Description

Overview

ERI is a regional gaming company, which currently owns and operates seven casinos in five states.  It is in the process of acquiring Isle of Capri Casinos, bringing an additional twelve properties into the portfolio.

We believe ERI is an attractive investment at current levels.  The synergy opportunities from the Isle of Capri transaction are compelling, and we believe there is a high likelihood ERI beats its communicated synergy targets.  The properties themselves are well positioned, in markets with limited competition from new supply growth and some idiosyncratic demand drivers.  ERI is also one of only a few remaining regional gaming companies of scale that owns significant real estate holdings at its properties, and we believe there is incremental upside potential from real estate monetization opportunities.  We believe the Isle of Capri deal closing in April 2017 could precipitate several other catalysts that could contribute to share price outperformance, such as an increased float and sell side research analyst coverage.  The valuation is attractive, with shares trading at roughly 7.7x EBITDA and a  ~13.7% free cash flow yield on our Pro Forma earnings estimates, multiples we consider too cheap for a property-rich regional gaming company of scale.  We could see the shares appreciating to $25 or more over a 2-year timeframe, representing >55% upside from the recent price.

Investment Thesis

ERI is a regional gaming company that owns and operates casinos.  It was founded in 1973 in Reno, NV, by the Carano family.  Its portfolio today consists of three connected properties in Reno (Eldorado, Silver Legacy, Circus Circus), as well as one property each in Shreveport, LA (Eldorado), northern West Virginia (Mountaineer), Erie, PA (Presque Isle Downs), and Columbus, OH (Scioto Downs).

ERI is perhaps less well known than some of the other regional gaming companies, such as Boyd Gaming, because it IPO’d relatively recently, in 2014.  The shares have performed very strongly as they IPO’d in the ~$4 range and have appreciated to >$16 in a little more than two years, as the company made and integrated two very successful acquisitions (MTR Gaming and Silver Legacy/Circus Circus).  Management’s proven track record of improving margins at acquired properties adds to our enthusiasm for the Isle of Capri acquisition.

High Likelihood of Exceeding Synergy Targets from Transformative Isle of Capri Transaction

In September, ERI announced the acquisition of Isle of Capri for cash and stock.  The transaction is expected to close in April 2017.  This is a transformative deal that roughly doubles the size of the company.

On announcement of the Isle of Capri acquisition, ERI put out a synergy target of $35 million.  On the conference call, Tom Reeg, ERI’s president, said this about that synergy target: “We have detail on that $35 million down to the penny…and just know that we would not have put a target out there that we’re not highly confident we will exceed.”

Our understanding is that the $35 million is purely based on taking out redundant corporate costs, which can be accomplished within 90 days of closing.  Isle of Capri has over 100 employees at its corporate office in Saint Louis, whereas ERI has been running a similar size operation with only 15 employees at its corporate office in Reno.

Beyond the corporate synergies, we believe there are operational improvements ERI can achieve by running the actual casinos more efficiently.  As mentioned above, ERI management has a proven track record of improving margins at acquired properties, from two acquisitions the company has made within the past few years. 

A good example is Scioto Downs, ERI’s Columbus, OH, casino acquired in its 2014 acquisition of MTR Gaming.  Scioto Downs generated $57 million of EBITDA in the last twelve months, up from $42 million before ERI acquired it, according to the company.  ERI has been able to improve EBITDA largely through data-driven analysis to reduce player acquisition costs, effectively cutting out complimentary play offers that were not driving additional spend and were, in fact, unnecessary as they were being offered to players who kept coming to the casino anyway.  ERI believes it has a similar opportunity to cut down on this type of inefficient marketing spend at several of the acquired Isle of Capri properties.

Pompano Park, an Isle of Capri casino in Florida, is an especially intriguing opportunity as it has similar market dynamics to Scioto Downs and generates similar revenue (~$170 million), yet generates only $38 million in EBITDA compared to $57 at Scioto Downs.  This is in spite of Pompano actually having a materially lower gaming tax on its revenues (35% vs 42% at Scioto).  ERI believes it can significantly close the gap through more efficient marketing spend.

Moreover, at the national level, Isle of Capri has been spending $12 million annually on a company-wide advertising program of questionable effectiveness.  ERI believes there is room to cut this budget with minimal impact on revenue as well.

As another example, ERI runs the buffets at its casinos at breakeven, whereas Isle of Capri loses on average $2 – 4 million across its buffets at each of its twelve properties.  ERI believes this is another area for potential operational improvement, once it is able to apply its best practices across the Isle of Capri portfolio.

Adding this all up, we believe it is not unreasonable to assume that synergies plus operational improvements can increase the Pro Forma EBITDA of the combined companies by closer to $60 – 70 million, as compared to the $35 million target that was communicated at the time of the deal announcement.  This would put the combined company closer to a 25% EBITDA margin, as compared to the 22% margin shown in the merger proxy.

