GCA shares sold off an astonishing 44.4% yesterday on massive volume (19.2MM shares) following the announcement that the company had received notice from Harrah’s that the casino operator would not renew its contract with Global Cash Access for ATM and cash access services.  The contract with Harrah’s will end on 11/30/10. Up until this announcement Harrah’s had been GCA’s single largest customer representing just under 14% of total revenues.  According to GCA’s management, the company does not know the reason(s) why GCA has been replaced, nor whom will be replacing the company as Harrah’s cash access service provider.  At first glance, all signs point to the next largest provider of cash access services to gaming operators – Global Payments (GPN).  However, GPN shares finished flat on the day on lower than average volume.  For now the stock price action in GPN is providing little confirmation that the Harrah’s cash access business has been secured by GCA’s next largest competitor.  Speculation surrounding the rationale behind Harrah’s decision and who might have won the contract (if anyone) has created a “doubt spiral” for GCA shares.  The conference call hosted by management yesterday afternoon did little to soothe investor concerns.

It’s Just One Contract, but the List of Concerns Are Substantial and the Potential Implications Far Reaching

In 2009, GCA generated 14.1% of its revenues from Harrah’s, or approximately $92.8 million.  The company’s exposure to Harrah’s overall has been reduced in the past several years following GCA’s acquisition of Certegy Gaming Services, Inc. and Cash Systems, Inc., which solidified the company’s position as the dominant provider of cash access services to gaming operators.  In 2007, GCA generated 19.3% of its revenues from Harrah’s.  The company’s reduced customer concentration provided little protection to shareholders today.  A $90 million contract caused GCA to lose $260 million in market cap.  Clearly it’s not just about the Harrah’s contract.  A huge sell-off with massive volumes inevitably leaves money managers to conclude that the market “knows something”, which of course prompts more selling.  Management’s inability to provide more detail on the reasons for the contract loss added fuel to the fire of uncertainty and further exacerbated the “doubt spiral”.  We have little doubt that the phrase: “just get me out” was uttered across several trading desks yesterday.

While we don’t have any unique insights into the real reasons behind the Harrah’s decision, we think it is important to outline the list of questions and concerns that are at the forefront of investor minds at this point.  Determining the validity of investor concerns is the first step towards determining the inherent value of GCA shares.  Here are the list of questions and concerns we have heard from investors most often in the past 24-hours:

Question: Who won the RFP for the Harrah’s contract?

Concern: Whomever wins the Harrah’s contract will emerge as a viable competitor to GCA in an industry in which the company was previously the dominant provider.

PAA Research take: All signs point to GPN, but the stock price action in Global Payment shares suggests it could have been another competitor.  GPN was the next largest competitor to GCA with just over $100 million in revenues on an annual basis for cash access services provided to gaming operators. It’s hard to imagine that Harrah’s would be comfortable outsourcing to a less experienced provider given the size of the contract.   Our intuition on this matter points to GPN, but the lack of a press release from Global Payments and response of GPN shares suggests something else is at play here.  Perhaps the market has already determined that GPN would have to bid aggressively to win the Harrah’s RFP and the contract as a result will be neutral to dilutive to earnings.  Either way the most reasonable conclusion is that GCA will likely face stiffer competition from a larger player in the space going forward.  Pricing on new business and contract renewals will likely be more challenging than in the past.

Question: What were the reasons behind Harrah’s decision?

Concern: GCA could face irrational competition from a pricing perspective or service quality issues.

PAA Research take: It appears that Harrah’s has not yet communicated the reasons behind their decision to GCA management. Worse yet, we can’t rule out the possibility that Harrah’s has explained their decision, but GCA management wants to withhold this information from investors for fear it would have negative implications on future contract negotiations and the perception of the company. At a minimum, it’s obvious that GCA will face stiffer price competition and tougher negotiations in its next round of renewals and new contract bidding.

