Thesis

I am recommending Global Cash Access Holdings, Inc. (GCA) as a long. GCA is a leading provider of cash access solutions for casinos. The company is an asset light, consistent free cash flow generator that produces mid-teens ROIC despite some competitive pressures. GCA is also returning cash to shareholders via a modest share repurchase program. The company is under-levered, giving management room for enhanced cash returns or a strategic acquisition. Although GCA is facing competition, the company is working to differentiate its offerings and expand into new markets such as foreign casinos and online gaming.

Investors can gain exposure to this growing business at a reasonable price (estimated 11% FCF yield on 2013 guidance and sub-10x P/E on cash earnings), and receive growth optionality via the company’s expanding  international and online gaming offerings. Current valuation provides a margin of safety given some competition in the core business, and investors get the growth optionality for free. I have a conservative $8.80/share price target (15% upside), but with a more appropriate capital structure, GCA could trade for $9.85 per share (29% upside). My valuation does not include the value of future growth from the new online gaming market, which is still in its infancy.

Please see below for important disclosures.

Business Description

GCA helps gaming patrons access money for use in gambling at casinos. The company’s customers are the casinos themselves, and it is the largest player in its industry. Casinos often outsource cash access services because it is not a core casino competency. GCA provides patrons with over $90b in cash via 90m transactions per year, and has over 1,000 casino customers in 35 countries. The company operates in four segments: 1) Cash advance; 2) ATM; 3) Check Services; and 4) Other.

1) Cash Advance (2012 Revenue: $228m, 2012 Op. Profit: $64m, 2012 Margin: 28%): GCA allows gaming patrons to use their credit or debit cards to access cash. Patrons can either pull money off of their credit card using the cash advance feature or withdraw money from their bank account using a debit card, which has a daily limit that is typically 5-10x as large as that for ATM cards. Patrons receive a ticket which is redeemed with a cashier, as credit and debit transactions generally require face-to-face finalization. The patron pays GCA a service fee, part of which is remitted to the casino (although such remittance is generally less than for ATMs). GCA must pay the card issuer an interchange fee.

2) ATM (2012 Revenue: $303m, 2012 Op. Profit: $32m, 2012 Margin: 11%): Patrons can use GCA ATMs to withdraw money from their bank accounts or use credit cards to access money. Patrons pay a service fee and GCA receives a reverse interchange fee from the patron’s bank. GCA remits a large portion of its fee revenue to the casino.

3) Check Services (2012 Revenue: $25m, 2012 Op. Profit: $14m, 2012 Margin: 55%): Some casinos allow customers to cash checks. GCA provides check verification and warranty services to casinos on a subscription basis, whereby GCA provides credit information about patrons cashing checks and in some cases warrants the check against being returned for insufficient funds.

4) Other (2012 Revenue: $28m, 2012 Op. Profit: $15m, 2012 Margin: 51%): GCA provides casinos with credit check and related marketing information services through its Central Credit and related products, such as Casino Share Intelligence, QuikReports, and QuikMarketing. GCA also makes, sells, and services slot machine ticket redemption and jackpot kiosks (which streamline the process when a patron wins a taxable slot machine jackpot which requires the issuance of a W-2G tax form). The company is developing and testing cashless gaming solutions such as QuikTicket and TableXchange, which will make moving money from table to table at a casino easier. Finally, GCA is developing and deploying a digital wallet product for use in online gambling in certain US states.

Competition

In 2010, GCA’s largest customer, Caesars, did not renew its contract.  As a result, 2011 marked the company’s lowest post-IPO revenue and EBITDA. In response, GCA bought one of its major competitors, MCA Processing, in 2011. MCA had been one of the companies that took the Caesars contract (along with Global Payments). Revenue and EBITDA have both rebounded from 2011 lows, although EBITDA will be modestly lower year-on-year in 2013.

Today, GCA’s largest competitors are Global Payments (in the cash advance and check warranty businesses), US Bank (in the casino ATM business), NRT (in ATMs, cash advance, and some kiosks), and smaller independent sales organizations (ISOs). NRT, a Canadian company, is the competitor with the broadest product offering. The small ISOs have been offering casinos “basic services and aggressive pricing,” leading to some margin pressure and customer losses for GCA. These are baked into company guidance.

Nevertheless, despite these competitive pressures, GCA’s core cash access business continues to offer attractive returns. GCA earns a mid-teens or higher ROIC (~13% in 2012 vs. pre-recession ~15%). EBITDA margins have fallen slightly from ~13-14%+ to ~11-12% as a result of competition. GCA has been able to take capital out of the business via share buybacks and debt pay-down to support ROIC. Management is addressing the competition by emphasizing the quality and comprehensive nature of its product offerings, innovating new kiosk and cashless gaming solutions, and working to monetize its extensive knowledge about patrons.

Growth Opportunities

GCA’s growth opportunities fall into four buckets: 1) Online gambling; 2) Kiosk offerings (including cashless QuikTicket); 3) New domestic contracts; and 4) International.

