Description

Argosy Gaming is a riverboat casino operator with operations in Lawrenceburg, Indiana (outside Cincinnati), Joliet, Illinois, Baton Rouge, Louisiana, Kansas City, Missouri, Sioux City, Iowa, and Alton, Illinois (outside of St. Louis). The Lawrenceberg operation generates approximately 46% of the company's EBITDA, while Joliet generates approximately 23% of EBITDA (pre-corporate overhead). The company currently trades at approximately 7.25x 2002 earnings and 5.6x 2002 EBITDA. The stock is down approximately 44% year to date due to a reduction in earnings estimates. The estimate decline has been a result of increased tax rates in Indiana and Illinois, competition in Joliet, Illinois from single level barges at two competitive properties, an aggressive competitor opening an expanded casino in St. Louis, slowing results at its lawrenceburg property in the last few months and threats from new gaming jurisdictions in Ohio and Kentucky.

The primary reason for the long position is valuation. At 7.2x earnings and less than 7x free cash flow excluding project capital expenditures (which I know is the big question mark with all gaming companies), this stock is cheap. Clean accounting, highly regulated industry, generally non-cyclical industry, and a decent management team should merit a somewhat higher valuation. Most of the bad news is priced into this name and it seems unlikely that much more could come out as a surprise.

The threat from legalized gaming in Ohio is overblown. The governor of Ohio recently vehemently opposed legalization of gaming at horse racetracks in Ohio, even going so far as to write a letter to legislators threatening them with not giving them board appointments after they leave office. The governor overwhelmingly won the recent gubernatorial election with an anti-gaming platform and his opponent favored gaming. In addition, Ohio has held two voter referendums in the last decade regarding legalization of gaming and both have been rejected. The threat from Ohio therefore seems overblown.

Legalization of gaming in Kentucky does pose a threat, but there is no certainty anything will be passed. The Attorney General of Kentucky has publicly stated in the past that he believes legalization of gaming would require a change to the state constitution meaning a voter referendum would be required. The governor has never really supported gaming in the past and is in the midst of a scandal regarding his personal life. Kentucky attempted to pass gaming last year and it failed. The major pro-gaming faction is the racetracks which want gaming to support the horse racing industry. It is hard to "handicap" the chances here, but Kentucky is a highly religious state and any gaming legalization would likely be a hard fought battle. Even with legalization of gaming at racetracks in Kentucky, Argosy's property in Lawrenceburg would do fine as it currently has more business than it can deal with. The property must turn people away every weekend and the biggest challenge is getting the most valuable players into the property before the lower end players. I am willing to take the risk of Kentucky legalizing gaming at this price.

Argosy's Joliet property has been hurt by competition from a nearby Harrah's property and a nearby Hollywood property which both recently renovated and installed single level barge based properties and other enhancements. In addition, Jack Binion's privately held nearby property is taking share due to recent marketing efforts. Illinois recently raised taxes on gaming and this is significantly impacting Joliet's profitability. Argosy is currently building a $40mm barge to install at Joliet to compete. The casinos in Illinois have been pushing to remove the 1200 slot limit at their properties to offset the higher gaming taxes. The last time Illinois hurt gaming operators with taxes it allowed dockside gaming the following non-election year, so there is some speculation that the same could happen this time around. Another risk to the Joliet property is that Illinois currently has an unused license which it is trying reclaim and auction. Chicago Mayor Daley has expressed interest in this license, but this is likely just a grab to make sure he gets some benefit from the next license (tax revenue or some other point in the next state budget).

Argosy's Alton property has been hit by the opening of Ameristar's large barge property. Ameristar has been heavily promoting this property because it is intent on gaining market share. Its pattern has been to historically spend a lot upon opening to gain share and then ratchet down the spending. Argosy is not responding aggressively to this marketing effort.

A final risk is increased taxes in Missouri (impacting the kansas city, missouri property) and Iowa. Both are largely expected and won't surprise any investor in Argosy. If Missouri doesn't raise taxes, this would be a positive surprise for Argosy.

The big question seems to be whether or not there will ever be any real free cash flow from this gaming company and others. It is a great question, and one which I do not have a great answer for other than that I believe the same is true in many industries and the stocks don't trade at 7x earnings. Argosy has a decent amount of leverage, so it can't really do anything stupid with its cash flow, although the board of directors is probably more interested in growth than deleveraging or stock buyback. The company could try to get into the racino (slots at racetrack) business if opportunities arise, but the management team understands the idea of generating good returns rather than growth at any price.

Catalyst

Argosy would make a highly attractive acquisition candidate for any larger company
Expansion of position limit in Illinois
Rejection of gaming in Kentucky
SHARE BUYBACK
Financial Deleveraging