This report was originally published on 11/4/2009.

Similar to other consumer oriented sectors, there are growing signs that a trough in activity in the gaming sector has been reached or is rapidly approaching.  Let’s look at a few recent comments from senior management of leading gaming companies:

“Here is the good news in Las Vegas. We just completed the best quarter in our history with respect to booking new group room nights in Las Vegas and today, we have more group room nights on the books of 2010 than we expect to realize in all of Calendar 2009…..”

Sheldon Adelson, Las Vegas Sands (LVS 19.41 ↓1.62%)3Q09 earnings conf. call (Source:Seekingalpha.com)

”The third quarter had encouraging results with three of our four business units posting year-over-year improvements in EBITDA…..The news from our Midwest and South region was also encouraging as we posted EBITDA growth of more than 6% year-over-year. The biggest shift during the quarter occurred at Blue Chip, where despite two months of new competition, EBITDA grew by more than 20% and the property experienced year-over-year revenue and EBITDA growth every month during the quarter.  To summarize, the stabilization trend we’ve mentioned on earlier calls continued during the third quarter”

Paul J. Chakman, EVP and COO Boyd Gaming (BYD 8.59 ↓1.26%)3Q09 Earnings Conf. Call (Source: Seekingalpha.com)

According to the Las Vegas Convention and Visitors Authority, total visitation to LasVegas declined 3.7% YOY in the monthof August, while gaming revenues in Clark County, NV were down 6.7% YOY. Although this is nothing to cheer about, the rate of decline has slowed considerably since the start of the year and based on recent commentary from senior gaming executives, it appears trends could stabilize further, if not improve in the next few quarters.  In Atlantic City, where the market has been hurt by both increased competition from slots in Pennsylvania and the economic downturn, total casino win in September fell 5.7% YOY, which is the slowest rate of decline thus far this year.

As those of you who have followed our research for a period of time well know, we always endeavor to identify an investment idea in a particular sector that has been over-looked or otherwise does not reflect a change in a broader trend.  For the most part,  we do not see value at this point in the traditional casino operators such as MGM (11.66 ↓1.93%), WYNN (70.58 ↓0.54%), LVS, and BYD that face tepid, albeit modestly improving revenue trends and the threat of increased supply in core markets such as Las Vegas, Atlantic City, and Macau.  However, there is one company that would be the direct beneficiary of an increase in gaming revenues and trades at a remarkably compelling valuation level, in our view – Global Cash Access Holdings (GCA 8.08 ↓1.46%), Inc.

GCA is the leading cash access provider to the gaming industry.  The company provides it products and services to over 1,100 casinos worldwide. GCA is the backbone through which casino patrons access cash through ATM transactions, credit card cash advance, point of sale debit, check verification, and other services.  We think the company represents the most compelling opportunity in the gaming space based on the following:

1. In the downturn, GCA has acquired two of its larger competitors, which now positions the company as the unequivocal leader in cash access services to the gaming industry with more than 80% market share in the US.
2. The company has rapidly reduced its leverage levels due to strong free cash flow generation, which should position GCA well to continue to add ancillary revenue streams through new product introduction and acquisitions while simultaneously reducing debt and potentially buying back stock.
3. GCA’s same store revenue trends are highly correlated to trends in leading gaming markets such as Las Vegas and Atlantic City, which are poised to stabilize.  To the extent that industry-wide revenues stabilize or increase, GCA should witness substantial operating leverage.  Additionally, unlike casino operators, GCA actually BENEFITS from increased supply.
4. GCA is an industry leader with robust margins, generates strong free cash flow, and delivers a high return on invested capital.  The stock appears cheap across almost every valuation metric we utilize.  At 14-16x our FY10 GAAP EPS estimate, GCA shares would trade at $8.50-$9.70 a share, 30-50% above current levels.

Company Overview

From a financial perspective, here is a quick snapshot of GCA.  The stock has been incredibly volatile over the past 12-months, even though it’s business for the most part has not.

Source: PAA Research, Yahoo Finance

The company has a checkered past, due in large part to the transgressions of the founders and former management team.  GCA finally severed all-ties to its former management when the company repurchased all of the shares owned by its founders in the second quarter and signed a processing services agreement with TSYS Acquiring Solutions.  GCA uses TSYS to connect with card associations and eletronic funds transfer networks to complete ATM withdrawals, credit card cash advances, and point of sale debit card transactions.  TSYS replaces USA Payment Systems which was owned and operated by the company’s founders.  In short, all connections to the founders of GCA have now been removed as should any negative halo on the company at this point, in our opinion.

