Slot machine manufacturer PlayAGS (AGS) has been destroyed in the recent broad market sell-off. Despite more than doubling from intraday lows on Wednesday, shares are down 85% over the past month.
As steep as the decline has been, it’s not notably out of line for the sector. While collapsing energy, cruise, and airline stocks have garnered the headlines, casino operators and suppliers have been crushed:
one-month chart as of Friday’s close
The sector-wide sell-off makes more sense than it might appear. There are more than just short-term considerations at play.
The entire sector is heavily leveraged. Valuations, particularly for regional operators like Eldorado Resorts (ERI) and Boyd Gaming (BYD), were at historic highs coming into the year. 2019 may well look like a multi-year peak in terms of earnings for the industry, even ignoring the short-term effects driven by what at this point appears to be a nationwide shutdown. Take a stock that was levered 4x or higher to begin with, cut profits and the EV/EBITDA multiple, and equity value can plummet in a hurry.
PlayAGS isn’t immune to those factors. The company closed 2019 with net debt of 3.6x trailing twelve-month EBITDA. About 78% of gross profit comes from participation agreements (nearly all of that from slot machine leasing), meaning the company will see much the same profit pressure as operators. Unlike giants Scientific Games (SGMS) and International Game Technology (IGT), PlayAGS doesn’t have a lottery business to provide some ballast in a recessionary environment. And it’s not as if the stock was headed in the right direction even before the last month.
This can go wrong. It can go terribly wrong, a core reason investors fled the stock in recent weeks. That said, I’m skeptical the news is quite as bad as a sub-$2 share price, and a $58 million market capitalization, suggest.
AGS’ debt doesn’t mature until 2024. A former P-E sponsor still owns a large chunk of the company, and perhaps can help steer the company through a rough patch. Enormous EBITDA margins suggest the company should stay solidly profitable even with a steep cut in revenue. There’s a realistic path for PlayAGS to muddle through the worst of the next few months, or years, and avoid bankruptcy.
With the equity slice almost exactly 10% of enterprise value, muddling through probably is enough for some upside at some point. Anything better suggests triple-digit returns. The risks are real, but the rewards are potentially huge. For aggressive investors willing to step into this plunging market, AGS is one of the better bets to make.
How This Goes Wrong
It’s worth reiterating: AGS has a chance of being a zero. The company closed 2019 with $534 million in debt, and just $13 million in cash on the balance sheet. Net leverage based on 2019 EBITDA was 3.6x.
Of course, EBITDA is going to come down in 2020, and potentially beyond. Per the 10-K, AGS has a maximum net leverage ratio of 6x — and there’s a real chance of tripping that covenant in a collapsing demand scenario (more on this in a moment).
There are short-term liquidity questions as well. On Thursday, the company drew down the maximum $30 million allowed under its credit facility. That suggests ~$40-$45 million in cash on hand at the moment. That’s about six months’ worth of operating expenses at the 2019 run rate. Obviously, AGS is going to reduce those expenses, but if losses continue into 2021-2022 as casino operators cut back on machine purchases and casino customers cut back on spend, it’s not guaranteed the company can make it to the February 2024 maturity of its term loan. (There is another ~$24 million in principal payments required before the date as well.)
Beyond the potential for a restructuring, there is downside risk to the equity. It’s not as if AGS was performing all that well heading into 2020. Guidance for the year given with Q4 results on Mar. 5 looks a bit soft, with Adjusted EBITDA projected to increase just 1-5%. That follows a 7% increase in 2019, the bulk of which came from last year’s acquisition of Integrity Gaming.
AGS was halved after cutting full-year guidance following the second quarter release in August, and had returned to post-earnings levels ahead of the Q4 report. Shares then fell 19%, though sector weakness likely played a role (IGT and SGMS both were down over 10% that day).
AGS has seen weakness in Oklahoma, its largest market, owing to execution issues at the Winstar World Casino on the Texas border. The oil bust potentially adds another source of pressure to that facility, which drove 9% of revenue in 2019 according to the 10-K. Another tribal property in Livingston, Texas is at risk after appeals were denied as to the legality of its Class II (ie, bingo-based games). If that property closes, per the Q4 call AGS would take a $9-$10 million hit to EBITDA (6.5% of the 2019 total). Even if Livingston stays open, lower shale production may hit revenue and profits going forward as well.