Question: Did Harrah’s Bring Its Cash Access Services Platform in House?

Concern: If one large scale gaming operator brings its cash access services needs in-house, others are sure to follow which would seriously impair GCA’s ongoing “raison d’etre”.

PAA Research take:  We view this as a highly unlikely scenario, although it has been a risk discussed surrounding GCA shares for a number of years.  There have been no indications from Harrah’s or other casino operators that they are currently considering bringing cash access processing “in-house” during the downturn as a cost savings measure.  The upfront costs would be considerable and we think it is the type of undertaking that would be difficult to keep “under-wraps”.

Question: What does this mean for the MGM contract renewal?

Concern: GCA’s contract to provide ATM and cash advance services to 10 of MGM’s casinos is up for renewal shortly.  In light of Harrah’s decision to choose another cash access services provider (or bring it in-house), MGM should be able to ask for its “pound of flesh” from GCA.

PAA Research take: GCA cannot lose the MGM contract. It would send a horrible sign to the company’s customers and investors. We know that, you know that, and certainly the executives at MGM know that. We think it is reasonable to assume at this point that GCA’s contract with MGM will be renewed on less than favorable terms for the company.

Question: Will GCA violate a covenant as a result of the loss of the Harrah’s contract or otherwise face a leverage crunch?

Concern: As of 3/31/10, GCA had total leverage of 2.6x on a total debt/trailing EBITDA basis and a 62.9% debt/cap.  Simply stated GCA remains highly levered.  The loss of the Harrah’s contract and tighter pricing on renewals could cause the company to violate debt covenants which could restrict GCA’s operating flexibility going forward or worse yet lead to a debt death spriral.

PAA Research take: As we will discuss in more detail later, we think there is a low probability that GCA will violate a covenant on its credit agreement over the next 18-months.  The company could face considerable liquidity risks. GCA”s term loans mature in November 2011, while it’s Senior subordinated note comes due in March 2012.  Refinancing risk has increased considerably for GCA in light of the contract loss.  Despite these risks and concerns, we think GCA should generate ample cash flow over the next 12-18 months to reduce its leverage levels to very manageable levels. It should be noted that the company has a long history of operating with high leverage, which has not impaired its growth trajectory over time.

Four Reasons Why We Think GCA Shares Could Witness Considerable Upside From Here

Although there appear to be more questions than answers surrounding the loss of the Harrah’s contract, we think GCA shares could witness considerable upside from current levels based on the following factors:

Under New Management GCA Has a Strong Track Record on Contract Renewals and New Business Acquisition

Up until today, we would argue that Scott Betts, CEO and the rest of GCA’s new management team have done a good job of executing and restoring investor credibility.  The loss of the Harrah’s contract and today’s poorly handled conference call leave management with significant “wood to chop” to place itself back in the good graces of investors.  Over the past several years, GCA management has proven that it is committed to improving shareholder returns, increasing the company’s market share through acquisition and organic initiatives, and developing new products that will help the company establish itself as a leader in cashless gaming products.  Each year approximately one-third of the company’s contracts with its largest customers come up for renewal.  Over the past 3-4 years under new management, the company has had a favorable contract renewal track record. In the past 18 months the company has renewed contracts with WYNN, Station Casinos, and several large Native American tribes.  We think investors are legitimately concerned about the company’s ability to maintain its current market share position in light of the loss of Harrah’s. However we think management’s track record should provide shareholders with some comfort.  Additionally, every pedestrian contract will now be closely scrutinized and to the extent GCA maintains a similar renewal rate, a could become a potential positive catalyst for shares.

There’s Only One Harrah’s

In 2007, GCA”s Harrah’s contract represented 19.3% of revenues while the company’s top five customers accounted for over 40% of total sales. In 2009, GCA’s exposure to Harrah’s had been reduced to 14% and its top five customers only represented 34.4% of revenues.  The company’s acquisitions in 2008 further diversified its revenues streams and reduced its customer concentration.  GCA now has more than 1,100 customers signed up under contracts ranging from 2-5 years.

