarantees of those obligations, are secured by certain assets of MSGN L.P. and each MSGN Guarantor (collectively, “MSGN Collateral”), including, but not limited to, a pledge of the equity interests in MSGN L.P. held directly by the Holdings Entities and the equity interests in each MSGN Subsidiary Guarantor held directly or indirectly by MSGN L.P.”

Perhaps SPHR should be more direct and call this out as non-recourse in a presentation like many companies do. However, for those that are still unsure, SPHR also did so on a conference call a year ago:

Ultimately, we believe the market is completely missing this dynamic, and that an accurate depiction of the capital structure would raise street price targets for SPHR by approximately $20, or 80% of its current trading price.

Disclosure: At the time of publication, the author of this article and one or more of the author’s affiliates holds a position in SPHR. This article expresses the opinions of the author. The author has no business relationship with any company whose stock is mentioned in this article.

The author of this article and one or more of the author’s affiliates has a long position in the company covered herein and stands to realize gains in the event that the price of the stock increases. Following publication, the author and the author’s affiliates may transact in the securities of the company, and may be long, short or neutral at any time.  The author of this report has obtained all information contained herein from sources believed to be accurate and reliable.  The author of this report makes no representation, express or implied, as to the accuracy, timeliness or completeness of any such information or with regard to the results to be obtained from its use.  Any projections, forecasts and estimates contained in this report are necessarily speculative in nature and are based upon certain assumptions. Accordingly, any projections are only estimates and actual results will differ and may vary substantially from the projections presented. All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this article or any of the information contained herein.  This is not an offer to sell or a solicitation of an offer to buy any security.

Catalyst

Sphere opening in the fall