How GCA Makes Money

GCA offers gaming operators four primary services to expand points of cash access on the casino floor to patrons: ATM cash withdrawals, credit card cash advances, check verification and warranty services, and central credit/other services.  The chart below outlines the company’s revenues by major service offering:

Source: Company reports

From a margin perspective, central credit and check verification are the most profitable, while ATM services are the most popular but the least profitable.  In many cases, the economic splits with the  casino are higher in the case of an ATM transaction (surcharge revenue).  The chart below depicts GCA’s revenue by serivce offering:

Source: Company reports

The following is an overview of each of the company’s major service offerings:

• ATM cash withdrawals- It is the largest category of payment transactions that GCA processes from a dollar value and transaction volume perspective.  In an ATM transaction the customer accesses an electronic funds  transfer network through GCA’s service platform.  The company is paid on a per-transaction basis, a portion of which is payed back to the casino operator.
• Credit card cash advance and point of sale debit card transactions – In a credit or debit card transaction the company’s processor routes the request through one of the card associations to the issuing bank.  GCA receives approval on behalf of the customer at which point the cash can be obtained.  GCA generates revenues based on a percentage of transaction size.
• Check verification – Although it is a small percentage of a casino’s cash carry, there are a number of patrons that continue to present checks to casinos in exchange for cash to be used on the gaming floor.  GCA will provide check warranty services to the casino whereby casino contacts the company to determine if they will honor the check.  If the check “bounces” GCA funds the casino for the full check amount, after which the company will pursue the patron for the balances.
• Central Credit – Through Central Credit, GCA enables casinos to extend credit to individual gaming patrons, otherwise known as a “mark”.  GCA has an extensive credit database through which it can evaluate the credit quality of any patron in a rapid manner.

Perhaps GCA’s biggest value proposition to a casino operator is its “Casino Cash Plus 3-in–1 ATM”, which enables patrons to access a greater amount of cash than they would otherwise be able to from a traditional ATM.  Most issuing banks establish strict limits on the amount of cash that can be disbursed from an ATM machine.  Through GCA’s “3-in-1 ATM”, patrons are seamlessly rolled over to credit card transactions when they have maxed our their ATM limits.  GCA estimates that their products can increase the amount of cash on the gaming floor by as much as 30%.  As the table below demonstrates, GCA generates the greatest amount of fees per transaction on credit card cash advances, which can cost the patron as much as 5% of total transaction value.  In recent quarters, the  company’s revenue and gross margins have been negatively impacted by a decline in credit card cash advance transactions as consumer pull-back on spending.

Source: Company reports, PAA Research

During the Downturn GCA Has Solidified Its Market Leadership Position

Over the course of the past 12-18 months, a period during which most gaming companies have been under duress, GCA has further solidified its market leadership position.  Through the acquisitions of Certegy Gaming Systems in January 2008 and Cash Systems Inc. in August of that year, GCA expanded its market share in the $1.0 billion gaming cash access services industry from 60-65% to 80-85% in the US.  The company only has one meaningful competitor at this point in the US market which is a subsidiary of Global Payments.  GCA management estimates that Global Payments gaming cash accesss services division generates approximately $20-$40 million annually in revenues.  We expect GCA’s market share position to yield improved pricing on contract renewals and allow GCA to gain further traction with clients beyond ATM and credit card cash advance processing.  In conjunction with its 2Q09 earnings conference call, GCA announced its intention to acquire Western Money Systems, which is a manufacturer of cash handling products.  We expect GCA to increasingly pursue “tack-on” acquisitions, which can enhance the company’s service offerings and accelerate the transition to cashless gaming.  We also wouldn’t rule out that the company could pursue strategic acquisitions in international markets.  Currently, GCA generates less than 5% of revenues outside the US.

Source: Company reports

GCA’s Leverage Levels Are Rapidly Declining Due to Strong Free Cash Flow Generation

Investor concerns about GCA’s overall leverage levels during a period of rapidly declining gaming acitivty was one of the primary reasons that the stock traded below $2.50 earlier in the year, in our opinion.  During the fourth quarter of 2008 and through the first half of this year, GCA paid off the $45 million drawn on its revolver as of 9/30/08 entirely from free cash flow.  GCA has been highly leveraged for the entire period it has been publicly traded.  As the table below demonstrates the company’s debt/cap still exceeded 60% as of 6/30/09.

Source: PAA Research

Due to the strong free cash flow generation inherent in GCA’s business model, we think the company can support 2.5x-3.0x leverage on a total debt/EBITDA basis even in environments similar to that of 2008/2009.  GCA has a deferred tax asset with approximately ten more years of amortization that provides the company with a shield from cash taxes of $18 million annually.  The business inherently does not require much CAPEX, and for the most part working capital is not a significant use of cash.

