Description

Gateway Casinos Income Fund (GCI-UN)

As Steve Wynn likes to say, the only way to make money in a casino is to own one, and Gateway Casinos Income Fund (GCI) offers an unusually good risk/reward profile for doing so.  GCI is a Canadian unit trust that operates seven casinos in what are essentially oligopoly markets in British Columbia (BC) and Alberta. It has a market cap of about CA$467mm, is trading at about CA$15.00, and has an intrinsic value of CA$20.00+ (margin of safety 25%). GCI also offers a distribution yield (equivalent to a dividend but paid monthly instead of quarterly) of about 10%, so you get paid to wait here and collect a nice total return when the stock appreciates.

Why Is GCI Attractive?

Ø       Classic Greenwaldian Competitive Advantage - Gov. License:  There are currently only 18 gaming licenses in BC and a moratorium on new licenses has been in effect in since 2002 (the majority of GCI’s revenues are earned in BC), and new gaming license issuances in Alberta, the other Canadian provice that GCI operates in, are very hard to get. GCI’s also benefits from exceptional locations in the Vancouver metro area. Since the BC gaming market is geared towards local gamblers, the proximity of GCI’s casinos to Vancouver suburbs and their easy road access reinforce the fund’s competitive position.

Ø       Growth W/in the Franchise For Free:  With a CA$1.43 / share annual distribution and a 9.5% WACC, the current price of CA$15.00 implies essentially 0% growth for GCI.  But:

o        The fund has in fact grown distributable cash per share at a CAGR of 4.6% since the IPO in 2002.

o        Recent acquisition of Cascades casino offers upside—it was accretive by about 3.7% per share but there is significant upside to the acquisition price EBITDA level .

o        Burnaby expansion –Target opening of expanded property in the Spring of 2008, will double the casino’s current number of table games and increase its number of slot machines by 47%.

o        Vancouver population growth – 2010 Olympics, Vancouver area becoming more popular retirement destination. lots of new residential construction.

o        BC demographics- BC has the highest rate of inter-provincial migration and its population is getting older (retirees like to gamble).

o        BC is undergamed - BC per capital annual gaming spending is CA$427.50 with Canadian average at CA$516.80.

Ø       Significant Inside Ownership & Good Management: Approximately 32% of GCI is owned by insiders, and management is sound and financially conservative.

Ø       FCF yield: GCI is trading at a free cash flow yield of about 9.8% (including FDF reimbursements) or CA$1.46 per share.

Ø       Cap Ex Reimbursement From The British Columbia Lottery Corporation (BCLC): Contributes to exceptional returns on equity.

Ø       Paid To Wait: The 9.5% distribution yield (Note: 15% of distribution can be withheld for non-Canadian investors) lets you get paid while you wait for GCI to grow and investors to bid down the yield as they become more comfortable with the story.  It’s also a good way to be short the U.S. dollar via a business w/ revenue and expenses in a stable Canadian economy benefiting from higher commodity prices.

Ø       A Business I Would Like To Own In Its Entirety: Simple business and great margins, significant barriers to entry, growing market, good management team, strong cash flow production, and not capital intensive (due partially to FDF reimbursement, see below).  I can’t predict the future, but I know that over the long haul things are more likely to go right than wrong for this business.

Why Is This Stock Overlooked?

Ø       The Canadian business unit trust is essentially a retail investor product, especially for the smaller caps. These investors are totally focused on yield and not particularly interested in fundamental analysis or really drilling into these businesses to distinguish them from the 250+ trusts out there. Since GCI’s debt level will increase temporarily over the next two years, the perception is that this makes the stock and the yield more “risky.” A thorough analysis indicates otherwise.

Ø       There is also concern about too much competition in BC, but again, a thorough analysis indicates that there is ample demand for GCI’s properties into the foreseeable future and that the business benefits from some significant barriers to competition.

