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In May, I wrote:

In a big-time downturn — 2009 being the best recent example, and Q4 2018 another — it’s the riskiest, most speculative and sometimes even kind-of-junky plays that provide the biggest returns when the market bounces back. (And let’s try and remember — it always bounces back, even if not all of the stocks in the market do the same.)

Casino supplier PlayAGS (AGS) would seem to fit that description. It’s risky, if only because of its balance sheet: net debt is more than 4x trailing EBITDA. It’s speculative, given its macro exposure, and, again, its balance sheet: the equity slice here is barely one-quarter of enterprise value.

There’s even a case that PlayAGS is, well, kind of junky. The company’s business obviously took a big hit from the novel coronavirus pandemic — but PlayAGS struggled before the pandemic arrived. In 2019, AGS stock declined by nearly half amid execution stumbles at its most important property and potential market share pressures.

Indeed, during the worst downturn in recent memory — the March 2020 sell-off — I purchased AGS stock. But the case then wasn’t necessarily based on the idea that the stock would snap back with the market. Rather, it was that the company wasn’t nearly as risky as panicked investors believed at the time. By the end of April, AGS stock had quadrupled from its lows.

Two-plus years later, a similar story is playing out. Amid a rout in small-cap stocks, AGS has plunged 37% just since the beginning of March. The selling seems to make sense, given rising fears of a recession and the cyclicality of the gaming industry.

But once again, it appears the market is overreacting to a story that is not nearly as simple, or as dangerous, as it looks. Gaming has been surprisingly resilient during past recessions, and PlayAGS’ key markets should outperform looking forward. Operating leverage here is not nearly the same as it is for operators (whose stocks too have plunged over the past four months).

Of late, we’ve been consistently bearish on the mid-term outlook for the markets, and it seems at least possible that the consumer does roll over. But that’s the point: even with that outlook, there’s a case that AGS at worst should hold up in the mid-term, while valuation and growth drive an attractive long-term thesis.

PlayAGS At A Glance

PlayAGS is a supplier of electronic gaming machines (EGMs) to casinos mostly in the U.S. The company’s original core competency was developing so-called Class II games. Class II slot machines are bingo-based; payouts technically are based on the bingo card on the screen, with the slot machine action based on the results rather than determining them:

Bingo card in top left corner. source: KnowYourSlots.com

Class II slots originally were developed as a workaround for tribal casinos. Those casinos were allowed to offer bingo but not traditional slot machines (known as Class III machines); Class II products allowed tribes to offer a facsimile of the Vegas experience.

For some time, the word “facsimile” was doing a lot of work. Class II machines were rudimentary and low-tech. (I’ve seen a few early models at various properties over the years; they’re reminiscent of early Nintendo video games, if not early Atari.) But as tribal casinos made more money, and invested more of that capital into their properties and their floors, the quality of Class II games rose to at least near that of their Class III counterparts. The leader in that evolution was Multimedia Games, now part of Everi Holdings (EVRI), though PlayAGS (founded in 2005) has done its part as well.

Over the years, Class III games have become a bigger part of business for tribal operators and for PlayAGS. But the legacy business still is at the core of the PlayAGS business: at the end of 2021, a little over two-thirds of the domestic installed base came from Class II machines. AGS doesn’t break out tribal revenue specifically, but 46% of last year’s revenue came from Oklahoma (28%), Texas and Washington state (the latter two 9% each). These are three states without commercial casinos. Most of the EGM revenue — close to 80% — is generated on a recurring basis, either on a fee-per-day or revenue-share basis.

There are some other, smaller, revenue streams. International markets accounted for 9% of revenue last year, and 15% in 2019; the lower proportion is driven in large part by a slower pandemic recovery in Mexico (5% of revenue in 2021 and 9% two years earlier).

AGS has built from scratch a Table Products segment that offers blackjack progressives, roulette and baccarat signs, and single-deck shufflers. Table Products isn’t large, at less than $12 million in 2021 revenue, but profit margins are strong: segment EBITDA of $6.4 million totaled 54% of revenue. An Interactive business offers games for social casinos, as well as real-money options in Michigan and other states.