The proliferation of legalized gambling in the US has reduced GCA’s reliance on any one customer.  More and more states are  considering legalized gambling as a way to boost revenues.  As a result, we expect GCA’s customer concentration to continue to decline over time.  Harrah’s was GCA’s largest customer by a wide margin.  GCA has indicated that it has no other customers that account for more than 10% of revenues. We estimate the company’s next largest customer is MGM which could represent as much as 6-8% of GCA’s total revenues. In the chart below we depict GCA’s US revenue exposure by state.  Following the loss of the Harrah’s contract, California will surpass Nevada as GCA’s largest revenue generating state.  There is no other contract at this point that could have the same impact on the company’s financial prospects as Harrah’s. Yes renewals will be more difficult and pricing likely more competitive, but this is not the first time in the company’s history that they have faced competition.  GCA has hundreds of contracts up for renewal over a multi-year period with a litany of clients. We think this should provide investors with a great deal of comfort on the company’s free cash flow generation over the next several years.

Free Cash Flow Generation Could Enable Rapid Deleveraging, Large Share Buybacks, or Both

Of all the conjecture we have heard over the past 24-hours surrounding GCA shares, we think concerns about the company’s covenant compliance or the potential it could face a debt death spiral have the least credibility.  GCA’s business inherently generates a substantial amount of free cash flow.  The company’s contract with Harrah’s will not expire until November of this year, in that time frame we estimate GCA will generate approximately $50-$60 million in free cash flow.  Stated another way, the cash flow generated in the second half of this year alone could enable GCA to repay as much as 50% of its bank debt outstanding.  GCA already paid off $25 million of its Senior subordinated notes in the second quarter of this year.

In the charts below, we depict GCA’s historical and projected compliance with its two major financial covenants under its credit agreement: the fixed charge coverage ratio and the total leverage ratio (total debt/trailing EBITDA).  Here are our primary assumptions:

• GCA loses 14% of revenues in 2011 due to the Harrah’s contract
• Gross margins of 25%
• Nominal operating expenses of $66 million
• GCA repays $10MM of its bank debt quarterly until 4Q11 when it pays down the remaining balance of its term loan.

GCA’s current fixed charge ratio covenant is set at 1.75x and will remain at those levels until the credit agreement expires in November 2011.  As the chart below demonstrates, GCA has ample room under its fixed charge covenant ratio to increase borrowings if need be (which we view as remote).

From a total leverage perspective, as measured by total debt/trailing EBITDA, GCA has a little less wiggle room, although we would argue that the company is at little risk of violating a covenant at this point.  Based on our estimates, GCA could incur an additional $30-$50 million in debt in the short term and still be in compliance with its total leverage ratio at year end.  Stated another way, we think GCA’s EBITDA could drop to $55-$60 million in 2011 and the company would still be in compliance with its leverage ratio.

Rapid Deleveraging or Share Buybacks

We recognize that investors are clamoring for a massive share buyback in light of the sharp selloff in shares.  However, we think management also likely recognizes the refinancing risk the company faces towards the latter half of 2011.  In the table below we depict GCA’s capitalization at the end of 2011 assuming the company uses the majority of its free cash flow to pay down bank debt. Under this scenario, GCA’s total debt outstanding would shrink to $127.8 million and its debt to cap would decline to 42.2%.   Based on our estimates, GCA could pay off all of its bank debt in the next 18-months, which should allay the concerns of those who think the company faces significant refinancing risk.

Realistically, we expect GCA management to pursue a combination of deleveraging and stock buy backs. Remember one of the few things we’re certain about is that GCA will generate $50-$60 million in free cash flow in the second half of this year. We currently estimate the company will generate another $55 million in free cash flow in 2011 even after giving effect to the loss of the Harrah’s contract.

