Tuesday, October 4, 2011

The Big Deal: Electronic Scratch Ticket Games and Nevada Gold.

Before my interview with Bob Sturges, I had absolutely no idea how good the legalization of Electronic Scratch Ticket Games (ESTGs) in Washington state could be for the casino market up there... I had an idea, but, nothing like I now think. As a result, I had no idea how good these new games could be for Nevada Gold.

After the interview and doing a little bit of math, it seems pretty apparent to me that if these things are legalized, it will be one of those moments where the company's profitability could go up by multiples and it's revenue could more than double. Before you get excited and say that I am overblowing this (in either direction), let's take a look at why I think this.

Please be sure to read my disclosure/disclaimer, as, there could be something incorrect in this post. The purpose of this post is for me to kind of outline my thoughts on the potential legislation, as well as it's potential reprecutions for the price of the stock. While value investors generally don't put much weight on developments that may or may not come, it is important in my mind, to think about such possibilities and to figure out how you would react. Many times, people will say something to the effect of "Hey! This stock just doubled! I should sell it!" without actually giving much thought as to the intrinsic value that would likely be created by such legislation if it is passed. For me, if the video lottery is legalized, and the price of the stock doubles, going on the information that I have now, there isn't a chance in Hell that I would sell my shares. In fact, I highly doubt that I would sell my shares unless they went well into the double digits... again, I can't stress enough that this is provided that the video lottery is legalized, based on the information that is out there about what the legislation will do. There are a million factors that can affect this to the positive, or, to the negative.

In respect to anything said by an executive of Nevada Gold, please heed this legalese from their website:

This interview may contain forward-looking statements, which are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. We use words such as "anticipate," "believe," "expect," "future," "intend," "plan," and similar expressions to identify forward-looking statements. Forward-looking statements include, without limitation, our ability to increase income streams, to grow revenue and earnings, and to obtain additional gaming and other projects. These statements are only predictions and are subject to certain risks, uncertainties and assumptions, which are identified and described in the Company's public filings with the Securities and Exchange Commission.

Now, to the meat and bones of the article...

Here is a snip from my interview with Bob Sturges:
J: Let’s talk about slots in Washington. The legislation called for more than 7,500 slots to be authorized. How many of those do you think you all could... If it is legalized, which there’s a remote chance of, but how many of those do you think you could fit into your casinos, and what are the cannibalization effects that it will have on your existing business, and what about other operators coming in as a result of this legislation?

Sturges: OK. The number that was in the last bill of 7875, the way that they got to that number was to multiply at that time, the existing number of card rooms, which was 63- there are a couple of less right now, and take an average of 125 machines per location, that’s how they got to 7875 and it would allow up to 200 slots in any one location. We have- most of our properties either have the space, or the space could be readily added on without a major problem, in, I want to say- at least 7 of the 10 properties. So, in our thinking we are looking at immediately, with not too much of an effort, we can get to 1500 machines, under the old bill, if that were to happen. In terms of- we don’t see any cannibalization of our existing business. We really see an expansion of additional gaming opportunities where the table game business would still be there but you would supplement that with, you know, with a whole new product and frankly, stereotypically, attract a lot more women, who tend to favor slot machines. Men tend to favor table games; obviously, there are exceptions. Couples now come and both couples now have a gaming option. It would just, it would be a tremendous expansion of our product offering and a tremendous expansion of our business if this were to happen. I am always careful to say I couldn’t handicap it.

J: Right.

Sturges: Because, you know, it’s politics. Who knows? It could never happen. It could happen, in January. There is a special session in November, that has just been called by the governor to plug a $2 billion dollar budget gap- mostly through cuts. Then in January, as I understand it, they are going to be talking seriously about where there are revenue opportunities and the slots in the mini casinos is definitely going to be part of that conversation... Whether it gets across the finish line, who knows, but, it is definitely going to be part of the conversation.

J: OK. With the slots is there a feel for the amount of revenue that can be generated by said slots, and also, what kind of margins do slot machines generally have? I remember in a radio interview, where you talked about kind of the logistics of slots and whatnot, but, I was looking for a little bit more clarity on that, if it was at all possible.

Sturges: Well, you know, it’s very market specific in terms of what kind of margins you can expect. It depends upon so many factors and that's why I would not want to speculate in Washington, because we don’t know what they tax structure is going to be. We proposed 35%, but we don’t know where that winds up and hopefully, it wouldn’t be any larger than that, because that’s the point where it makes business sense. Once you start getting above that, it becomes problematic. What are the restrictions on promotional activities? What’s your competitive set going to look like? But in terms of win per unit, with only 7,800 slot machines in Washington, being such a huge market, I think it’s safe to say that you should be in the $200 to $300 dollar win per unit range. So, you can kind of do the math based upon the win per unit in terms of a top line. And then margin wise, obviously, slots are far more efficient than table games. But again, there’s so many factors I don’t know that will be in place in Washington that I wouldn’t want to speculate. But I can tell you, the 20-30% margin that we run between sometimes with our table games in our WA 1 properties should be easily achievable with slots.

