Thursday, 10 November 2016

Revisiting Great Canadian Gaming: Lessons on Capital Allocation

Thought I would revisit some preliminary thoughts I had on Great Canadian Gaming. I first wrote about the company back in January 2016. My initial post is here.

At the time, I had purchased $5K face value of the company's July 2022 6.625% bonds for par. Not a bad idea in hindsight as the bonds have rallied modestly to 105 since the time of my initial purchase and I'm still collecting 6.625% in a tax deferred account. As the bonds will mature at par, I'm going to ignore the temporary capital appreciation aspect of my purchase and just focus on a 6.625% YTM if I hold through maturity. Again, not bad, but not great.

Here's the problem with my idea: Back in January, I did what I thought was a pretty thorough analysis of the company's prospects, but in the context of continuing to progress (and hopefully evolve) in my investing journey, I realize now that what I did was analyze the company's runway without realizing it (more on this later).

Here's what I wrote:

"On Jan 11, 2016, GC announced the closing of a deal to operate casinos / facilities in Ontario. The company had previously disclosed that it was in the bidding for the license. 

So, I take this to mean the following:
  • The company is diversifying it's exposure base away from Western Canada to Ontario with this win.  Prior to the win, the Company had revenues of approximately $330M from existing facilities over the 9 months ended 09/30/15.  The OLG win gives them a minimum guaranteed fixed fee component of $15M per year (before Belleville is opened), and $24M thereafter, and a variable component = 70% of gross gaming revenue plus a fixed amount for approved capx + 100% of non-gaming revenue.  Even if the variable component is 0% (unlikely), the OLG piece is somewhere between $15M & $24M depending on when Belleville opens.
  • EBITDA would have been $16-$17M had the OLG win been in place for the year.  

I get EBIT of around $103M annualized (excluding new OLG).  EBITDA should be $103M + $28.9/9*12 = $38.5M, so EBITDA margin = ($103M +$38.5M) / $332.7/9*12 = 32%

Quick and dirty, taking the low end of their pro-forma range of $16M and applying overall company wide EBITDA margin, I get pro-forma revenues $16 / .32 = $50M.  $50 / $443M = 10% incrementally

My rough calculations only estimated incremental returns from existing casinos acquired and did not factor in the Belleville casino (under construction). As a result, I was too conservative (which was ok for the purposes of analyzing interest coverage at the time).

The company released results yesterday and reported that the recent acquisitions added around $26M in adjusted EBITDA for the 9 months ended Sep 30, 2016, on incremental revenue of $84.9M, a 30% EBITDA margin on incremental revenue (before Belleville)!

Let me digress quickly and discuss John Huber again. As I've pointed out previously, I am a big fan of reading John's blog, Base Hit Investing, and his various articles on the concept of return on invested capital. For anyone new to my blog, I highly suggest visiting Base Hit Investing and reading the series of articles John has written on ROIC. One of my favourite articles is here, which articulates the difference between legacy and reinvestment moats. 

Once you get through this article, there is a further article on calculating the returns on invested capital here, and a recent article articulating the differences between John Huber's methodology of calculating ROIC vs. Buffett's methodology, here, which is central to the direction I believe my thought process is taking me over time.

Buffett discussed a very simple approach to calculating ROIC in his 2007 shareholder letter using the example of See's Candy. Without going into huge detail (I will leave this for the curious reader), Buffett took incremental pretax income divided by incremental invested capital over time. Buffett's definition of invested capital is net PPE + net working capital in this example (a simplified method of measuring invested capital, but it worked for See's Candy).

Huber on the other hand, looks at invested capital from the financing side of the balance sheet. His approach is to take incremental NOPAT divided by incremental capital (Equity + Debt + off balance sheet leases - cash - goodwill).

For the most part, the two approaches should yield similar results, as the capital financing side of the balance sheet should lend itself to analysis of use (the equity + debt raised has been invested in net PPE + working capital over time). I'm oversimplifying as all businesses are different, but what the above approach has led me to do is to start developing a database analyzing all companies I'm interested in from both perspectives in an attempt to understand ROIC.  The flipside of course, is to compare ROIC to WACC in an attempt to determine the economic spread between the metrics.

