Note: This article was exclusive to House Edge members until after the market opens today (June 30 th).(firstname.lastname@example.org).
“Blue skies, smiling at me, nothing but blue skies, do I see…”
On September 20 th, 2016, we posted an SA article on El Dorado Resorts (NASDAQ;ERI) when the stock was trading at $14.25. Our belief was that the market was missing the real story of this consistently strong regional performer which was then, and remains, a management play.
At writing ERI is now $20.45, a gain of over 40%.
This strong move was propelled among other reasons, by the news that ERI had reached a definitive agreement with Isle of Capri casinos to acquire that company for $1.7 billion which included assumption of $929 million in Isle debt. That deal was subsequently approved by Isle shareholders despite the trade tipping above the acquisition price before the May 1 st settlement of the deal.
A negative media spike disguised post-1Q upside momentum for the stock we believe is already in motion for Q3 and Q4.
When ERI announced its Q1 big revenue and earnings miss, negative sentiment on the company soared. Consensus price targets sunk from $26.00 PT to $21.50 and lower. The stock presently has a 50 day moving average of $20.57 and 200 day moving average of $18.06. Much of the negative coverage sprung from Q1 results published May 4 th. The company reported $0.04 EPS missing a consensus estimate of $0.20 by a whopping $0.16. Revenues for the quarter scraped past $200.90 million, missing analyst’s expectations of $209.75 million. Forward earnings projections predict $0.76 per share for the 2017 fiscal year.
So what happened in Q1 to send the bears rushing in?
1. Mother Nature is what happened, not much else. The bulwark of ERI’s regional strength lies in it’s tri-property position in metro Reno. A quick peek at the weather reports for northern Nevada during Q1 would have been quickly revealing for anyone who knows how the area’s gaming calendar works. In brief, a succession of heavy snow inundated the Northern Nevada area reaching a record number of inches. This kind of weather drastically reduces Reno-Tahoe business from key feeder markets in northern California like Sacramento and San Francisco. It also thins locals drive in business. Both these factors took their toll on earnings despite some compensatory gains in ERI’s Scioto Downs and Mountaineer racing properties. ERI has also completed renovation of 300 rooms at its Circus Circus Reno property which should start contributing to that property's EBITDA. Weather has always been one of the key drivers of the Reno gaming market during the winter months. Ski weather from excessive snow mass can be both good news and bad news. In ERI's Q1 it was all bad news and the revenue miss showed it in spades.
So following the often irascible swings of Mother Nature, business rises significantly during normal snow winters and takes a hit in excessive downfalls that clog transportation by air or road. If you examine the relationship between excessive snowfall and casino property performance in the area over the last 20 years, you will find there is a trade off that ultimately results in a predictable long term balance.
You can be certain, the very savvy Carrano family, majority founder/ owner/operators of ERI input long range weather forecasts into their annual business plans. In this past Q1, the weather factor was simply off the charts from any possible normalized input into a business plan. This produced a knee-jerk reaction among many market watchers and that produced a slew of negative outlooks on the company.
2. The rapid growth of the Reno metro area attributable to healthy, above average, population and job gains we outlined in our 9/20/16 SA (seekingalpha.com) article on ERI has become a singularly bullish trend for casino operators there. That means even locals tend to curtail driving in heavy snow, The sunny side of that contingency is that when weather isn’t a factor, casino footfall is increasing with metro population, rising average income from technology centered jobs and the general vitality of the marketplace showing up in all aspects of the local economy.
With the winter behind us and the Isle of Capri acquisition complete, what forward catalysts do we see that supports our sentiment that ERI has runway ahead and is worth a hard look by investors now?
Against consensus PT of $21.50, we’re setting a House Edge PT of $30, by Q1 2018 or before. Here’s our thinking based on our own industry metric analysis. It is a core valuation we use in our consulting practice which rates management quality in gaming. That number puts ERI in the top ten percentile among operators for marketing program effectiveness, track record, floor management know-how and margin controls. Note: Despite a big miss quarter, ERI reported a gain in gross margins from 31.30 % to 32.03%. That tells us that management is nimble and deft in dealing with macro factors, a skilled acquired over many decades by the Carrano family. Going forward for the balance of the year we’re looking at a significantly accretive EBITDA base for ERI.
1. The acquisition of Isle of Capri has created a company with combined annual revenue of more than $1.7 billion and in our view, building toward $2 billion by the end of 2018. Adjusted EBITDA looks like it could reach $394 to $400 million after giving effect to identified cost synergies amounting to $35 million post-acquisition. Now lets be clear: It’s a common mantra against management PR happy talk after mergers or acquisitions to talk about “synergies”. Such savings sometimes pan out, other times get lost in the hammada hammada excuse making in subsequent earnings releases when they don't materialized. But in this instance we have the Carranos. When they say $35 million in savings are ahead, that’s bankable, based on their long history of solid performance, distinct aversion to hype and hands-on management style.
2. The Isle acquisition smooths out ERI’s geographic reach with 12 casino resorts including 19 properties in ten states with 20,000 slot machines and VLT’s, 550 table games and over 6,500 hotel rooms. Quite simply this transaction has vaulted ERI into the ranks of transformation into a major national player in the $70 billion US casino market. The Isle deal expands ERI geography and scale. It diversifies risk to an extent that increases its moat against smaller regional downturns. For that reason it deserves to be valued as a sleep tight, long term earnings producer. Our view, once Isle is fully integrated into the ERI management culture, we expect earnings to surpass consensus of $0.76 and cozy up to $0.84. (Note: Prior to closing the transaction Isle sold its Lake Charles Louisiana property to local developers for $134.5 million so that property will not move into the ERI portfolio).
The takeaway: ERI is a bet on superior management proven over time to a) maximize operational profits from its legacy properties b) Flawlessly integrate acquisitions into its portfolio. They understand how to build off a long track record dealing with player motivations and service. It's conservative, cost conscious management contains a generational bench of Carranos who have literally grown up in the business. That establishes continuity of succession ERI investors can have confidence will move with the times..
It's not my habit to cheer lead stocks I like. Yet having been an industry insider from back in the day and understanding how the dynamics and gears of management skill sets grind against the hard realities of running casino properties, I have to plead guilty in this case. I have watched the Carrano heirs, who could have easily afforded to sit life out on fat trust funds, standing for hours in the center of casino floor slot carousels, selling change back in the day. I have seen them constantly interfacing with customers—not sitting in executive offices. These guys are the real deal. You can bet on it. Stay long, we’ll look for a plus in Q2.
Author’s note: My own gaming portfolio is held in a blind trust for my children an grandchildren so as to avoid any possible conflict of interest with casino clients past, present or future. ERi is not, not has ever been, a client.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.