Description

Do you know what tends to get mispriced when interest rates go so low?  A good debt paydown story – that’s what. Investors clamor to own junk rated bonds at 250-300bps over treasuries.  Meanwhile no one clamors for the equities of certain high yield issuers that may offer a 20%+ FCF yield. Plus, these lucky issuers get to borrow and refinance at super-attractive rates and their business get stronger and more valuable every day as each dollar of deleveraging accrues value to the equity.  Sure, low rates can be a sign of an economic slowdown and some businesses are currently over-earning and quite properly priced at low equity multiples. But others, with decent cash flow stability and growth prospects, appear to offer fantastic entry points for multi-year equity gains. 

This leads us to Scientific Games (SGMS), the highly-levered casino gaming and lottery operator controlled by Ron Perelman.  Perelman, a proven long-term business builder, amassed a market leading position in casino gaming equipment by consolidating Bally’s, WMS, Shufflemaster and Scientific Games in 2014.  Along with that came a market leading position in lottery systems, a secularly growing, recurring revenue business with healthy returns on capital. Perelman is famed for building his empire with high yield debt and, in putting together SGMS, debt peaked at about 7x EBITDA which has deterred many investors.  High leverage has caused the stock to be quite a roller-coaster. Since the Bally’s acquisition in 2014, SGMS’s thin slice of equity has ranged between $4.68 in Feb 2016 and $62.80 in June 2018. Currently, SGMS is about 65% off the 2018 highs due to softness in casino capex and push-out of the debt paydown story.  Bearish sentiment abounds although Perelman and management have continued to buy more stock on the way down. 

Thesis. Our SGMS thesis is basically that all facets of the bear case can be rather convincingly disproven on closer inspection.  The bear case we’ve heard can be summarized as follows:

• SGMS is not actually de-levering.  They promised to, but have only added more and more leverage to date

• Casino gaming (slots) is in secular decline and SGMS overall returns on capital are poor

• SGMS only looks cheap on an excessively levered, heavily “adjusted” and un-taxed FCF basis

Our rebuttals to the bear case are summarized as follows:

• SGMS can and will rapidly de-lever ahead.  They took a smart strategic detour the past couple years to establish market leading positions in sports betting, mobile and social gaming technology and lottery point-of-sale improvements.  This has clearly tried investors’ patience causing the market to grossly undervalue the strong market position and virtuous de-leveraging flywheel power of SGMS. 

• Contraction in casino gaming sales is temporary and caused mostly by a shift to a revenue sharing model.  Underlying gaming growth will ultimately flow from the success of the new model for revenue sharing as well as the record number of new gaming jurisdictions globally.  We use +3.5% for company-wide sales CAGR with Lottery Revenue and Social & Digital Revenue growing faster than that average.

• Reported numbers become far less complex in 2Q2019 after refinancings, strategic investments and the SCPL IPO are behind the company.  We have them for you here ahead of the lazy sell-side (see below). The 2020 Unlevered FCF yield is nearly 10% and the FCF/equity yield exceeds 20% of the market cap.  We model approximately 0.5x year-over-year deleveraging, though SGMS can accelerate that as they have done YTD by selling down their unencumbered equity interest in SCPL.  Plus, the FCFE stream is poised to grow at a pace starting in the high teens and accelerating from there. This is the power of the so-called virtuous de-leveraging flywheel.  Though there is a large tax shield in place now and for years, we show that fully-taxed FCF can grow nearly as robustly.   

Valuation. We have calculated price targets around $50 (up over 150%) based on healthier multiples applied to 2021 estimates (see below).  However, we feel that if SGMS does get to $50 it can go much, much further than that as investors would then start to focus on capital return options and the potential new market opportunities in sports betting and mobile igaming.  

We don’t put much stock in sum-of-the-parts nerd math.  However, for those who are into that kind of thing, we note that SGMS’s 82% interest in the recently IPO’d (but still consolidated) Sci Play (SCPL) is $1.4B or $15 per SGMS share - 75% of the market cap.  That rapidly-growing mobile gaming piece of SGMS trades at 12x EBITDA vs. under 8x for SGMS overall. The SCPL interest is unlevered and unencumbered by SGMS debt load. Thus it provides a major margin of safety ensuring future liquidity options.

For that and other reasons, we view SGMS downside as around $15, absent an unforeseen existential crisis.  That level, equating to about 1x EBITDA or 1x the SCPL interest, has proven to be somewhat of a floor when the story looks challenged.  SGMS actually has a very well termed debt maturity schedule with interest coverage of 1.85x run rate (ebitda-capex) and improving. Their 1.2B issue of 10% coupon bonds trade 105 and can be refi’d in December 2019 (i.e., 3.2% yield to call) at a probable savings of $40mm per year in interest cost.  Beyond that, the next significant maturity is in 2024. All their debt is CCC+/B- rated and trading above par.  

In sum, Mr. Perelman has a long time frame and is poised to make additional billions here, we believe. He has put together a first class team and market leading assets.  Patient investors can tag along for the volatile but ultimately rewarding ride. More color around our thesis points follow.

SGMS deleveraging power.  SGMS runrate FCFE yield supports 0.5x turns per year of organic deleveraging.  In May they enhanced debt paydown with $300mm of SCPL IPO proceeds. The FCFE yield is poised to grow rapidly as interest costs fall and capex moderates, without heroic revenue growth assumptions.  Eventually, we expect debt rating upgrades and much better trading multiples. Carving SCPL out of the covenant package was a masterful move that, we believe shored up the downside immeasurably. It is one of the reasons we warmed up to this story after being initially deterred by the high leverage.  Reported numbers at 3/31/19 were messy showing >$10B gross debt. But this was before cash was applied and the SCPL IPO proceeds were raised. Year-end net should be a more manageable 6.2x - marking the first year of significant deleveraging progress. 

Gaming segment growth prospects. The biggest controversy around SGMS is whether casino gaming is in secular decline.  As with media, there is undeniably some fragmentation of consumer options at play. In addition, the slots industry has been shifting from equipment sales and replacements to a revenue sharing model which has had the effect of pushing out (and smoothing out) sales patterns during the transition. SGMS, specifically, has consolidated several competitors and, naturally some of its savings and synergies gets shared with customers along the way.  These three factors have weighed down SGMS gaming segment revenue growth to a 3-year CAGR of +1%.  

However, two of those factors are temporary and transitional and speak to an ultimately stronger company.  SGMS large market share and leading product innovation team position it well for longer-term leverage over customers and rivals.  Secondly, evidence shows that the revenue sharing model is a marked success for the casinos and their commitment to it should ultimately be strong and growing.  There has been a planned rationalization of casino floor space devoted to slots - in response to changing consumer tastes. But we believe this is not ongoing attrition of the segment.  The new model works and is more profitable than the older model. Lastly, we expect major domestic and global expansion of gaming jurisdictions ahead. We do not see a dying industry here.  And with the recurring revenue nature of lotteries and the significant growth potential of new gaming - mobile, social and sports it is far from a stretch to model modest GDP+ sales growth for the market leader.  We use 3.5% sales CAGR below. 

Enterprise Value

Cash flow projections (2019-2021)

Target prices

Catalyst

Virtuous de-leveraging flywheel.

Inflection of gaming segment growth.

New markets - sports betting, igaming