Still, this is largely an EGM (electronic gaming machine) story: that segment drove more than 90% of revenue and profit last year. And it’s a story that the market isn’t terribly interested in at the moment: late last month, AGS stock touched an 18-month low.

The Case Against AGS Stock

The case for AGS stock is the sell-off to some degree is unjustified, and driven by a market that doesn’t quite understand the particulars of this small-cap/micro-cap (depending on your definition) story.

The case for selling here is that PlayAGS is a cyclical, struggling, overleveraged company heading into a likely U.S. recession. It’s a case that seems to have some support. Gambling seems among the most discretionary of consumer spending.

Indeed, AGS stock has struggled since its 2018 IPO:

source: finviz.com

The same seems true for the business. Between 2018 and 2021, revenue and EBITDA declined 9%. The installed base shrunk 2% in the U.S. and 8.5% overseas. Unit sales fell 46%.

And, of course, the balance sheet is highly leveraged. Add it all up, and even in a charitable analysis this seems like a dangerous value trap, and to more skeptical eyes a short (maybe to zero) opportunity. But… from here, that may well create opportunity.

Slot Revenue Holds Up

The idea that gambling spend plunges in a recession makes intuitive sense, but it isn’t borne out by what actually happened during the financial crisis:

source: Credit Suisse

U.S. gambling revenue declined less than 2% in 2008, and 4% in 2009. As seen in the chart to the right, tribal revenues were actually stable through the period.

There are some underlying factors to understand. The first is that during that time, new commercial casinos came online, particularly in the Pennsylvania and Maryland markets. Same-property revenues thus posted sharper declines than overall industry data suggest, though regional properties did better than Nevada (where revenue fell more than 10%).

Second, tribal strength no doubt was helped by the shale boom. Oklahoma, Texas and Kansas accounted for about 11% of national tribal revenue at the time — and in 2008 those three states (mostly Oklahoma) grew about 18%. Those states aside, tribal revenues appear to have declined that year (and 2009 was likely the same).

Third, a core worry for the coming crisis (should it arrive) might be that casinos are significantly overearning at the moment. Stimulus payments clearly drove heightened consumer spending across the board in 2020-2021; a return to normalcy on that front should amplify typical cyclical effects. That certainly appears to be the case in consumer retail, for instance.

Still, the knee-jerk assumption that casinos are in for trouble — and more importantly for our purposes, that PlayAGS is in for trouble — doesn’t quite hold. The industry is more resilient than skeptics might realize. Energy industry strength presumably can provide ballast for PlayAGS, given its concentration in Oklahoma (which serves the Texas market as well) and Texas.

Indeed, a big driver in 2008-2010 was higher oilfield activity, which created flush workers; that activity only now is starting to pick up:

source: Bureau of Labor Statistics

The steady stream of new residents into Texas provides another potential source of support.

As for the comparison problem, slot spending indeed has risen — but in 2021 was up 10% from 2019. That’s a sub-5% CAGR; hot but not exactly scorching.

The macro impact on the way down may not be much bigger than it was on the way up. Slot machine players are older: more than 70% of slot revenue nationwide comes from players over the age of 55. Those players presumably are less economically-sensitive. Inflation no doubt is a concern — casino executives talked endlessly about gas prices amid the economic recovery of the early 2010s — but gas prices are reversing and, again, the Texas and Oklahoma markets provide a bit of hedge.

There’s a risk here, certainly, in a “stagflation” scenario — but that’s true to profits everywhere in the market. There’s also the possibility that casinos tighten their belts as their results deteriorate, hitting PlayAGS machine sales (23% of 2021 revenue). Overall, this is a cyclical business.

But the point is that this is not that cyclical of a business, or at least not quite as cyclical as public market investors (judging by their treatment of the sector) seem to believe at the moment.

A “Struggling” Business

The potential risk to equipment sales highlights another key point here: despite the supportive macro environment, it’s not as if 2021 (or, indeed, Q1 2022) was a banner period for PlayAGS.

Indeed, particularly in the first half of the year, PlayAGS customers still were dealing with pandemic-driven restrictions. Q1 2022 EGM revenue rose 32% year-over-year in part due to that soft comparison. Trailing twelve-month revenue is only 3%-plus below where it sat in 2019; all of that weakness appears driven by international markets.