GCA recently signed a deal with Scientific Games International to provide payment services and digital wallet functionality to US internet lottery patrons. Revenue benefits from the deal should begin in 2014. Scientific Games helps states run their lotteries, and currently provides instant win tickets to 40 US jurisdictions in addition to helping run the Powerball and MegaMillions lotteries. GCA’s partnership with Scientific Games links the company with a leading provider of lottery services that is greatly expanding its online presence over the next several years.

Nevada, New Jersey, and Delaware have all legalized intrastate online gambling, and more states are likely to follow once they see the revenue potential. Nevada has already gone live with poker-only gambling, while Delaware is targeting an October 2013 launch and New Jersey is targeting a mid-November 2013 launch. New York, Illinois, and California are currently debating legalizing intrastate online gambling. Some projections peg potential annual online gambling revenues at $50-$250m in Nevada and $500-$1,000m in New Jersey. While still some time away, Federal legalization of interstate gambling remains a more distant prospect.

With GCA’s new contract with Scientific Games secured, the company will have a proven track record of working with online providers and will able to offer its digital wallet expertise to other online gambling service providers as legal online gambling expands. In addition, as physical casino operators expand into online gambling, GCA can help them bridge the gap between physical and online gambling with integrated offerings that unify customer loyalty programs. Relationships with these existing, physical casino operators should help GCA gain further traction in the online marketplace.

GCA believes it is entering a kiosk replacement cycle, where new kiosk offerings are replacing not only older GCA products but also other brands. The kiosk business is a high margin growth area. GCA recently won a contract with Graton Casino in Northern California to supply a comprehensive payments solution, including kiosks. Revenue benefits from the deal should begin in late 2013 and early 2014. GCA plans to further roll out its QuikTicket (cashless gaming solution) product in 2014 after successful testing this year. Gaming patrons find the product to be easy to use and convenient, and casinos like that it makes moving around the casino (and therefore continued gambling) easier. Product adoption in 2014 should help grow revenues.

As the economy continues to slowly improve, gaming activity both in the US and globally should grow. There are plans for several new Casinos in the United States in 2014 and beyond, in places such as Iowa, Massacusetts (after licensing in 2014-2015), Ohio, and New York (a ballot measure to expand gambling is up for a vote in November 2013).

In addition, currently only 1.7% of GCA’s revenue is from outside the United States. GCA has started services in 47 locations in Europe over the past year, and is looking to expand further in Europe. The company is also looking to grow its presence in Asia, and has a sales office in Macau that caters to local customers.

Barriers to Entry

While competition in the cash access business has pressured margins, rivals tend to compete on price and have more limited product offerings. Several barriers to entry affect industry dynamics.

1) Regulatory: Like gambling itself, cash access services at gaming establishments are also heavily regulated. This regulation makes entering the industry more difficult and time consuming, and provides an incumbent advantage to larger, existing operators with scale. In addition, the regulatory hassle and reputational risk may keep larger financial players away from the gaming market, which is only a small sub-segment of the global payments system (among financial institutions, only US Bank is a major GCA competitor). Existing industry players, particularly in emerging areas like online gambling, are incented to team up with reputable, large partners with strong reputations, so as not to endanger their licenses.

In many jurisdictions, GCA is regulated by the local gaming authority and must obtain the necessary permits after making substantial disclosures to the government. GCA holds over 300 licenses in the course of business. At least ~45% of GCA’s domestic revenue is in states that require gaming related cash access providers to obtain licenses, while at least ~70% of domestic revenue is in states that require a license to operate slot machine ticket redemption and jackpot kiosks. Importantly, kiosk licenses tends to be more rigorous than cash access licensing, since kiosks are regulated more like gaming equipment.

2) Scale and network effect: Because of GCA’s market share, it has access to meaningful information about customer habits that has marketing value for casinos. Smaller competitors with less market share do not have this information reservoir (GCA has data on 8m patrons). For example, GCA can provide casinos with information about customer wallet share via its Casino Share Intelligence, QuikReports, and QuikMarketing products. GCA also operates the only casino related credit bureau, called Central Credit Services, which helps casinos make lending decisions based on both traditional credit reports and patron gaming histories.

3) Mission critical: While casinos have shown themselves to be price sensitive, they also know that cash access services are essential for their businesses. Casino patrons need a means to access money on the casino site that is fully functional 24/7, as they often do not bring sufficient funds themselves. GCA has the size and scale to minimize outages and provide 24/7 customer service to its casino customers. The company’s comprehensive product line-up also offers casino customers a single source of accountability, with one point person for GCA product and service issues (instead of 2-3 as with multiple vendors).

Valuation

I believe that GCA’s current business is worth ~$8.80 per share, but could be worth ~$9.85 per share with a more appropriate capital structure. Any additional earnings growth from online gaming, a market that is currently in its infancy, is further upside. GCA currently trades at a ~11% FCF to equity yield and a sub-10x P/E on cash earnings.