Ø       Macro issues – there was talk in late 2005 of changing the tax treatment of unit trusts, and most of them traded down. There will be no tax change over at least the next few years, but many stocks never recovered from this threat.  Also since the unit trust is an income-oriented product, all of them are susceptible to market gyrations over interest rates, and GCI has suffered from this to some extent as well.

GCI’s Business

Headquartered in Burnaby BC, GCI went public as a unit trust in October 2002.  It currently operates seven casinos:

-Burnaby Casino in Greater Vancouver, BC (37% of 2007 Revenue)

-Cascades Casino in Langley, BC (20% of 2007 Revenue)

-Four Lake City Casinos in Kamloops, Penticton, and Vernon BC (26% of 2007 Revenue)

-Palace Casino in Edmonton, Alberta (17% of 2007 Revenue)

The company breaks out P&L for each property in its filings on Sedar, I won’t waste your time here repeating it.

Some additional detail on the key assets:

Burnaby

The Burnaby casino is approximately 35,000 square feet in size and is located in an eastern suburb of Vancouver.  In 2005, Burnaby had sales of about CA$46mm (14% increase over 2004) with an EBITDA margin of about 55%.  The casino has a very convenient location and a strong following from local die-hard gamblers.  Burnaby’s 2005 performance was especially encouraging given new competition from the River Rock Casino that opened in 4Q05 (see below – Direct Competition) and the fact that the facility is cramped and not particularly attractive—it is essentially a converted parking garage. GCI recently purchased a hotel across the street from the casino and is in the process of expanding the property into a 100,000 square foot casino that will include a full-service restaurant, a new lobby for the hotel and convention centre, as well as upgrades to the existing 200 hotel rooms. Upon opening the new facility, the existing casino will be converted to parking. Excavation and site preparation work has been completed and piling work is ongoing. The expected opening date is spring of 2008. Management believes that the total project cost, including the purchase price, will be ~CA$130 mm and estimates that approximately 80% of this cost will be reimbursed under the FDF. This demonstrates the tremendous ROE opportunities available to GCI via its relationship with the BCLC.  Management recently signed a contract fixing ~70% of the project’s total cost. The remaining costs primarily represent items such as furniture and fixtures, interior finishing, pre-opening costs, etc. Burnaby revenue in 2009 (its first full year) is expected to be about $66mm with some EBITDA margin compression due to the addition of the hotel and F&B offerings that are not quite as profitable as pure gaming operations.  

Cascades

In April 2006, GCI purchased the Cascades Casino in Vancouver from GC Inc (see below), its developer.  The casino opened in May 2005 and is comprised of a 53,000 square foot casino, offers full F&B, a 420-seat for live entertainment and a 77-room hotel.  The purchase price was approximately CA$106mm—GCI paid CA$32mm in cash (financed via bought public offering of 5.35% convertible bonds) and issued 4.6mm units of GCI (@  about $15.70 per share). The purchase price equated to an EBITDA multiple of about 9.8x and the transaction is expected to be accretive to distributable cash per share by about 3.7% in 2006.  Cascades only recently finished its first full year of operations and is still completing a parking structure.  The facility has not yet done any marketing for its convention center and its entertainment center is closed until adequate parking can be provided. Given these considerations and the fact that cash flow for these assets typically ramp in the first few years, it is likely that Cascades will deliver significantly increased EBITDA over the years. It did CA$11mm in its first year, and management has stated that it would not be surprised to see an EBITDA run rate closer to CA$13mm over the next 12-24 months.  Given its immediate success, it would not be surprising to see Cascades could deliver accretion closer to 7% in 2007. Concurrent with the acquisition, GCI announced a 3.9% increase of the monthly distribution.  The purchase of Cascades drew mixed reviews and the deal was only approved by about 52% of the shareholders—some claimed that valuation was too generous for GC Inc. Management points out that (1) it was a competitive process and had they not paid what they did they would have missed it, (2) there is real upside in the EBITDA, (3) it is important for GCI to secure its dominance in the Vancouver area from a competitive standpoint, and (4) there are synergies to be had by GCI (ex. marketing w/Burnaby, centralized management).