Finally, it is worth noting that ERI likely has additional opportunities to improve profitability from capital improvement projects with high ROIs.  The company has improved traffic at properties it’s acquired in the past by adding smoking patios or adding its proprietary Brew Brothers microbrewery and restaurant concept.  Isle of Capri also recently completed a new land-based casino extension to its property in Bettendorf, Iowa (originally a riverboat casino), and given that Isle of Capri has several riverboat properties in its portfolio, ERI could complete similar projects if it believes that makes sense, although we imagine the company will be highly selective around spending capital on these types of projects given its disciplined track record.

Properties in Well Positioned Markets with Limited Competition from New Supply Growth and Idiosyncratic Demand Drivers

Regional gaming is, for the most part, a mature industry, with limited expected demand growth nationally across the industry beyond GDP/inflation.  Generally there is also limited new competition from incremental supply growth, and that is true of Pro Forma ERI’s markets as well.

A compelling aspect of the ERI story, though, is that roughly ~40% of Pro Forma EBITDA will be generated from three markets that have idiosyncratic growth drivers:

Reno – ERI generates ~16% of combined pre-synergy EBITDA from its three properties in Reno, which are connected by enclosed sky bridges.  These are centrally located in Reno, and comprise ~1/3 of all hotel rooms in Reno.  Reno has been experiencing a rebound in its local economy and undergoing a bit of a renaissance, or as we are calling it, a “Reno-ssaince.”  Due to its proximity to Northern California, significantly lower taxes and cost structure than California, and inviting environment, the market has been attracting both more visitors and more investment from companies in California.  The best evidence of this is Tesla’s decision to build its multi-billion dollar gigafactory in Reno, which by some estimates will be the largest building in the world and create several hundred million dollars of wages annually for its local factory workers.  ERI’s Reno properties grew revenue ~6% in the first nine months of 2016, and this type of growth should continue for the foreseeable future as the Tesla factory is not expected to begin initial production until mid-2017, and should continue to scale through 2020.  Lastly it is worth mentioning that ERI is in the process of spending $50 million in growth capital expenditures to upgrade these properties, to make sure they are truly the best in the market and able to handle the expected influx of demand.

Scioto Downs – ERI generates another ~16% of EBITDA from Columbus, OH, where it has grown revenue ~5% year-to-date.  This is an undersupplied market with a growing population, only two casinos, and no more casino licenses expected for at least the next five years.  ERI is participating in a JV to build a Hampton Inn adjacent to the property, which should open in the very near term and continue to drive demand.

Pompano Park - ~11% of Pro Forma EBITDA will come from Isle of Capri’s Pompano Park casino.  Pompano Park is the only licensed harness racetrack in Florida, and this is another supply-constrained market with attractive local dynamics.  And as mentioned above, there appears to be no structural reason why EBITDA shouldn’t be more in line with that of Scioto Downs, which is ~50% higher.

We would also note that the new land-based facility at Bettendorf has only been open for two quarters, during which it has driven ~10% top line growth and ~18% EBITDA growth since opening.  So we would expect at least two more quarters of strong growth there.  And as mentioned above, ERI has the opportunity to build similar extensions at other of Isle of Capri’s riverboats, such as Kansas City and Cape Girardeau, although we are not expecting that in the near term.

Incremental Upside Potential from Real Estate Monetization Opportunities

Regional gaming companies have been monetizing their owned real estate in recent years.  Penn Gaming spun off its real estate holdings to create Gaming and Leisure Properties Trust (GLPI), a publicly traded real estate investment trust (“REIT”).  Subsequently, Pinnacle Entertainment did a large scale sale-leaseback, selling its owned properties to GLPI and signing a master lease with GLPI for those properties.  These transactions have been value creative for Penn and Pinnacle.

More recently, MGM Resorts also created a REIT, MGM Growth Properties (MGP).  Caesar’s is in the process of doing so as well.  As a result, there will be three publicly traded REITs focused on owning casino properties, all of which have a strong appetite for growth to satisfy their own investors.  The only way for them to grow is effectively through acquisition, and there are few regional gaming companies of scale left who own their underlying real estate.

ERI is one of those, owning property at the substantial majority of its casinos.  GLPI openly discussed on a recent conference call that it had been interested in acquiring Isle of Capri real estate when Isle of Capri was exploring a sale of the company. 

Given the low tax basis of many of ERI’s properties, we believe a full-scale sale leaseback, similar to what Pinnacle did, is unlikely.  However, we believe that there is a portion of the portfolio (roughly ~25% of the properties), where the tax basis is substantial enough that performing a sale leaseback could create significant shareholder value.  Bettendorf, Mountaineer, and Presque Isle fall in this category.  We believe the company is open to exploring this possibility.

On our math, this could create an additional $2 – 3 / share of value, as GLPI or MGP might pay ~12x for the rental income stream on roughly ~25% of the portfolio, which would obviously be value accretive given ERI now trades at ~7.7x EBITDA.

Additional Catalysts Once Acquisition Closes

We would call out several additional potential catalysts once the Isle of Capri transaction closes (expected April 2017):

Improved Float – Today, ERI only has an ~$800 million market capitalization, and an even smaller float as ~36% of shares are held by two families.  As a result the stock only trades ~$8 million of volume per day.  The shares issued in the deal will increase the market capitalization by ~60%, to close to $1.3 billion.  The improved liquidity of the shares should attract more investor interest.

