Description

Thesis Summary

AGS is a business with high recurring revenue and high profit margins with a strong balance sheet that can position them for growth for many years in the future. The company will continue to take share of leased and sold slot machines domestically, while expanding their footprint in new markets, with huge upside if certain foreign markets legalize gaming. There is also an opportunity for the company to optimize their existing installed footprint to further improve returns. In addition, AGS is the only viable competitor to Scientific Games for table games/shufflers where customers are hungry for another player to break that monopoly. The company currently trades in line with peers even though they are growing top-line faster and have less leverage.

Background:

PlayAGS was a recent IPO in January 2018 and operates in three segments: Electronic Gaming Machines (EGM), Table Games, & Interactive. Apollo acquired the company in late 2013; shortly thereafter hired a new CEO and pursued a series of acquisitions to position the company to take share in the competitive market for gaming machines. Apollo currently owns about 22% of the outstanding shares (Post IPO they owned 65%) and will likely exit the position within the next few years.

Segments explained:

EGM (95% of rev) – Split into two businesses 1) Leased games (68% of EGM rev) – games owned by AGS and placed in the casino with a revenue share agreement 2) Slot machine sales (32% of EGM Rev) – pure equipment sales to casinos which is typically a one-time sale with no revenue share.

Table Games (3% of rev) – Custom table games and accessories (ie: card shufflers) that are leased to casinos.

Interactive (2% of rev) – White label platform for real money and social gaming which includes AGS content as well as 3^rd party.

Management Team:

Most of the management team came from Shuffle Entertainment which sold to Bally’s in 2013. David Lopez (CEO) was the former COO of Shuffle & former CEO of EVRI (at the time called Global Cash Access). Kimo Akiona (CFO) was the SVP & Corporate Controller at Shuffle and Bally’s post the acquisition, and Julia Boguslawski (CMO) was also previously at Shuffle, managing dual roles as Vice President of IR & Vice President of Corporate Communications. Before joining AGS, Boguslawski was the Chief of Staff at Scientific Games and prior to that, served as Vice President of Global Marketing at Bally Technologies. John Hemberger is the Senior Vice President of Table Products at AGS. Hemberger joined AGS from Bally Technologies/Shuffle Entertainment, where he served as the General Manager of the Company’s table games division following the 2013 acquisition of Shuffle Entertainment.

This management team comes highly regarded and was largely credited for the success of Shuffle and eventual sale to Bally’s.

Other notable employees include; Robert Perry (head of sales) who was hired in 2015 and was the former VP of sales @ Aristocrat (highest quality / most successful slot manufacturer today), Sigmund Lee (CTO) who came from the Cadillac Jack acquisition was previously VP of engineering at Bally’s.

Competitive Landscape:

The top 3 suppliers control >70% of  the market and beyond the top three the market is fairly fragmented. Both IGT & Scientific Games grew through acquisitions which have contributed to their higher leverage. Historically when the industry consolidates, bigger players lose market share as casino operators prefer more diversification which provides an opportunity for the smaller players like AGS.

Thesis

1)   MGAM 2.0 – AGS has huge runway for growth in the US & Canadian market - MGAM (Multimedia Gaming) was acquired by EVRI in 2014 and had an almost identical strategy to that of AGS. In fact current board member, Adam Chibib was the former CFO of MGAM and his fingerprints are all over AGS. If you were to compare MGAM presentations vs AGS presentations today, you would see a very similar strategy which is likely credited to Adam’s efforts. As it relates to AGS’ strategy, in order to sell into a market, AGS must go through a rigorous licensing process. Their current opportunity is only in markets where gaming is legal and where AGS has a license to sell into those markets. There is a large and growing addressable market as AGS gets licensed in more jurisdictions and further sells into existing whitespace. The company has been successful in attaining new licenses, since 2012 new licenses grew by 117%. As per the chart below, AGS has a 2.9% market share and the opportunity to gain share in early entry (where AGS was recently licensed to sell) & prospective markets (where AGS is unlicensed but is currently or will in the future apply for a license).  The company is on average shipping units at a 5% share which, if can continue, should provide many years of longer term growth as the early entry & prospective markets converge towards that 5% ship share. I estimate they will hit a 5% market share in late 2022 (assuming no acquisitions) and will outgrow the addressable market by an average of 800bps annually through 2023.   