In a follow up email, I asked:
In the event that slots are legalized, how much additional expense do you see coming from them (replacement of units, maintenance, administrative, ect)

To which, Sturges responded:
As far as the operating margins, I would only say at this point that they should be superior to the Washington I margins which have been in the 20% range. This assumes no more than a 35% tax rate on slot revenue. On the capital side, we don't know whether it will be our responsibility to buy the equipment or if the lottery officials will front that expense as is the case in some states. The replacement cycle varies from 5-7 or 8 years depending on a lot of factors. One machine with all the bells and whistles including signage would cost close to $20k.

Since Bob didn't want to speculate, I will... First, let's take a look at and analyze the legislation and then take a look at the effects that the potential legislation will have on Nevada Gold (I suggest that read the article I just linked to).

The Political Battle...

Lets take a look at just what the legislation would do (here is the full text of the bill). Since gaming is already legal in the state, all that the proposed legislation would do, is let places where you can already go and blow your money by playing cards give you another way to lose money. Instead of having face to face contact with a card dealer and other players, you simply press a few buttons after putting money in a machine, and over time, the machine will give you less back... Basically, these things are the "U-Scans" of the gaming world and only make a digital for of what people can already buy on their way home from work, at their local gas station.

The beauty of this legislation is that it isn't really an expansion of gaming in the traditional sense. The machines are only going to be allowed in places where people already go to gamble. Legalizing ESTGs in non-tribal areas should be more popular than closing down monuments, cutting support for the elderly/disabled, those that can't afford basic necessities such as food, or even police salaries, which have historically been the arguments used in the past to push through legislation of this nature. Furthermore, the big issue here, according to Representative Charles Taylor, is that at present, Native American Tribes have a monopoly on video lottery terminals, which, in his mind, is an unfair advantage over other businesses, that the state isn't actually able to give.

Furthermore, when looking at the specifics of the legislation, the revenues that it generates would help out kids: ~50% of the taxes raised from the proposed legislation would go to funding K-12 education, another ~30% to "the most vulnerable" or, more specifically, Health and Human Services, and the remaining ~20% to Public Safety (here is the announcement from the legislature). Other allocations will be for those needing gambling treatment and for administrative costs. How can any reasonable person with any semblance of a heart dislike that?

Keep in mind, these machines are already all over the state, but, they just sit inside of casinos that sit on various Indian Reservations. While talking about the reservations, how will this affect the various tribes? Some reports say that they will experience a ~9% decrease in revenues, but, it is apparent that even a loss such as that will hardly destroy their operations- everywhere else in the state, there is generally at least a 10% tax on gaming revenue (which tribal gaming operations don't pay), so, at worst, they should still be doing better than their counterparts throughout the state. When talking with Representative Taylor, he didn't seem to buy the argument that the various tribes would be dramatically affected. He said that most all of the tribal locations were destination spots complete with hotels, whereas, the card rooms are generally locals only, where many of the patrons can stop by on their way home from work.

When looking to let card rooms have these units, it would certainly do a lot to spur growth in the Washington economy. Nevada Gold, not to mention many other card rooms, would need to alter their present locations or even expand their buildings to accomodate the new machines, which would generate investment from outside of the state. It would help out regional banks looking to make construction loans, it would employ a host of contractors... the very contractors who have been slaughtered by the downturn in the housing market and the broader economy. In a day in which people need work, this legislation would provide it and do so in a manner that doesn't spend money the state doesn't have or raise the mandatory tax burden on anybody by a single cent.

The bottom line is this: it makes a whole Hell of a lot of sense for the state to pass the bill, as it is a way of not only containing slot machines to buildings where gaming is already allowed, but, is also an activity that people actively engage in, but due to where they do it at, doesn't contribute to the tax coffers of the state. By industry estimates, slots could generate $160 million in revenue for the state. As if this wasn't enough, it will spur economic activity through out the state!

Clearly, legalizing slot machines in Washington is not only the ethical thing to do, but, it also is one that puts people to work, and would decrease the budget shortfall by as much as 15%!