Gateway Casino Inc. (GC Inc.) & Inside Ownership

GC Inc. has managed casinos in BC since 1992. All the casinos that GCI operates were originally developed by GC Inc. At the time of the IPO, management opted to leave under-development properties at GC Inc. Once such properties matured and achieved stable cash flow generation, they could be acquired by GCI (GCI holds right-of-first-offer). The Chairman and the CEO of GCI are also directors of GC Inc. In addition, 3 other directors of GC Inc. are Trustees of GCI. As a condition to obtain the approval of BCLC for a secondary offering in Sep/2004, the GC Inc. shareholders have agreed that their collective ownership of GCI cannot go below 20%. Management and Trustees currently own 2.3% and 14.9% of GCI, respectively. GC Inc. is currently developing two properties that can be vended in: Queensborough Casino in New Westminster, BC (scheduled to open late-2007) and Baccarat Casino in Edmonton, Alberta (currently going through rezoning process).

Direct Competition

GCI essentially controls casino gambling in the BC interior, while Great Canadian Gaming (GCD), a public company that operates 7 casinos in BC, is the only casino operator on Vancouver Island. GCI and GCD compete directly in the lower mainland region of BC, (i.e., metro Vancouver).  GCD is Canada’s largest casino operator (9 casinos and 2 racetracks) and also has a presence in the US (Washington State – 4 casinos). The founder and CEO, who owns 25% of shares outstanding, has been rapidly growing the business through an aggressive acquisition spree in 2004 and 2005 combined with facility improvements at its existing locations. BC’s lower mainland is essentially a duopoly between GCD and GCI. In addition to its 7 casinos in BC, GCD also owns 2 horse racing facilities in the same province, which combined have 800 slots. GCD also owns 2 casinos in Nova Scotia, 2 horse racing facilities in Ontario and 4 casinos in the Washington State.  The market sees GCD as a likely continued consolidator of the Canadian gaming industry, mostly through the acquisition of other racetracks in Ontario, which is still a fragmented market for these gaming facilities that combine horse racing and slots.

River Rock

The recently completed River Rock is the crown jewel of GCD’s properties. The resort portion of the hotel was fully opened during Q3 05 (casino floor opened in 2004). It is part of the next generation of BC casinos (larger, destination-style) and the main competitor of GCI’s Burnaby Casino. However, since the opening of the casino, both River Rock and Burnaby have continued to show strong top line growth and sustained high margins, indicating that the market is big enough for both casinos to thrive.  Great Canadian recently issued an “earnings warning” for its Q4 2005 results. Management estimated that at least 50% of the EBITDA “miss” in the quarter was one time in nature relating to incremental start-up costs in River Rock and Boulevard casinos. The balance can be attributed to acquisition expenses, higher overhead, an increase in stock-based compensation and amortization costs, and general ebbs and flows in the nature of calculating the win. A bond rating agency put GCD's debt rating under review with negative implications, despite recognizing that the primary causes of the earnings shortfall appeared to be temporary factors. GCD’s stock price suffered a 25% decline in the weeks following the announcement, leading to the resignation of the COO. Although all of the problems faced by GCD seemed company-specific, the stocks of the two other publicly traded Canadian gaming companies (GCI and Gamehost) also declined. There has been speculation during 2005 that GCD will convert to an income trust.  In addition to GCI’s redevelopment of the Burnaby Casino, two other projects with completion targeted for 2006 and 2007 are under development: (1) a racetrack at Hastings Park, with 600 slot machines (October 2006), (2) the Queensborough Casino in New Westminster (December 2007). These properties are expected to have very minimal impact on GCI and GCD operations.