Those pressures obviously extend beyond the short-term impacts of casino closures, or even the mid-term effects of a recession. Investors are taking on short-term price risk as well, as volatile trading last week shows:
Particularly in a sector with so many stocks that have plunged, investors might prefer to take those risks with a company whose performance into March was more consistent.
Stress-Testing the Business
But price matters. So does the size of the equity slice. It’s probably a bit too simplistic to argue that AGS will rise sharply if it avoids bankruptcy — but with a market capitalization still at $58 million, it’s not that far off.
And I don’t believe bankruptcy risk is as high as the headline leverage ratio would suggest in this environment. EBITDA margins are impressively high: just shy of 48% in 2019. Even assuming the business looks very different going forward, profits still should be able to hold up reasonably well.
2019 Adjusted EBITDA was $146.1 million. Assume that equipment sales (which is mostly slots, but does include small contributions from table products and equipment) go to zero. Gross profit dollars on those sales, which totaled $48.7 million in 2019, are lost.
Cut gaming operations revenue (which, again, come from participation deals) by 20% and assume gross margins hold. Deleveraging could have a modest impact, but margins for that revenue already are over 80%, and those margins actually have compressed modestly as revenues have grown over the last few years. At flat margins, that cut would suggest a loss of another $34 million in gross profit.
In this scenario, with gaming sales at zero and ‘same-store’ participation revenues down 20%, Adjusted EBITDA still comes in at $63.4 million.
That’s a concerning figure, to be sure. Net leverage rises to about 8x, and EV/EBITDA to ~9x. But it assumes zero gaming sales, a 20% decline in revenue — and no response in terms of operating expenses. Cash operating expenses last year were $87 million (assigning all of the $9M in share-based compensation to SG&A and R&D). Cut those operating expenses 20% and AGS starts getting close to satisfying the 6x maximum leverage covenant, with EBITDA above $80 million (at current net debt, it would need to get the figure to $87 million).
That opex figure also suggests minimal near-term risk. Again, AGS should have in the range of $40 million in cash at the moment. (The company didn’t update its cash post-Dec. 31 after Q4, which shows just how much the world has changed in the last two-plus weeks.) That’s ~six months’ worth of run-rate cash expenses for 2019, a figure which almost certainly will decline in 2020.
There are three other factors to consider. First, tripping the covenant doesn’t necessarily mean lenders are going to push the company into an immediate restructuring. It would seem unlikely — indeed, unwise — for the lenders to do so. No one wins if a company looking to expand into new U.S. markets, drive interactive growth, and build out a still-small table products business gets put through a restructuring in the midst of a recession. It’s possible that happens, but if AGS still is posting positive EBITDA, it seems highly likely the company would be given the next few years to recover.
Second, AGS may be able to raise additional cash beyond the $30 million drawdown on its revolver. Apollo Global Management (APO) still owns over 22% of the company. It could backstop a rights offering that would raise additional capital, or purchase convertible equity in the company. Apollo no doubt will have its own cash concerns in the coming months, but an injection into AGS would hardly break its bank.
This obviously is a highly fluid situation, and it’s impossible to pound the table for any outcome. But a bankruptcy in the next twelve months, or even in the next three years, seems unlikely. PlayAGS has time.
Is Gaming Cyclical?
The third factor to consider is that we don’t really know how cyclical the casino business is. We definitely don’t know what demand will look like this summer, when (hopefully) facilities have re-opened and some sense of normalcy has returned.
In a note on AGS in August 2018, Credit Suisse made the case that the industry actually was somewhat defensive:
In our view, domestic gaming revenues are quite defensive, and we think the next recession will be nowhere near as severe as the last. There is a common misperception that the domestic gaming industry is highly cyclical and therefore should be volatile through the next recession. We disagree, as we think this view unfairly extrapolates the experience of the 2008 recession but also confuses some industry-specific factors that were at work in the last recession.
Indeed, overall revenue in the US did not fall that far. Tribal casinos, based on estimates, actually held up:
To be sure, casino stocks plunged across the board. The leveraged buyout of Caesars Entertainment (CZR) by Apollo and TPG Global turned into one of the industry’s most infamous disasters. A similar takeover of Penn National Gaming (PENN) was called off. Boyd Gaming (BYD) went from $50 in mid-2007 to under $4 at the lows.