2)    Large international market opportunity - 

a.      Mexico – The Company expects to install an incremental 1,500-2,000 units over the next 3-5 years in Mexico. Over the last year AGS has installed about 1,000 new units into Mexico and based on this trend, I would expect them to do better than their 3-5 year view as reflected in my model (+3,000 units over 5 years). 

b.      Philippines – AGS recently started shipping units to this market and I assume over the next 5 years they get to 5% of that market.

c.      Rest of World – AGS is significantly underpenetrated (basically has no presence) in Asia, Europe & most of Latin America. I assume that they will begin selling into some of these markets in 2H20. This can be a much larger opportunity in the future but hard to quantify exactly as management hasn’t communicated a strategy at this time.   

d.      Brazil – AGS has an MOU in place for 8,700 units which is 1.7% of the theoretical market if Brazil was to ever legalize gaming machines. This is a wildcard and is not in my model. However, this could be a huge opportunity for AGS as the same box going into the Philippines would be suitable for this market as well meaning no new incremental R&D. As highlighted in the chart below, if AGS was to only install MOU units there is an incremental $0.88 of EPS, @ a 15x multiple would be a stock price ~70% higher than today.

3)    Further opportunity for yield optimization - When AGS optimizes a unit, they typically remove an underperforming game and replace it with a refreshed look and/or new content. Every $1 of incremental revenue/day/machine lift equates to an incremental $6 million in EBITDA. Typical gross margins for leased units are ~80%, thus revenue/day optimization (aka yield optimization) is also critical because incremental revenue has a very high flow through rate (>90% incremental margins). 

4)    High ROI for leased units – I estimate that the revenue payback for leased machines is at least 3-5x the initial capital investment, making future capex pivotal to the revenue growth opportunity at AGS. Highlighted in the chart below are my assumptions and returns from a leased unit in both domestic and international markets. This assumes win/day stays constant at the 1Q19 level which is doubtful given yield optimization opportunities mentioned in point #3. 

5)    Table Products & Shuffler growth opportunity – Scientific Games is dominant in this segment due to their acquisition of Bally’s which owned Shuffle Entertainment. As I mentioned earlier, the AGS management team largely came from Shuffle and laid the foundation for what that business is today. Most notable is the addition of John Hemberger in 2014 who was responsible for overseeing the table/shuffler business at Bally’s before being acquired by SGMS. Having John run the team is a huge leg up given his experience managing the only competitor. Over time AGS should be able to take a 5-10% market share in this business through introductions of new premium table games, upselling customers to include premium progressives & side bets, and successfully taking share of the automatic shuffler market with the introduction of their Dex S Shuffler (this is the only shuffler in the market not owned by SGMS). Incremental profitability is very high and within the next 5 years, the company should reach north of 50% EBITDA margins.

6)    AGS could be an acquisition target – The high mix of profitability coming from leased units at AGS would make it appealing to an acquirer. The most likely acquirers would be EVRI, Konami or Aristocrat. If it was EVRI, there would have to be a mix of cash & stock, but Aristocrat has a big enough balance sheet to pay all cash. An acquisition by EVRI could make sense because it would get them more scale in the US (double their market share) and better position the company to compete with larger players. This also assumes recent news that EVRI is for sale does not come to fruition. For Konami, acquiring AGS would get them more exposure to leased games, an area they have had difficulty growing. Aristocrat already has a strong market share for leased games and is known as best in class among the gaming equipment suppliers. However, Aristocrat is still far behind IGT/SGMS for owned games and could help accelerate AGS’ efforts in game sales particularly for the international market. 