Gaming In Canada

GCI currently derives about 83% of its revenues in BC (57% in the Vancouver area), so this analysis will focus on BC.  GCI operates six of the 18 gambling facilities currently licensed in BC (other than GCD’s properties, the rest are mostly “racinos.” BC licensees operate pursuant to Casino Operational Services Agreements (COSAs) signed with the British Columbia Lottery Corporation (BCLC). These COSA’s require licensees to share a substantial portion of their revenue with the BCLC (see below), and this revenue is a significant source of revenue for BC—in 2005 BC earned $819mm in revenue via these revenue shares, or 2.4% of the province’s operating budget.  Each COSA has a ten-year term and can be extended at the option of the licensee as long as the licensee is not in breach of a COSA, there has been no change in government gaming policy, and the BCLC approves a business and facilities plan for the extended term. GCI’s has remaining terms on all of its licenses of at least five years, except for one casino (Penticton ~8% of revenue) that expires in 2009. 

The BCLC determines which games and products are available, the rules of play and operating standards and the payouts. GCI provides the facilities, furniture, labor, security, marketing and administration required to keep the casino running smoothly. In exchange, it receives a fixed percentage of the win (amount wagered less pay out to customers):

­        25% of slot win

­        40% of table games win

­        70% of win on craps up to CA$240,000 per quarter and 40% thereafter

­        75% of the “rake” (3-5% poker table charge for providing a dealer)

Cap Ex Reimbursement

Under the terms of the COSAs, the BCLC deposits a facility development fee (FDF), equal to 3% of the total revenue generated from the table games and slot machines at each BC casino into a trust account managed by the casino operator. These funds are used to reimburse GCI for eligible capital expenditures. When GCI incurs an eligible expenditure, it can draw the amount of the expenditure from the FDF. Any funds not reimbursed accumulate in the facility development fund for future eligible expenditures. In general, all capital expenditures to develop or improve a casino are eligible for reimbursement (e.g. building, leasehold improvements, cash and coin equipment, and leases for premises net of interest). For example, GCI will be reimbursed via the FDF for its major expansion of the Burnaby facility.

No New Licenses

In January 2002, the BC government announced a moratorium on new casino licenses and restricted relocation of existing licenses only to those casinos that had already taken significant steps and made investments based upon direction from government. Thus, the only way to get access to the gaming market in BC is to buy existing operations subject to a rigorous license approval process by the BCLC. It is possible that this moratorium could be lifted in the future, but the need to obtain community support for new locations makes expanding existing licensee properties a more desirable route for increasing the BCLC’s revenue. Further, since the BCLC provides the slot machines and other gaming equipment used in any licensed casino, it must consider ROI for each license it grants. It is economically preferable for the BCLC to invest in proven existing locations with high traffic levels and proven operators by licensing expansion (ex., adding 200 slot machines, expanding gaming floor) instead of taking the risk of outfitting new, possibly less desirable locations/facilities that may suffer from low attendance.  This is demonstrated by the trend towards expanding existing casinos into miniature destination-style casinos (ex., Burnaby expansion, River Rock Casino) from the stripped-down neighborhood gambling halls that they started out as when gambling first became legal in the province.

Valuation

There are several ways to think about valuation for GCI, all of converge on a value of CA$20.00+. 

First, given that business unit trusts were designed to be stable cash-flow businesses that distribute all of the cash they generate to income-oriented investors, it is useful to think about the stock in terms of the Gordon Growth Model.  GCI’s current annualized distribution per share is CA$1.43 (excluding annual top-off payments which have in fact been made each year since 2002). GCI has grown the distribution at a CAGR of about 4.6% since the IPO, and given the expansion of the Burnaby facility, the potential accretion from Cascades, limited competition in an “undergamed” BC, and a Canadian economy growing at 2.5% a year (average annual GDP growth rates are 2.83% and 2.97% over the 1986–2005 and 1976–2005 periods respectively), it seems reasonable to assume a perpetual distribution growth rate of say 2.0%.  Assuming a cost of capital of 9.5%, this produces a value of about CA$20.00 per share.

