|Shares Out. (in M):||40||P/E||33.0x||19.0x|
|Market Cap (in $M):||300||P/FCF||5.0x||4.1x|
|Net Debt (in $M):||1,019||EBIT||102||112|
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I am recommending a long investment in Isle of Capri Casinos (NASDAQ:ISLE). At an EV of ~$1.3bn, ISLE is uniquely the only public regional gaming operator left that is both (i) large enough to be significant to larger peers as an acquisition target, and (ii) small enough to be digestible. I believe the stock will do well over 6-12 month horizon given (i) its meaningful valuation discount relative to peers, (ii) substantial free cash flow (yield ~25%), and (iii) a soft catalyst from Penn National Gaming’s (NASDAQ:PENN) pending propco spinoff and REIT-conversion over the next 3-4 months.
ISLE is a derivative trade on the gaming-REIT theme, which is playing out in regional gaming. PENN’s formation of the first dedicated gaming REIT will introduce a new source of capital to the gaming sector, which has the potential to raise valuations across the entire space. As I discuss herein, the dynamic of expanding multiples in regional gaming, combined with highly acquisitive management teams will likely lead to a takeout of ISLE in the intermediate term. ISLE’s high financial leverage (debt-to-EV) combined with its long-dated maturity profile, provides long-term optionality and leverage to rising valuations and consolidation in the regional gaming sector, resulting in 100-150% upside for the stock.
ISLE focuses on smaller markets and a lower-end client demographic. While its customer base was hurt disproportionately in the downturn, this niche focus has helped to shield ISLE from some of the competition and cannibalization facing the larger regional players. Smaller markets offer less compelling demographics to prospective new entrants, and higher-end product is of less interest to ISLE’s core customer. To draw a rough analogy, if a Saks opens up across the street from a Neiman Marcus and a Sears, it’s going to compete primarily with the Neiman Marcus – not the Sears. In a similar way, a new Ameristar property (which tends to be among the larger and higher end of regional properties) opening in a market where ISLE competes is more likely to cannibalize the larger BYD/PENN/PNK properties than it is to take customers from ISLE. In this way, ISLE can fly somewhat under the radar in markets where it faces competition. This small market focus also results in more limited overlap with larger peers, and therefore, forced divestitures of properties are less likely to be required by the FTC if ISLE were acquired by one of these peers.
ISLE owns 15 regional casinos based primarily in the Midwest and Southeast, and has a fairly geographically diversified footprint. Pro forma for new properties in Giarardau, MO and Nemacolin, PA (both brought online within the past year), ISLE’s revenue composition by state will be: ~25% MO, ~20% IA, ~15% FL, ~11-13% in each of LA/CO/MS and ~5% PA. Its largest markets by revenue are:
In conversations with management, they have indicated ISLE may pursue small acquisitions of privately owned casinos if the opportunity arises, but they acknowledge the multiple arbitrage to be realized through a sell-side transaction with one of its larger peers. The CFO, Dale Black, has a long background in regional gaming (previously at Trump and Argosy) and has lived through past periods of industry consolidation. As CFO at Argosy, he oversaw its sale to Penn in 2005. I view the management team as accommodative to an acquisition of ISLE at the right price. ISLE is too small to really make sense as a standalone public Company, and its overhead (~12% of property EBITDA) could be completely taken out through consolidation with a larger peer – not to mention other synergies to be realized through player databases, marketing, etc.
Regarding ownership, ISLE is a fairly closely held company with a small float. The Goldstein family, heirs of the Company’s founder Bernie Goldstein, owns ~40% of the equity. The family is not involved in the business, except through Board seats, and given generational separation between the current owners and the founder, the family likely has fewer non-economic motivations than sometimes exist in other family-owned businesses.
Over the LTM, ISLE has experienced softness in its markets, consistent with what other operators are seeing, especially in Mississippi where the economy has been especially poor. In recent months, Florida (ISLE’s second largest property) has shown strength in contrast with many areas of the country. In May, June and July, the Pompano property’s gross gaming revenue (GGR) was up 16%, 6% and 5% respectively, and August is pacing up mid-teens MTD – this growth has helped to offset softness in weaker markets. Blackhawk and Lake Charles both put up top-line growth in 1Q’14 (ended July’13), and the recent opening of a remodeled hotel tower at Lake Charles should support growth there into the rest of this FY.
