On Tilman Fertitta’s acquisition of the Houston Rockets (Part 1)

This article was originally posted for Red94.net on December 28th, 2018.

In September 2017, Leslie Alexander sold the Houston Rockets to Tilman Fertitta for $2.2 billion. Les had owned the Rockets for 24 years, fortuitously purchasing them from Charlie Thomas for $85mm in 1993. Doing the quick math, Mr. Alexander was able to make a return of 25 times on his original investment at an annual compounded rate of 14.5%. This return may be greater as it is (a) unknown what distributions Les made to himself throughout his ownership tenure and (b) unclear what kind of leverage was used by Les at the time of acquisition (Mr. Alexander does come from a bond trading background, after all). Still, this is the type of return a hedge fund manager dreams of – the Dow Jones Industrial Average comparatively appreciated 7.6% annually in that time frame.

Fertitta purchased the Rockets for an EBITDA multiple of 35x. That is a staggeringly high price to pay for any investment, but the idea is that one is paying a premium for future growth potential.

Les’ timing proved impeccable and followed the old adage of buying low and selling high. Having acquired the Rockets with a championship contender already in place, Mr. Alexander was able to reap the future increase in value associated with the 1994 and 1995 championship seasons, which dramatically grew the Rockets’ fan base overnight. Further, with the drafting of Yao Ming in 2002, Les oversaw the team’s expansion into the most populous country in the world. The Rockets remain the most popular team in China, and Zhou Qi’s short presence on the current roster was, perhaps, more of a business decision to continue that trend. Finally, Les maximized his ROI through the hiring of Daryl Morey in 2007. The general manager’s value investor philosophy kept the Rockets below the salary cap, competitive and never below .500 for 10 years straight.

When Les sold the team in Fall 2017, he did so at the peak. Long-term contracts with the team’s symbiotic trifecta in superstar James Harden, Morey and head coach Mike D’Antoni were all in place, and the Chris Paul trade had been enacted over the summer. Further, the Rockets were coming off five straight playoff appearances, and there was a belief that the team would be able to contend for a championship in the 2017-2018 season (and if it wasn’t for a certain hamstring, perhaps we would all be celebrating on Richmond Avenue again). Lastly, Steve Ballmer’s 2014 acquisition of the Los Angeles Clippers for $2 billion gave a benchmark price for the team.

When Tilman ultimately bought the Rockets, the team’s estimated annual profits were $62mm. That means Fertitta purchased the Rockets for an EBITDA (earnings before interest, tax, depreciation and amortization) multiple of 35x. That is a staggeringly high price to pay for any investment, but the idea is that one is paying a premium for future growth potential (as a comparison, Amazon trades for a 30x EBITDA multiple for that very reason). The restaurant business, Mr. Fertitta’s primary source of wealth, typically trades in the 10-14x EBITDA multiple range, so the transaction would seem, at first blush, quite dilutive to Tilman.

The acquisition, according to sources, was financed mostly via debt. Of the $2.2bn, $1.415bn was funded via a private bond offering with an interest rate of 6.75%. This bond offering helped pay for Tilman’s $1.75bn in equity, $175mm of assumed debt, and a $275mm seller financed note from Les (man, the guy continues to make money even after he sold the team!). This means the resulting loan-to-value stands at ~85%. This is a fair amount of debt to be serviced at a relatively high interest rate, but follows Fertitta’s fearless philosophy on leverage.

However, there is a case for why Fertitta’s acquisition will be quite successful. A critical characteristic of the NBA is that it is a defined market with high barriers to entry – the amount of market participants stays static unless the league agrees to a new team. Hence, a team’s value is somewhat due to the non-competitive nature of the market. It is a principal reason why the value of a sports team continues to grow over time.

Further, the median age of the NBA viewer is 42 vs. 50 for the NFL and 57 for the MLB, with much of league’s audience growth coming from younger fans. To grow its young audience, NBA has done a magnificent job expanding its social media presence – a sect of fans find #NBATwitter more engaging than the games themselves. The demographics are certainly in the Rockets’ favor to sustain its continued financial success.

Finally, Tilman bought the Rockets because of how the team will benefit his main casino and restaurant businesses. Typically, ownership of an NBA team is seen as a separate interest without any synergies with said owner’s main source of wealth. But look closer and it’s clear how the Rockets can benefit Tilman’s businesses. Every Rockets game at Toyota Center has advertisements for Landry’s – this is known as cross-selling in marketing. And with sports gambling deemed legal by a recent Supreme Court decision in May 2018, Tilman’s casino operations could stand to benefit tremendously. I wouldn’t be surprised if we end up seeing James Harden-branded slot machines at the Golden Nugget in the near future – you can bet on it (at the Golden Nugget, of course).