Second, GCI at its current price compares favorably to public comps. GCI is currently trading at about 9.7x 2007 proforma EBITDA (includes Cascades acquisition but does not include increased revenue and debt from Burnaby expansion).  This is at the low end of the range of comparable publicly traded American Casinos, which tend to trade for 10.0 – 12.0x EBITDA. But GCI is arguably a better business than the typical American casino for the following reasons: (1) it does not pay corporate taxes which contributed tp operating margins that significantly higher, (2) it is reimbursed for capital expenditures by the government and does not have to endure ever-escalating cap ex battles with its competitors, (3) it has a significant competitive moat via its licensee relationship with the province in a strong gaming market.  Given these considerations, it seems reasonable to apply an EBITDA multiple of say 12.5x 2007 proforma EBITDA of  CA$55mm,  which implies a stock value of about CA$20.00.

Third, given the steadiness of the GCI business and the relatively predictable nature of its distributable cash, a 5-year DCF is also a useful approach to valuation here.  Assuming a discount rate range of 8.5 - 9.5%, Revenue CAGR of 11%, EBITDA margins that erode slightly into the 38% range, and a terminal value calculated using a 2% perpetual growth rate (terminal value accounts for approximately 75% of the NPV), GCI shares are worth CA$20.00 - CA$23.00.

Finally, perhaps the most practical consideration in terms of GCI’s share price appreciation potential is the distribution yield, as this is how most Canadian investors think about these stocks.  Since the IPO, GCI average yield has been about 8.6% (7.7%, since Jan-04) and it currently trades at about a 10% distribution yield.  Assuming some of the concerns about GCI that have been holding the stock at this yield (see Bear Case) fade over time as the company continues to deliver solid distribution growth but that rising interest rates still prop up the yield somewhat, it is reasonable to assume GCI settles into say an 8.5% trading value over the next two years.  Assuming that the distribution grows only at its historical rate of about 4.6% (this rate was purely organic other than an increase in the number of slot machines at Burnaby from 300 to 679 in 1Q05), GCI would trade at about CA$18.46 in two years.  This would equate to a total return (distributions plus unit appreciation) of about 44% at the current stock price of CA$15.00 (20% per year).    Also, GCI is currently distributing only about 92% of its distributable cash—management expects to increase this rate over the next few years as it completes the Burnaby expansion.  This provides additional upside to the per share distribution (and therefore potential valuation) that is not included in the above calculations.

Bear Case

Some potential negatives on GCI are as follows:

Competition/Demand – Three new casinos opened in BC in 2005: River Rock, Cascades, and Edgewater.  Some have been skeptical of the area’s ability to absorb this much gaming, and this has weighed on the stock.  But the fact is that revenue has continued to grow steadily at GCI’s BC properties despite these additions and a thorough review of the market shows that there is ample demand for gambling among BC’s growing population. The BCLC could end the moratorium at some point in the future and increase its share of it revenue splits with operators after their agreements expire.  This is certainly a risk, but BCLC has a strong economic incentive to ensure the success of existing operators by not making dramatic changes in the supply of gaming venues going forward, and changing the splits would surely damage the BCLC’s reputation and diminish interest among operators in working with the BCLC in the future. A change in the splits would also be unprecedented—no Canadian province has ever done it.

Cascades Vend-In – The recent purchase of the Cascades casino from GCI Inc. passed the shareholder vote by a very narrow margin.  The opposition viewed the purchase price multiple as too high, and there was a suggestion of insider dealing, given the relationship between GCI and GCI Inc. (see above).  Some investors may have bailed out of the stock after this, putting pressure on the stock price.  But the acquisition was accretive at an EBITDA level that is probably significantly below where it will be in the next two years, and it was a competitive auction process.

Burnaby Cost Over-runs -- GIC has already increased the budget for the Burnaby expansion from CA$105 mm to CA$130 mm, and there have been concerns that the project could go significantly over-budget. However GCI has essentially locked in the cost of the project via a $73.1 million contract with a reputable general contractor.  It is also possible that opening costs exceed the budget (this happened to GCD with River Rock) and that the project is delayed.