For valuation purposes, I compare GCA to one of its competitors in the ATM business, Global Payments (GPN). I also look to Western Union (WU) for benchmarking. Although WU operates a very different business, it is a transactions related company that many believe is under secular pressure. Given that I believe GCA has much brighter prospects, WU can offer a something like a “floor” valuation, and is a helpful, conservative comparison.

Both GPN and WU trade at ~8.5% 2013 FCFE yield. Best-in-class payment processor Visa (V) trades at a ~3.5% FCFE yield, with the payment processor average around ~6% FCFE yield. Given GCA’s intellectual property and differentiated growth avenues, I believe it deserves to trade at a modest premium to pressured peers GPN and WU, so I target an 8% FCFE yield for GCA.

GCA does not pay meaningful cash taxes due to a tax shield stemming from the company’s conversion from an LLC to a C Corp in 2004. The conversion-related deferred tax asset is expected to result in annual cash savings of ~$19m through ~2018-2019 (total anticipated remaining cash benefit of ~$114m). In addition, the company can use $32m in deferred tax assets related to net operating losses (representing about $95m in net state and federal net operating loss carryforwards). I account for both of these tax shields separately by normalizing cash taxes in 2013, and adding the present value of future tax savings.

2013 Adj. EBITDA: $72m (guidance of $70-74m, excluding equity compensation expense)

- Cash Interest: $7m

- Est. Normalized Cash Taxes: $18m

+ Bad Debt Expense: $6m

- Capex: $15m (guidance of $14-$16m)

= 2013 FCF to equity: $38m

Value @ 8% FCF to equity yield = $475m

+ PV of future tax savings @ 8% discount rate: $114m

= Value including tax shield: $589m

Value @ ~67m shares = ~$8.80/share

+ ~$1.05/share under target capital structure (see below)

= ~$9.85/share bull case

Debt and Capital Allocation

In addition to two acquisitions over the past several years, GCA has been using its cash to de-lever and buy back shares. Gross debt has declined from $274m in 2006 to $112m as of 2Q13. In March 2011, GCA refinanced its existing credit facility and senior subordinated notes with a new credit facility. The new facility amortizes, requires an excess cash sweep, and is subject to financial maintenance covenants. In May 2013, the company renegotiated its current credit agreement, lowering the  LIBOR margin to 3.0% from 5.5% and LIBOR floor to 1.0% from 1.5%. The change should save ~$3.4m per year based on current debt levels.

I believe GCA is under-levered, and that a more appropriate capital structure could add ~$1.05/share in equity value ($71m in additional debt-funded share buybacks). The company currently has $112m of gross debt and $47m of net debt outstanding, equivalent to 1.7x and 0.7x EBITDA respectively. Net interest is covered 5.2x by EBITDA. In comparison, GPN has 2.8x gross leverage and 1.1x net leverage. A $71m increase in net debt would bring net leverage to ~1.75x (modestly above GPN, but still well below 2011 levels of 2.2x). Now is a great time to lock in low rates with fixed rate borrowing (as opposed to the current floating rate facility) and eliminate many of the restrictive covenants in the current credit agreement (leverage, coverage, excess cash sweep).

The proceeds could be used to accelerate share buybacks or for a strategic acquisition. GCA has a $40m, two-year share buyback authorization outstanding. Since this most recent authorization took effect in early 2013, the company has repurchased 1.7m shares for $11.7m, leaving roughly 75% of the authorization outstanding. Capacity for additional debt means there is the potential to accelerate buybacks, but this would likely require refinancing the current debt into a new covenant light facility or bond. Management has not addressed this topic, but I see potential.

Risks

1) Contract renewals: GCA’s contracts with casinos typically last 3-5 years, but a portion are typically renegotiated every year. Over the past several years, pricing has been under pressure due to competition, particularly in the easier to access ATM market. While GCA is managing this pressure by emphasizing the comprehensive nature of its offerings, creating new, differentiated kiosk products, and expanding into new markets (online, international), competition could remain a factor.

2) Interest rates: GCA finances its business and ATM cash balances with a LIBOR linked loan. Substantially higher interest rates would increase borrowing costs. However, GCA recently negotiated a lower LIBOR margin on borrowing facility, which will help offset any increase in rates.

Cash EPS excludes stock compensation expense, amortization related to the LLC to C Corp conversion, and deferred taxes.

Important Disclaimer

The above text is the view of the author and is for informational and educational purposes only. It should not be construed as investment advice or a solicitation to buy or sell securities. The author may hold a position in the securities mentioned, and does not have to provide updates for changes to his view. The author does not warrant his work for correctness or accuracy. Perform your own due diligence before making investment decisions.

Catalysts

1) QuikTicket roll-out in 2014

2) Benefits from iLottery contract in 2014

3) Further legalization of online gambling in the US

4) New casino openings in the US

5) Additional expansion internationally