Now, to the potential effects for UWN:

If we take a look at this table, under an average scenario (the one highlighted in green) being 1500 slots, generating $250 in wins per unit (which, I feel comfortable with, based on the numbers from other states, such as Pennsylvania, and even Las Vegas, where the market is extremely competitive, driving down WPU and by extension, margins), we will see an additional $136.88 MILLION in revenue for the company. Slap a 25% EBITDA margin on that (which is the middle of the margins for table games at the Washington 1 properties) and you get over $35 million in what I will loosely refer to as "profit". Take out 20% of that for various cash expenses like interest, non-cash charges such as depreciation (which, essentially gives the company a float), and another 40% for income taxes (a guesstimation, based on other casino operators), and you end up with ~$17 million (or, ~$1.29/share) in what I will loosely call "earnings".

Now, this is a pretty big deal for a company that is trading for under $25 million, or ~$1.90/share...

Put another way, if you value the present company at nothing... Then slap a 10x multiple on the potential earnings of my average scenario from slots, the company shoots from $25 million in market capitalization to $170 million in market capitalization, or, up nearly 700%. Again, this values the present company, which is doing a stellar job operationally (and is growing by leaps and bounds), in formerly hyper inflated Zimbabwe Dollars...

If the scenario that I lay out in regard to earnings from slots is something that Mr. Market believes is feasible, then, he is implicitly putting a very slim chance on the legislation passing. From what I can gather from various readings, talks with legislators in the state, and a look at the Washington budget, I think it should be closer to a coin flip (that's even what one of the legislators said). It is believed that there are the votes to pass the bill, even. It just needs to get to the floor for a vote. To get an idea of how the populous could feel about it, in 2004, for example, a move to legalize slots barely missed the mark. The initiative was not only a lot more liberal than the one that is presently being proposed, but, was also during a time when deficits were not the issue that they are now, which should make the legalization much more probable.

What about other operators coming into the state and stealing a piece of the ESTG pie? This is something that I am not worried about, as, the legislation caps the number of video terminals at 7,875... With that kind of cap, it essentially gives present operators control of the market. Then, on top of that, it puts a drag on further expansion of card rooms, as, if new locations can't get video slot terminals, it limits their product offering. Making them significantly less competitive and less likely to destroy the margins that present operators enjoy. Culturally, with the implied limit of card rooms, you actually keep gaming from expanding, and destroying the ethos of the state, as many worry about (the link is a document download).

In regard to the expense of actually installing and buying slots, even if the state doesn't front the money for the machines, as has occurred elsewhere and the company must buy the machines for as much as $20,000 dollars a piece, I am not concerned. The company's newly filed S-3 could be a way to get quick funds. The company could borrow from Wells Fargo, which has apparently expressed interest in a long term relationship with the company. Certainly, if the company believes it can produce numbers that are anything close to that which I think are possible, people would likely line up to give the company money in the form of debt If the company would have some sort of a rights offering, even, I would be far from upset. This kind of offering is something that would take money from outside of the state, and put it directly into Washington. I for one, would be likely be willing to invest- which would take money out of my local economy (where I have been buying limited amounts of real estate) and sending it off to help people in Washington.

If Nevada Gold doesn't want to go the dilution route, there is always the options of leasing the slot machines from various vendors. Sure, it would reduce the amount that the company would earn, but, not by so much that a huge upside wouldn't be left for the stock; again, looking at the table from earlier, under the most conservative scenario that I can imagine; being 1,250 units, with a WPU that is like those in the over saturated Las Vegas market, and an EBITDA margin that is 75% of that at the Washington 1 properties (~15%), the company's revenue will more than double (going up in excess of $68 million dollars)...

From where I sit, my investment in Nevada Gold was an investment with a margin of safety before I knew the extent to which slots could help the company... Now, it is an investment with a margin of safety that also has one of the nicest looking call options that I could imagine, which is essentially being given to me for free. While I would never invest in a company solely on the hope the actions of a legislature that sits over 2,000 miles from where I reside, it is certainly a nice bonus.

Disclosure/Disclaimer: I own shares of UWN. This is not advice or a recommendation of any kind. Always do a ton of your own research in regard to anything that I say, do, write, or so much as even think about. While I try to get everything correct, I am human, and may have botched something up.


Michael M said...

How do you feel about the risk of legalized online gaming?I mean, Washington DC needs money too and may even realize it at some point.

I live in Denmark so I have no idea who frequents these places in Washington state, but imagine the kind of lonely big-heared motorized women and drunken bros I've seen in Vegas, whom I assume will not substitute social gaming for the online "experience".

jeff said...

We live in a world where we will likely eventually do everything online, though, I don't think that the demographic of people that generally gamble in a physical location will readily trade that for a computer screen in the coming decade.

Plus, I don't think there is the political will in Washington (DC) to more or less repeal legislation that was passed in the past handfull of years.