Sell-Side Research Analyst Coverage – ERI has no sell side research analyst coverage, while Isle of Capri actually had a few analysts covering it (Deutsche Bank, Stifel, Wells Fargo).  We believe once the deal closes, we could see increased research interest in the company given its larger size and interesting story.  Initiation reports are likely to help disseminate that story.  JP Morgan is providing committed financing for the acquisition, so it could potentially initiate coverage as well.

Third Largest Regional Gaming Company – Related to the above points, Pro Forma ERI will have the third largest market capitalization in the regional gaming industry, after Boyd Gaming and Red Rock Resorts.  The increased scale should put the company on many more investors’ and analysts’ radars.  Scale also helps in the regional gaming business in that it allows an operator to offer higher expected return games that have higher variability (i.e., table games), since, with earnings diversified among more properties, an “unlucky” period at one property cannot have an outsized impact on consolidated results.  

Rapid De-Levering – ERI expects to have net leverage of 5.1x at closing.  The company has said it is comfortable between 4x – 5x given the real property ownership.  That said, with EBITDA growth and copious free cash flow generation, ERI should de-lever quickly – we estimate to 4.2x within two years.  It is worth noting that the new debt will have long maturities, of 7 years on the term loan, and 8 years on the notes.

More Acquisitions – Some estimate that there are another ~$1 billion of regional gaming assets that should trade hands in the next five years, based on the life cycles of funds owning them, and the trend of continued industry consolidation.  ERI has created value through a roll up strategy in which it runs acquired assets more efficiently, so we would not be surprised to see that trend continue in the future.

Attractive Valuation

At the current share price and Pro Forma for the Isle of Capri acquisition and the pending sales of two Isle of Capri properties (Lake Charles and Marquette), we estimate ERI will have a $1.24 billion market capitalization, with $2.09 billion of net debt, for a $3.34 billion enterprise value.

Pre-synergies and operational improvements, and post the two divestitures, 2016 EBITDA of the combined companies should be ~$360 million.  With a very small amount of growth, synergies, and operational improvements mentioned above, we believe this can grow to ~$435 million by year three, or 2019.  We would note this compares to a $455 million 2019 EBITDA estimate Pro Forma for synergies, taking the numbers from the merger proxy.

On our estimate, the current TEV represents 7.7x Pro Forma EBITDA of ~$435 million, and only 9.1x EBITDA less maintenance capital expenditures of ~$70 million.

With EBITDA of ~$435 million, total capital expenditures of ~$100 million (including $50 million of Reno upgrade spending spread over two to three years), and Pro Forma cash interest of ~$105 million, at a full tax rate the company would generate ~$170 million of free cash flow, compared to a market capitalization of $1.24 billion, representing a ~13.7% yield.  We would note that the company won’t actually be a full tax payer for the first two to three years, and is likely to have a cash tax rate in the low 20%s next year, scaling to 35% as it depletes tax attributes over the course of the next few years.  As a result of this, management actually said it expects Pro Forma free cash flow close to $200 million on the acquisition conference call, which would represent a >16% yield.

As we think about valuation, we are inclined to use EBITDA less maintenance capex, and use 10x, arguably a conservative multiple, especially considering the property ownership.  For reference, on our estimates, BYD trades at 10.8x this metric.  Using 10x our estimate of EBITDA – Maintenance CapEx of $365 million in 2019, once all the operational improvements are in place, and using a 12/31/18 net debt estimate of ~$1.7 billion (assuming interim free cash flow is used to pay down debt over the next two years), gets us to a target price >$25 per share, representing >55% upside from the recent price.

We believe this valuation is conservative in a few ways – the multiple, as mentioned above, as well as the timing, in that we are assuming the operational improvements aren’t fully complete until 2019, whereas in reality, if the company is making progress down this path, it is certainly possible that the market begins giving the company credit for these improvements in the stock price in an earlier timeframe.

Finally we note this valuation assumes no additional upside from real estate monetization, which, as mentioned earlier, we believe could add an incremental $2 – 3 per share of value.

Conclusion

ERI is an underfollowed regional gaming company that has announced but not yet closed a transformational acquisition.  We believe there is upside to the company’s formal synergy targets, backed up by management’s track record of improving operations at acquired casinos.  The acquisition should lead to a larger float and more interest from investors and sell side research analysts.  There is also an intriguing incremental upside opportunity from potential real estate monetization.  Adding it all up, we believe the shares could appreciate to $25 or more in two years or sooner, representing >55% upside from the current price.

Catalyst

Isle of Capri acquisition closing (April 2017)

Increased float

Sell side research initiations

Revenue growth from well-positioned properties

Margin improvement from exceeding synergy targets and realizing operational improvements at Isle of Capri properties

Free cash flow generation

Rapid de-levering

Incremental acquisition announcements

Potential sale leasebacks of owned real estate