The last time I covered Accel Entertainment (NYSE:NYSE:ACEL), a distributed gaming operator was in June 2021, when it was still recovering from the Covid lockdown measures which had impacted businesses from the services sector in 2020. The recovery was subsequently slowed by the second pandemic wave in October last year as seen by the slump in the orange revenue chart, but the pickup has been nothing short of phenomenal with record sales of nearly $267 million for the third quarter of 2022 (Q3).
However, the share price as shown in blue has not followed suit and, at $8.95, remains far below the pre-pandemic high of $14. Thus, by considering the profitability as well as the inflation dynamics prevailing in the service sector, the objective of this thesis is to assess whether an investment in Accel makes sense.
I start by looking at top-line growth amid the wider gaming industry.
First, bringing some precisions as to the 38% YoY top-line growth for Q3, this was primarily due to the acquisition of Century Gaming earlier in June this year thereby adding more than 8,300 gaming terminals across 900 licensed locations in Montana and Nevada. Therefore, as of September 30, the company owned and operated 22,429 terminals across 3,517 locations in Montana and Nevada in addition to its home turf of Illinois.
Also, organic revenues in the form of same-store sales grew by 3% in Q3 compared to the same period last year. Accel's diversification efforts also led to two acquisitions in Nebraska during the month of August, namely VVS, an amusement operator based in Lincoln, and River City Amusements based in Sioux City.
This expansion strategy remains well above the growth witnessed in the wider gaming industry. Thus, according to the AGA or American Gaming Association, commercial gaming revenues hit an all-time high in Q3, beating the previous record established in the second quarter by 2%. The revenues of $14.81 billion also show that the industry has not only recovered past its pandemic high of $11 billion but continues to thrive.
However, there is also the competition to factor in as well as the fact that this level of inorganic growth, especially at a time of high inflation with the Federal Reserve raising interest rates, could make borrowing from banks more expensive. Thus, it is important to assess the company's business model for potential risks and profitability.
First, as shown by data from the AGA earlier, despite the persistence of high inflation this year, people have shown a tendency to continue spending money on gaming. Also, for convenience purposes, people tend to spend more in the local gaming of the establishment they are already used to like bars, instead of having to make the displacement to Las Vegas.
Looking at the modus operandi for the last ten years, Accel has established partnerships with local business owners in each state where it operates. These in turn receive incremental profits as more players use the gaming machines.
Now, in the current macroeconomic environment where both inflation and supply chain problems have increased the cost of doing business, the company has been impacted by the higher-than-expected cost of sales, such as expenses incurred during the installation of new machines or buying of parts during equipment upgrades. As a result, gross margins have decreased to 29.74% or 3% less than during the same period of 2021 as shown in the table below.
Operating margins have also suffered and the question is whether with wages in the services sector going up, profitability may not take a hit.
In this respect, the partnership approach helps to mitigate some of the higher labor costs as Accel does not incur the operating costs for manning the gaming machines which are under the responsibility of the local establishments with whom there is a revenue sharing on terms which have already been agreed beforehand.
To support my point, I perform a comparison as per the table below with big gaming and casino operators Las Vegas Sands (LVS) and Flutter Entertainment (OTCPK:PDYPY) which have their own staff to supervise their gaming operations and are more directly exposed to wage inflation.
Going into details, these two giant operators enjoy much higher gross margins of above 60% compared to Accel's 31.54%. This is mostly because of their much higher revenue bases, in the order of billions of dollars, on which to spread fixed costs. They are also much larger as evidenced by their market caps, which enables them to benefit from better economies of scale in turn resulting in more favorable per-unit costs for their gaming machines. This in turn means lower cost of revenues and higher gross margins.
On the other hand, Accel’s relatively higher EBIT margins show that it is able to control operating costs much better than its two larger peers. This confirms that its partnership model with local establishments on a cost-sharing basis is working. As such, Accel incurs relatively lower site supervision expenses as these are taken care of by the local bars where its terminals are installed.
Thus, the company has a better chance of navigating in an environment of increased cost pressures as wages in the service sector have to be constantly increased to make up for higher consumer prices.
On top, Accel’s competitive positioning should be enhanced by Century's technological capabilities along the whole gaming machine value chain. More concretely, it means that with its control now having been extended from a gaming operator to the machine ecosystem, Accel should see a lower cost of revenues as it saves on spare parts and related costs.
Thus, this is a company that prioritizes growth, while the partnerships forged with local establishments help to differentiate it from the competition. and should also be useful to mitigate increased cost pressures. The company also has a highly variable cost structure, which allowed it to quickly adjust to Covid lockdowns through a drastic reduction in cash usage and furloughing of the vast majority of its staff, as well as drastically cutting executives' salaries. That was in the second quarter of 2020.
On the other hand, in order to fuel such a high level of growth, Accel has been spending heavily with debt reaching $521.4 million at the end of Q3. At the same time, CapEx has jumped to $19.8 million from $7.8 million in the last quarter year, in order to fund investment in the Nebraska market and in anticipation of potential supply chain disruptions in 2023. This in some way puts into question Accel's "capital-light" or low capital requirements. However, continuing on a positive note, Nebraska represents considerable growth opportunities. Moreover, the company generated cash from operations of $37 million during the last reported quarter, translating into $17.3 million of free cash flow (levered). This remains well above the $6.2 million of interest paid on loans.
Furthermore, compared with the median for the Consumer Discretionary sector, Accel's Free cash flow margin of 7.18% outpaces peers by a whopping 400%. Consequently, this is a stock that is suitable for investors looking for growth within the United States, while at the same time being keen on profitability. Thus, I value the company using the trailing GAAP price-to-earnings multiple of 12.32x, where it is undervalued by 6.87% as shown in the table below.
Adjusting accordingly, I obtain a target of $9.7 based on the current share price of $9. This remains far from the $14 mentioned in the introduction.
Thus, this may not look to be a high price target, but, my rather cautiously optimistic position is justified in view of the current market exuberance created out of indications that inflation may have peaked, together with a signal that the Federal Reserve may reduce its hawkish tone. What's noteworthy in this case is that it is only during the next FOMC meeting scheduled for Dec. 13-14 that the decision on interest rates will be known, and in the meantime, it is better to exercise caution when investing.
As for Accel, this is a company that prioritizes growth, both organic and through acquisition but, not at the expense of profitability. Its ability to partner with local businesses confers an attractive cost structure which results in better-operating margins than casino and gaming giants. At the same time, it has superior cash-generating metrics. All these mean a business model which can produce growth without sacrificing profit margins.
Finally, geographical diversification in order to increase the percentage of revenue generated outside of Illinois is another positive together with expansion into new industry verticals with the Century acquisition.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
Additional disclosure: This is an investment thesis and is intended for informational purposes. Investors are kindly requested to do additional research before investing.