My thesis on ISLE is premised on a base case of flattish organic revenue growth. However, comps ease substantially throughout the rest of the year, and any organic growth is upside to my thesis. There is an ongoing discussion around why softness in regional gaming has persisted in the face of a somewhat strengthening (or at least not increasingly worse-off) consumer. While the recession caused patrons to change visitation habits and these habits have not returned to pre-recession levels, I do not believe there is anything that has structurally changed so as to impair flow-through of consumer spending to gaming eventually. Consumers may be first focusing discretionary spending on home-repair, postponed vacations, or other deferred purchases, but increased leisure spend should eventually contribute to growth in regional gaming as the economy improves. I am not forecasting a near-term rebound in gaming, but I believe that flattish y/o/y growth will persist and near-term risk is likely to the upside given relatively easy LTM comps.
Cash and Marketable Securities: $153mm*
Notes and Other: $1bn
Net Debt $1bn
Market Cap $300mm
*PF for sale of Davenport property
Most of the regional gaming market is concentrated in the hands of PENN, BYD, and PNK (which recently acquired ASCA), while a few of the Las Vegas Strip operators (CZR, MGM, WYNN) own regional assets also. Regional gaming assets vary from riverboats and racinos to larger hotel & casino properties – some assets are located near large cities and even in CBDs, while others are based in rural locations. As with Las Vegas gaming, regional markets are strictly regulated by state agencies, and the taxes/availability of licenses/etc. vary state-to-state. Whereas regional gaming began with only a few markets, many more states have since legalized gaming in varying forms, resulting in inter- and intra-state cannibalization. While US regional gaming is approaching a point of stabilization of supply in the established markets, some markets are still characterized by promotional competition and the threat of new entrants.
I will generalize the key players: PENN is the largest and generally viewed as the best operated collection of assets with a strong management team. Its assets are scattered across the Midwest, South, and Southeast. BYD acquired Peninsula gaming in 2012 and is a play on Las Vegas locals, Midwest/South/Southeast markets, and to a lesser extent Atlantic City through its 50% ownership stake in Borgata (MGM owns remaining 50%). BYD has also benefitted from investor interest in online gaming, given its minority stake in bwin.party (Party Poker) and NV/NJ presence. BYD is heavily levered and until recently has been primarily focused on deleveraging through FCF and non-core asset sales. However, with its recent secondary offering (proceeds used to redeem notes), management has signaled that it is comfortable with its balance sheet and seems to be turning back towards it historical ‘go-to’ strategy of growth through acquisitions. Before its acquisition of ASCA, PNK was heavily concentrated in the Louisiana market, but now is more diversified across the South and Midwest. Like BYD, PNK’s acquisitions have resulted in high leverage and a need for debt reduction through FCF generation. Below are estimated PF valuation multiples and leverage for the publicly traded regional gaming operators:
TICKER / EV / LEVERAGE / FWD EBITDA MULTIPLE / FCF YIELD (ex-growth capex)
GLPI / [6.1bn] / ~6.5x / [14x] / [8%] *
BYD / 5.2bn / ~6.3x / ~9.0x / ~18% **
PNK / 5.1bn / ~5.5x / ~7.5x / ~23% ***
ISLE / 1.3bn / ~5.0x / ~6.5x / ~25% ****
*Estimated PF PENN REIT (“GLPI”) spin-off
**At-share and PF for secondary offering
***PF for ASCA acquisition
****PF for divestiture of Davenport property; based on PF FY’15 EBITDA and FCF of $204mm and $73mm
On average, BYD, PENN, and PNK’s properties are larger than ISLE’s, but a meaningful component of these larger operators’ portfolios is smaller market, lower revenue properties. While there is certainly a desire by these larger operators to preserve the integrity of popular casino brands, I have spoken with management teams at all of these companies, and I believe that they are interested in accretive acquisitions (even) of smaller assets at the right price. As regional markets have become saturated, these casino operators are in search of new ways to grow. With consumer spending growth in casino properties persistently anemic, management teams will surely look to smaller operators as a way to grow their footprint.
The debt markets have always loved gaming assets due to their real estate component and cash flow. Management teams have come to expect this readily available low-cost capital and therefore feel comfortable pushing enterprise debt-to-equity ratios up to 3x or more in order to finance acquisitions and new developments. This high leverage has juiced the equity FCF yields (before growth capex) of gaming operators, with yields commonly exceeding 20%. Unfortunately for those operators with concentration in highly competitive markets, most of this FCF has been reinvested in new developments, just to maintain existing volumes and offset cannibalization. This running-in-place dynamic has led some management teams to look for other means of growing and generating shareholder value – they naturally gravitate toward acquisitions. Below are precedent transaction comps for regional gaming assets:
ANNOUNCED / TARGET / ACQUIROR / PRICE / FWD PROPERTY EBITDA MULTIPLE
Aug-13 / Lumiere Place (PNK) / Tropicana / 260mm / 7.5x
Mar-13 / Oxford Casino / Churchill Downs / 160mm / 7.5x
Dec-12 / ASCA / PNK / 2.8bn / 7.7x
May-12 / Peninsula / BYD / 1.5bn / 7.0x*
May-12 / Harrah’s St. Louis / PENN / 610mm / 7.8x
June-11 / IP Casino / BYD / 332mm / 7.2x
AVERAGE: 7.5x EBITDA
*Deal included an earn-out for the Kansas Star property, which is not reflected in this multiple (i.e., this multiple is conservative)
Valuations for regional gaming asset transactions have ranged from 7-8x over the past two years. Since the IP Casino transaction, regional gaming stocks are up well over 130%. I expect this public multiple expansion will continue, leading to expanding transaction multiples. At a multiple of 7.5x ISLE’s PF property EBITDA, the stock has upside to $18.60 (+150%). At a more conservative 7.0x, it has upside to $15.60 (+110%).