We think the company has reached an inflection point in terms of its free cash flow generation relative to its debt burden.  As of 3/15/10, GCA will be able to tender its senior subordinated notes at par, which we think might become a use of the company’s free cash flow over the next 12-months. Otherwise we expect the company to use the $150 million in aggregate free cash flow generation from 2009-2010 to pursue strategic acquisitions and potentially repurchase more stock.  GCA has two primary financial covenants in its credit agreement: a fixed charge coverage covenant and a leverage covenant (Total debt/LTM EBITDA).  The company is no where near violating its fixed charge coverage covenant, so the leverage covenant is the one we have focused on.  Based on our forecasts for the remainder of 2009 and 2010, we estimate GCA could incur another $100 million of debt without running the risk of violating its total leverage covenant.  As the chart below demonstrates, we expect GCA’s financial flexibility to continue to grow.

Source: GCA, PAA Research

GCA’s Revenues Are Highly Correlated to Trends in Leading Gaming Markets

Although GCA is typically compared to other transaction processing companies, its fundamental prospects are unequivocally linked to those of gaming operators.  Over the past five years, the YOY change in GCA’s same store sales have demonstrated a strong correlation to the YOY change in win in Atlantic City, Las Vegas visitation, and Clark County revenues.  It is important to point out that GCA’s same store sales have exceeded the average growth in Atlantic City and Las Vegas by 2-6%.  This has been driven in large part by GCA’s traction with gaming clients outside of the two major casino capitals of the US.  Unlike a casino operator, GCA benefits from increased capacity in existing markets and expansion of gaming into new markets. We anticipate the approval of gaming in Deleware or table based games in Pennsylvania would be a positive catalyst for GCA shares.  Additionally, the company continues to pursue international expansion opportunities in markets like Macau.

Source: PAA Research

Across Almost Every Valuation Metric We Look at GCA Shares Appear to be Cheap

GCA shares have declined in excess of 30% from their peak levels in July.  We cannot point to any single factor that would have caused the sell-off outside of ongoing investor concerns about not yet deep rooted recovery in consumer spending.  Over the past two weeks, one issue has surfaced about GCA.  On October 20th, approximately 40,000 ATM transactions failed due to issues GCA had with VISA’snetwork.  According to a company representative, it was a VISA issue and GCA was not at fault. We’re not particularly interested in the blame game in this case. Although it sounds like a significant number of transactions (and brand damage is never a positive), in the context of GCA’s  ATM transaction volume of more than 21 million in a quarter, it is more of a rounding error.  GCA is working to resolve all customer issues and we expect this issue to represent a tiny bump in the road it what has otherwise been fairly steady execution for its casino clients.

We think the recent sell-off has created an opportunity to invest in a unrivaled franchise in the gaming industry.  The company will report 3Q09 results after the close on Wednesday, November 4th.  We currently forecast $180 million and revenues and EPS (excluding non-cash taxes) of $0.19 compared to consensus of $173 million and EPS of $0.18.  We expect the company to highlight the stability in its same store revenue trends over the course of the quarter and in the early parts of 4Q09.  We anticipate management will reiterate full year guidance for revenues of $700-$730 million and EBITDA of $90-$94 million. It is important to note that consensus estimates for revenue are already below management guidance.  Expectations are low.

In the table below we outline our forecasts for 2009 and 2010.  We expect a very modest recovery in YOY revenue growth for GCA in 2010 of 3%.  We expect some gross margin expansion as more customers return to credit card cash advance transactions in the casinos in which GCA operates.  For the full year we expect GCA to generate EBITDA of $110 million and free cash flow of $95 million.  This implies that GCA’s free cash flow yield now exceeds 19% on our FY10 estimate.

Source: PAA Research

Historically, GCA has traded off a non-GAAP measure called “cash EPS” which is effectively GAAP EPS plus the benefit of the company’s deferred tax asset.  Remember, the company’s deferred tax asset will reduce cash taxes paid by $18 million annually through 2019.  On cash EPS, GCA shares now trade at 8.7x current year earnings.  We recognize that the secular growth story in the US gaming market and the notion that gaming revenues were “recession proof” has been more or less demolished by this downturn.  We now view the gaming industry as cyclical with the potential for cycle-to-cycle growth.  GCA’s revenues are far less cyclical and the company has the opportunity to expand into ancillary service lines and introduce new products.  We find 12.9x and 10.6x our GAAP EPS estimate for FY09 and FY10.  We think a 14-16x multiple for GCA shares is more than reasonablegiven the stability of the company’s free cash flow, its strong market position, high ROE and improving returns on capital. At 14-16x our FY10 GAAP  EPS estimate GCA shares would trade at $8.50-$9.70/share or 30-50% above current levels.

As always, please act accordingly…