But CS argues that increased supply — notably from Pennsylvania and Maryland — exacerbated relatively modest ‘same-store’ declines by pressuring casinos facing new competition from adjacent states. Its “same store” calculation of revenue in mature markets (which adjusts for supply and ‘cannibalization’) suggests revenue growth actually was relatively modest during the crisis — and that growth was similarly quiet during the recovery. Tribal properties don’t appear to have struggled at all.
The counter-argument would be that nationwide revenue still declined ~4% in 2009 even with new supply. Tribal properties, meanwhile, may have held up not because their revenues are defensive, but because many are near oil and gas-heavy regions such as Texas, which mostly dodged the worst of the recession.
We don’t know how the industry will respond to this crisis. Again, AGS has outsized exposure to Oklahoma, where $25 crude represents its own risk. But there is at least a possibility that the industry will see significant pent-up demand this summer, and more manageable declines even should a 2020-2021 recession hit. Cut AGS’ participation revenue by 5% and gaming sales by 50%, and run-rate Adjusted EBITDA likely comes in closer to $110 million. Assign a 6x multiple to that figure and AGS rises 140% to almost $4.
And from there, the long-term bull case still holds. AGS still is moving into Class III commercial games from its Class II base. It continues to take market share: figures from Credit Suisse (based on the well-regarded Eilers-Fantini slot survey) show market share went from under 1% in 2014 to nearly 7% by the end of 2017. State-by-state expansion offers a tailwind going forward:
source: PlayAGS fourth quarter earnings presentation
The interactive business is growing, with a recent deal signed with UK (and New Jersey) iGaming operator 888 Holdings (OTCPK:EIHDF). There’s going to be significant short-term disruption, but the long-term case isn’t broken.
Alternatives and Long-Term Risks
To put it simply, I believe $4+ is a much more likely outcome than $0. And I’d rather own AGS than larger operators which themselves could, and most likely will, rally if cyclical fears prove somewhat overblown. Balance sheet leverage is much higher for the operators, particularly those like Penn, Caesars, and Eldorado Resorts (ERI) that have gone the REIT route. The rewards in theory could be higher — ERI, for instance, would rise 700% to its 52-week high — but the risks are more significant as well.
Among suppliers, I’m still long IGT, but to be honest that’s due more to not being nimble than any real conviction, and that company has significant exposure to what could be a collapsing Italian economy. Valuation and price action aside, SciGames has done basically nothing in the years since it rolled up Bally Technologies and Shuffle Master to drive any sort of investor confidence. That’s a ~7x leveraged business which couldn’t grow profits in the boom times and now faces an uncertain period.
AGS has had its own struggles, but it’s grown market share at an impressive clips for years now, and new products like the Orion Starwall and new markets suggest it can drive growth when and if the industry returns to normal.
That’s not to say that nothing can go wrong. It can. And I do see one potential long-term risk which is difficult to quantify. One of the odder aspects of the casino business in the U.S. is that so little has changed in the last twenty years. Technology has transformed American life. Save for larger cabinets and bigger signage, casino floors look much the same as they did at the turn of the century.
Casino operators have not been terribly happy about that. It was seven years ago that MGM Resorts International (MGM) CEO Jim Murren told Bloomberg that “the traditional model of selling boxes to operators is obsolete.” Former Caesars chairman Gary Loveman said in early 2015 that “I remain very concerned that the [slots] product is antiquated as a category.” The replacement cycle has arrived in fits and starts in recent years, but it’s likely operators still want the underlying slot model to change going forward.
Do those operators, whether by focusing on their own survival or using the leverage created by the risks to suppliers, finally bring about the end of $20,000 individual and incompatible cabinets? Do they push slot manufacturers into “race to the bottom” pricing in terms of either sales or in reduced participation shares? If so, they can apply pressure to suppliers like AGS at a time when those suppliers can least afford it.
This is a situation that can play out in myriad ways. And I’m imagine that wherever AGS trades in 24 months — whether it’s $0.05 or $8 — that the outcome will in retrospect seem obvious. But the potential upside, by definition, is much higher than the downside. And I believe upside is more likely than downside. The risks are real — but they’re worth taking, even in this market.
Disclosure: I am/we are long AGS, IGT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.