The Penn REIT
PENN has been previously written up on VIC and its REIT conversion discussed at length. So, I will not go into detail here, except to provide a high level overview given its relevance to the ISLE thesis.
In November 2012, PENN announced plans to separate its real estate through an Opco/Propco structure and convert Propco to a REIT. A spinoff of Propco is expected in 2H’13 with the REIT-conversion in 1Q’14. The transaction was structured to effectively split PENN’s EBITDA between Propco/Opco on a 50/50% basis, and with a number of mechanisms geared at forming a sustainable relationship between the Opco (gaming operator) and Propco (landlord). Opco will enter into a master lease agreement with Propco under a triple-net structure.
As with all non-traditional REIT conversions, the question in the market is always: ‘where will the REIT trade’? In attempting to compare PENN, a gaming REIT, to triple-net or lodging REITs, there are clear differences that diminish their usefulness as a valuation barometer. Most argue that the PENN REIT should at least trade above 13x EBITDA (~6.6% dividend yield and ~12x AFFO) and many argue for a 14-15x valuation (~5.5% dividend yield and ~14.5x AFFO). In either case, a low/mid-teens valuation implies substantially cheaper cost of capital than non-REIT operators trading at 7.5-9x EBITDA, and even more-so compared to ISLE trading at 6.5x.
ISLE is a small market operator with lesser quality assets than its larger peers, but it is run by a strong and experienced management team, has a low-cost long-dated capital structure, and trades at a valuation suggesting well over 100% upside. The trade works two ways: First, the PENN REIT conversion in the beginning of 2014 should provide a tailwind to valuations across the sector, and ISLE’s discounted valuation most of all. PENN will likely be an aggressive acquiror of assets right out of the gate, and a couple successful transactions will lead the market to increase its valuations of all operators’ real estate. Second, the lack of new markets and capacity constraints in existing markets, combined with rising valuations across the sector, will lead larger operators to look for acquisition targets. There are a number of different scenarios under which ISLE could be bought out: (i) equity financed acquisition by BYD/PNK that would be deleveraging to the buyer, (ii) acquisition of ISLE’s real estate by the PENN REIT and properties operated by another non-ISLE operator (ISLE’s corporate overhead dissolved), (iii) (while less likely) a sale of the real estate of certain properties to the PENN REIT while ISLE continues to operate as a standalone company, or (iv) acquisition by a smaller private operator. While it’s hard to handicap which scenario plays out, I believe ISLE is sure to benefit from the PENN REIT spinoff and will likely be taken out at some point over the intermediate term.
In addition to the valuation arbitrage play, ISLE is also a FCF story. With the completion of its Giarardeau and Nemacolin developments, and with most of the remodels and deferred capex from the recession now caught up, ISLE should generate $70-75mm of FCF next FY (~25% yield). Management has indicated its focus on deleveraging, and possibly other shareholder returns.
Given the dynamics surrounding the regional gaming sector and PENN REIT spinoff, I view ISLE as a high potential takeover candidate with optionality on rising valuations in the sector. It’s discounted valuation, strong management team, and high FCF yield makes it the most attractive regional gaming trade that capitalizes on the gaming REIT theme.
DISCLAIMER: DO NOT RELY ON THE INFORMATION SET FORTH IN THIS WRITE-UP AS THE BASIS UPON WHICH YOU MAKE AN INVESTMENT DECISION - PLEASE DO YOUR OWN WORK. THE AUTHOR AND HIS FAMILY, FRIENDS, EMPLOYER, AND/OR FUNDS IN WHICH HE IS INVESTED MAY HOLD POSITIONS IN AND/OR TRADE, FROM TIME TO TIME, ANY OF THE SECURITIES MENTIONED IN THIS WRITE-UP. THIS WRITE-UP DOES NOT PURPORT TO BE COMPLETE ON THE TOPICS ADDRESSED, AND THE AUTHOR TAKES NO RESPONSIBILITY TO UPDATE THIS WRITE-UP IN THE FUTURE.
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