Owing to the industry’s efforts to preserve capital particularly in 2020, the replacement cycle has slowed. That’s been a key factor in the plunge in unit sales as well. At some point, those sales will reverse, even with macro difficulties, simply because machines need to be replaced. At the very least, they’re unlikely to decline much further.

As for the shrinkage in the domestic installed base of leased machines, PlayAGS did struggle before the pandemic, particularly with Class II cabinets in the key market of Oklahoma. (Tribal customers there, particularly at the two big Vegas-style resorts in the southern part of the state, were ramping Class III placements which widened competition.) But of late, the modest reduction has come largely through strategic efforts by PlayAGS to “prune”, as management puts it, underperforming machines.

Those efforts are over. Chief executive officer David Lopez said on the Q1 conference call that the Class II base was “healthy and stable”. PlayAGS is moving into premium cabinets for both Class II and Class III, which improve yield for leased machines and selling prices for sold units.

Even on a trailing-twelve-month basis, growth here doesn’t look all that impressive. Indeed, an investor might wonder how results are going to stay stable in a recessionary environment when they didn’t grow in an expansionary one.

But not all expansionary environments are created equally. PlayAGS has dealt with tightened purchasing budgets, casino shutdowns, supply chain issues, and inflationary issues of its own. In that context, performance — admittedly going back to 2018 — has been somewhat disappointing. The company has responded to those challenges, however, and has growth opportunities in Table Products, Interactive, and historical horse racing (HHR).

HHR, as the name suggests, works similarly to Class II machines, though it uses already-run horse races to drive the underlying results. HHR has been legalized in Kentucky, Virginia, Wyoming and New Hampshire, and Lopez said after Q1 that “our market penetration in HHR far exceeds our penetration in the other markets.”

Just as there’s a more resilient industry and business than macro fears might suggest, there are better prospects going forward than headline, backwards-looking metrics might suggest. With EBITDA margins targeted to 45-47%, and decremental margins not terribly high, at the least PlayAGS should be able to muddle through and keep driving positive free cash flow. At a $195 million market cap, that’s enough.

A Cheap Stock

Based on trailing twelve-month results, AGS trades at 5.7x Adjusted EBITDA. Back out share-based comp and the multiple expands by about a turn. EVRI, on the former basis, is about 7x.

Like so much else here, that gap on its face perhaps makes some sense; EVRI is larger and less leveraged (~2.4x vs 4.2x for AGS). But AGS has a key advantage here.

In a debt refinancing, executed in February. PlayAGS lowered its outstanding principal by $40 million — but also cut its annual cash interest bill by $10 million. That’s a significant saving, given that NOL carryforwards will minimize any cash-tax impact, and that in 2018, 2019 and 2021 PlayAGS averaged free cash flow just over $20 million.

Pro forma for the reduced interest, AGS is trading at ~6.5x its average free cash flow from the last three years. And while, yes, the macro environment in those years is likely better than it will be in 2023 (and potentially beyond), it bears repeating that the operating environment for AGS in 2021, and its execution in 2018-2019, both were far from optimal.

Note too that PlayAGS is guiding for net leverage below 4x at the end of the year, which appears to contemplate both modest debt reduction and an increase in EBITDA even following the soft Q1 comparison. If that guidance is hit, either the equity value expands to keep enterprise value stable, or the EV/EBITDA multiple starts shrinking to 5x or so. If the guidance is not hit — a risk to any outlook at the moment — there’s some slack in the valuation (and from some level of debt reduction) to potentially keep the stock intact.

Once again, the news here is better than an initial view might suggest. It certainly seems like AGS is receiving a multiple befitting a leveraged, cyclical stock — but neither risk is nearly as pronounced as that multiple, or a 37% decline since Feb. 28, would suggest. In a bear market rally, that should be enough for some upside. In just a bear market, it should be enough for the stock to hold.

As of this writing, Vince Martin has no positions in any securities mentioned. He may initiate a position in AGS this week.

Tickers mentioned: AGS

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