Here's Great Canadian Gaming updated through yesterday (for simplicity, I took yesterday's 9 month reported results and annualized by /9x12

As can be seen, ROIC under both Buffett and Huber is pretty close, I take this to mean that I haven't made any egregious errors in calculating ROIC. The problem here is that ROIC is blended, it includes everything. What about ROIC on the newly acquired casinos?

For this, I'm going to take incremental EBITDA of $26M above and annualize this: I get $35M, on a purchase price of $94M per the 2015 audited financial statements. Out of the purchase price, $75M was allocated to land, building/leaseholds, and equipment, and the majority to building/leaseholds, so I'm going to assume a 30 year amortization period (roughly equivalent to tax amortization).

The OLG east bundle cost $47M, and out of this purchase price, $28M was allocated to property, plant and equipment. I'm going to assume a similar 30 year amortization period.

In total, I get ($75M + $28M) = $103M / 30 = $3.4M per year in incremental amortization, so say incremental EBIT of $31.6M. Borrowings didn't change significantly, but let's assume the purchases were financed with incremental borrowings of $103M x 6% = $6.2M in incremental interest per year.  I get pretax income of $25M on invested capital of $103M, or an ROIC of 25% incrementally. Interestingly, ROIC is in excess of my legacy calculated ROIC with respect to the newly acquired casinos (and this is before Belleville is completed!). 

Tying it all together

What I'm trying to come up with here is a feedback loop mechanism in an attempt to evaluate my initial analysis in January. For this I need to ask the following questions: 1) Was my January analysis correct (for the most part), and 2) Did I make the best use of my analysis in order to make the correct investing decision (i.e., was it correct of me to buy the debt instead of the equity).

1) Was my January analysis correct:

Yes, I believe I was on the right track. Without knowing it, I had the beginnings of attempting to evaluate potential growth runway by virtue of analyzing what the new OLG east bundle might have earned going forward. A simple approach here could have been taking the purchase price of the net assets acquired and estimating pretax income or NOPAT by using historical  incremental ROIC as calculated above.

From the January 11 press release:

Better yet, the company provided ttm EBITDA of $16M-$17M, so on a purchase price of $51.3M + working capital of $12.3M for the first casino out of the bundle, the company basically purchased an annuity stream for 3.75x -3.95x TTM EBITDA.

At the time, the company was trading at around 7x TTM EBITDA in the market, so my conclusion here is that this was an exceptional demonstration of capital allocation buying incremental assets at 1/2 of the then current market EV:EBITDA multiple.

The total OLG purchase package ended up being $141M (pre-Bellevile), so using EBITDA of $16-$17M on the first casino purchase of $51.3M + working capital of $12.3M, I'm assuming that total expected EBITDA on the entire bundle would be 26% x $141M =  $37M, or almost 20% of 2015 EBITDA before Belleville was built!

All of a sudden, TTM EV: EBITDA 7x becomes 6x fwd EV:EBITDA factoring in expected earnings from OLG East, and this for a company which arguably has a pretty solid moat in terms of owning and operating casinos (casino licenses aren't just given away)!

Put another way, EBITDA : EV was around 16.67% at the beginning of January (1/6).

2) Did I make the best use of my analysis in order to make the correct investing decision (i.e., was it correct of me to buy the debt instead of the equity):

This is a more difficult question to answer (but easier to answer in hindsight). At no times were the bonds distressed. Even during the midst of the January swoon, the bonds traded at par. Buying the bonds at par was a secure way of locking in a 6.625% coupon for 6 years, but there was no prospect of capital appreciation.

The equity on the other hand, was being priced in the market at distressed levels, partly due to perception of the company's exposure to Western Canada, and the astute analyst (of which I was not) would have realized that even without OLG east acquisition, the existing casinos under operation were being valued at 7x EV:EBITDA. The same $5K invested in the equity at $16 would be worth $7,930 today, and I missed the idea because I don't believe I realized what I was analyzing in real time.

By buying the debt, I was securing a very nice 6.625% YTM. By buying the equity, I would be getting OLG East virtually for free.  I will chock this one up to experience.

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