Valuation Now Appears to Overstate the Potential for Additional Contract Losses, Competitive Pricing, and Covenant Issues – Estimate Revisions Will Not Be As Large as the Stock Price Action Would Have You Believe

In our forecasts for 2011 we have assumed the following:

• A total revenue decline of 12%, which includes approximately 14% of lost revenues from Harrah’s and low single digit same store sales growth
• Gross margins of 25%, which is 2-3% below historical averages. We expect pricing on renewals to be more competitive and the mix of traditional ATM transactions to remain high.  The loss of the Harrah’s contract actually will provide a modest tailwind to the company’s gross margins.
• Operating expenses of $66 million, up slightly from 2010 levels. This could prove to be conservative.
• Interest expense of $16.9 million, which assumes the company pays off $10MM in bank debt quarterly until the end of the year
• No share buybacks

Based on these assumptions, GCA trades at approximately 7.2x our cash EPS estimate for FY11 of $0.54.  Keep in mind we have not included any benefit from cost savings related to the Harrah’s contract or share repurchases, both of which we expect to benefit earnings in 2011.  On a free cash flow basis, GCA now boasts a yield of 21%, which could attract the attention of private equity buyers. We would argue that the current valuation level prices in a far more negative earnings and free cash flow outcome for GCA than we currently have modeled.

The Catalyst for GCA Shares Now

We expect GCA shares to remain volatile for the next several trading days as investors try to sort out the implications of the Harrah’s situation.  We think there are a number of positive potential catalysts for GCA over the coming weeks and months, including:

1. GCA’s 2Q10 conference call on August 4th.  Scott Betts needs to do a much better job of explaining the factors that led to the Harrah’s contract loss, how GCA is positioned competitively now going forward, the time frame for new product introduction which could enable the company to sustain or expand its market share, and most importantly the outlook for FY11.  This is absolutely essential. Certainly management provided enough information about the revenue contribution of the Harrah’s contract and its margin profile for investors to draw their own basic conclusions about the financial implications on FY11 and beyond.  Clearly, investors want to hear granularity and conviction out of GCA management about the company’s revenue and earnings prospects in FY11.  Additionally, we expect management to be better prepared to discuss how the company will allocate the its ample free cash flow generation between debt repurchase and stock buy backs given the acute sell-off in shares today.  We think initial FY11 guidance that is inline with our revised estimates will be sufficient for shares to trade higher.  More detailed discussion surrounding the company’s intention to repurchase shares would also be viewed favorably.
2. Renewal of the MGM contract.  After Harrah’s we estimate MGM is GCA’s next largest customer and could account for as much as 6-8% of total company revenues.  In the first quarter of 2006, GCA announced it had signed a multi-year agreement with MGM to provide 10 of the company’s casino properties with ATM and cash advance services. In addition, MGM signed a contract for GCA’s central credit services.  At this stage, everyone knows that GCA has to keep that contract, even MGM management. We expect pricing on that contract to be more onerous than previous arrangements, but a renewal would send a powerful message to GCA’s customers and investors.  We anticipate renewal discussions will ramp up in the next 3-6 months.
3. Approval of new cash less gaming products.  GCA currently has a number of cashless gaming products in various stages of approval and beta testing. The best way for GCA to maintain its market leadership position is to continually enhance the value proposition to its clients through new product introduction and innovation.  We anticipate GCA is on the cusp of obtaining approval in key gaming markets for new ticket-in ticket-out products, which would help the company distance itself from the competition.

GCA shares are certainly not for the faint of heart. We think the shares are poised to witness a sizeable rebound as investors gain greater comfort with the company’s market leadership position, ability to maintain its contract renewal rate, strong free cash flow generation, balance sheet flexibility, and rate of new product innovation.  At 12x our cash EPS estimate for FY11, GCA shares would trade at approximately $6.50/share, more than 60% above current levels.

As always, please act accordingly….