7)    Further upside not accounted for in my model –

a.      I assume all gaming machine sales happen in the US and none into international markets. However, not all international markets/customers want leased units and instead prefer to buy gaming machines. My expectation would be that AGS will benefit from sales overseas, but it is hard to quantify today. In addition, limited disclosure around Intl EGM sales make this difficult to project.                                                                   

b.      Management expects their interactive segment to grow from negative profitability to a $15-20 million EBITDA business in 5 years. This is a large market, particularly with potential further legalization of online gaming in the US, but the market is becoming hyper competitive. I have largely tempered my expectations here as I have not seen any sign of management’s ability to compete here. Thus have it only growing to $5 million in EBITDA by 2023.

c.      As mentioned above Brazil is not in my numbers

d.      I assume no future acquisitions

e.      I assume no share repurchases

Valuation

Taking a 5 year view, I see a path to a stock price of ~$50 using an average of 9x 2023 EBITDA and a 5% FCF Yield. To get to those valuation metrics, I use MGAM’s takeout multiple of 9x EBITDA & FY1 FCF yield of ~5.5%. I recognize that the direct US comps, SGMS & IGT, are trading at a lower valuation of 7.5x EBITDA & 6.5x EBITDA respectively. These companies are more levered, have smaller margins, and slower revenue growth. In addition, there is more optionality for AGS to use their cash to either invest in the leased base at higher returns, initiate a share repurchase program, pursue acquisitions and/or reduce leverage below 2x. This flexibility should warrant a higher multiple. In the charts below I highlight my EBITDA expectations, stock price valuation cadence through time, and a comparison of AGS today vs MGAM at take-out. 

Risks

1.          New installs in the leased base have been decelerating organically over the last few years. This could be a sign that they are having difficulty organically growing their footprint in new markets, their games are beginning to perform lower than expectations, and/or aggressive optimization schedules are causing the expansion to slow. I have this market growing for many years organically and only assume a normal cadence of machines being pulled out for yield optimization.
2.       This is a hit driven business and if the R&D/software teams are incapable of continuing to produce successful games, parts of my thesis will not play out. Great content is the lifeblood of their growth strategy. However, I would like to note that AGS has recently opened new game development studios which will help towards this effort (today they have 5 in total: 2 in Atlanta, 1 in Reno & 2 in Australia).
3.       20% of revenue is concentrated among two Native American tribes in Oklahoma & Alabama. They recently renewed their contract with the Chickasaw tribe in Oklahoma, but it is uncertain if increased placement fees would offset any benefit from more machines being installed. In addition, 30% of total revenues are concentrated in those two states.
4.  The Interactive Unit could continue to post losses for longer than estimated.
5.  In table games, It could be difficult for AGS to take share from SGMS, particularly if the latter begins to cut prices to be more competitive for shufflers.
6.  A recession domestically would have the dual effect of lowering EGM sales and reducing win/day on leased units.
7.  Apollo ownership will continue to be an overhang. Since the IPO they sold at the following prices, by order of sale: $21.50 (4.7 million shares), $29.25 (5.5 million shares), $25.25 (4 million shares). I would expect them to continue to sell on strength. However, if this were to occur it would be easier for AGS to get licensed in states like Minnesota, Missouri & Colorado due to the Apollo ownership threshold (>5%).
8.  As AGS grows internationally there could be losses if there is political instability or further regulation of gaming in countries in which they operate. For example: Philippines is a new market for them and I wouldn’t view it as politically stable.
9. 11% of 2018 revenues were from international markets. They have the biggest exposure to the Mexican peso
10.  A 3^rd party survey from Eilers-Fantini comes out quarterly and can move the stock even though it only covers 44% of the market. There are times when it underestimates AGS game sales / leased unit market share and the stock can be volatile around the release of this survey even though it differs from actual results.

Catalyst

1) Continued share gains in the US & Canada as well as progress on entering new markets

2) Large International Opportunity - at some point could include Brazil (if they ever legalized) or any other new markets announced

3) Yield optimization on existing footprint to improve revenue/day

4) Further share gains and penetration of table games and shufflers

5) Potential acquisition Target