Tuesday, September 30, 2014

Scratch and Win with Scientific Games

We've all been there. Due to the conspicuous absence of timekeeping devices on the casino floor, you aren't really sure what time it is, but your judging by the cramps in your ass and the tingling in your sleeping leg, you've been sitting far too long. What, it's 3 or 4 am most likely? Not really sure.

You're break even for the night, which is great, but disappointingly there have been no moments of ecstasy or terror. Just rote, repetitive play, chipping up and chipping down. Then finally, an interesting hand. Not a guaranteed winner and not a guaranteed loser, but substantive. If you play it right, you'll end your night walking away with a huge pot, without having risked a ton of money.

I feel the same way about Scientific Games $5.1B takeout of Bally Technologies. Its a deal that some holders seem to be particularly concerned about because post close, their debt/EBITDA will jump up to 8X. Debt levels, circa 2008's binge mentality is not something I'd typically consider, although I feel like this is a smart move for $SGMS. Understandably the perceived risk of renewed pressure on the balance sheet has some people worried, although I am not one of those people. Ron Perelman doesn't seem to be too concerned either.

From my perspective it's fundamentally a very simple story about cost savings, FCF and management. No fancy chart wizardry, short-sale hit pieces, 10MB excel spreadsheets or 3 hour investor presentations necessary. Within two years the combined companies will enjoy $250M in annual savings via capex and cost synergies. Within the same time frame the company will improve FCF to ~$400M, which they'll use to pay down debt their debt load.

Really, when you think about it, even though the chatter around the deal seems to be either on the future of gambling or on the financing, the story is about neither of those so much as it is a story about management. It's easy to just assume in a powerpoint deck you'll be able to hit all these targets, but you don't have to look far back in the company's histories to see for yourself they can execute on integration. Applying management's plan to the last 12 months would have seen EBITDA margin improve 10% and the FCF margin increase to over 30% on EBITDA of $1.335B generated from over $3B in revenues.

Ultimately the company plans to use the improved FCF to quickly pay down their slated debt to ~4X within a few years, but again that all depends on management's pro formas and whether or not you believe them.  Sure there has been some softness in some of the areas they operate in, but the combined entity will be very diversified, sourcing revenue from ten major areas (instant tickets, lottery systems, slots, WAP, gaming systems, utility products, prop games, electronic table games, online gaming and social gaming). As easy as it is to hate on the casino space 60% of SGMS/BYI combined revenues are stable and recurring in nature; 24% of their revenues are from instant products and lottery systems. The biggest risk to the combined company is that about 31% of their revenues (~$900M) is attributable to non-recurring gaming machine sales and gaming systems, although their combined sales in this segment doesn't appear to pose a grave risk to their health. This entire segment of their business would have to completely implode in the coming months to pose a serious risk to their operational plan and based on SGMS & BYI's recently filings, this shouldn't be a concern. In fact combined WMS/SGMS gaming segment sales for 2013 were just shy of $1B at $997.8M and in SGMS's latest 10Q the segment is showing revenue of $403M for the last six months and on track to achieve roughly $850-900M for the year. Also, BYI's EGM segment has grown ~13% to $382M. The combined company will be well positioned in the general space, ranking number 2 in revenue and EBITDA(behind GTECH/IGT) with EBITDA margin at roughly 45%. Their consolidated operations and resulting synergies will also help them manage any continued downturn in gaming sales, as seen in the WMS/SGMS merger.

Moody's seems to think that the debt is riskier than I do but they've made some key assumptions I disagree with:

  1. the expectation of continued softness in the gaming sector and only a modest level of consolidated EBITDA growth
  2. 75% of the company's proposed $220 million of estimated cost synergies are achieved
  3. and between $400 million to $450 million of absolute debt repayment.

Looking back at management's long list of acquisitions, BYI recently confirmed they'll hit $42M in savings as a result of their SHFL acquisition, although they originally estimated $30M. Likewise SGMS confirmed $100M in cost synergies by end of 2015 for their WMS acquisition. SGMS estimated $50M in savings for 2014, and they've revised that to $80M with $65M already realized. If you want to penalize management for anything it would be underestimating how efficiently they'd integrate their acquisitions, not falling 25% short of their informed synergy estimates. 

The SGMS/BYI debt-financed merger represents an excellent opportunity presented by a very seasoned management team that has already demonstrated their ability to acquire, integrate and execute, without overpromising. They went to the debt market because they are confident they'll be able to deliver on their promised acquisition plan. And how do I know their pro-formas are up to snuff? I don't. No forensic accounting, no investigative journalism, just good old fashioned reading. I read management's old plans, their updates on those plans and compared that to where they're at now and then read some more. Management has done pretty good by that measure, so when they say they'll be able to execute these plans, I believe they will. This isn't a sexy momo name or activist target yet; it's a fundamentally solid long term investment that is significantly undervalued at $10.91/share(time of publishing). I don't even have anything snarky to say. I've been desnarked by the straightforwardness of it all. You either believe management can do this or you don't. You can buy or sell accordingly. To me its a gaming stock that seems more like an investment in management than it does a gamble on estimates.

Wednesday, September 10, 2014

The Importance of Being Furtive: Why 34.72% is the Most Importantly Unimportant Number that is Important to Valeant, Pershing Square and Allergan

An engrossing strategy is playing out in the Southern Central District Courtroom of Judge David Carter.

First off, let's agree to set aside the Delaware Chancery proceedings and do our best to completely ignore them for now. The Delaware proceedings are basically attempting to determine if the special meeting Allergan has set for December 18th is being held early enough. Suffice it to say that a special meeting has been called and Delaware will determine if it needs to take place earlier than December 18th. Delaware isn't considering how the special meeting requests were obtained and that is where the California Federal proceedings play in.

Getting back to the California courtroom and the often hilarious one-liners (Exhibit A below) that

Judge Carter has injected into his admitted fascination with the Allergan case, Allergan has called that special meeting because Pershing Square and Valeant have delivered at least the 25% of shareholder requests necessary to call the meeting. I say at least because there are conflicting reports surrounding just how many requests have been delivered. David Faber at CNBC reported back in August that Pershing/Valeant will hit Allergan with more than 30% of shareholder votes and The Street reported just last week that they've delivered 34% of shareholder votes, although Allergan's press release seems to indicate a number closer to 28%. It is interesting to note that yesterday (September 9th) during proceedings in Judge Carter's court, counsel for Pershing/Valeant stated they were about to cross 30%, not that they have. Mark Holscher of Kirkland & Ellis stated
"We're about to climb the 30 percent amount."

I don't know if it is PR shenanigans attempting to make the takeover appear imminent that the inflated numbers got put out there, but we know from Pershing's own lawyers that they haven't hit the 30% mark yet, so there is still a considerable way to go before Pershing & Valeant hit the 34.72% mark. Just looking at page 1 holders of Allergan, 48.7% of shares out are held by twenty large, sophisticated institutions, and another 12.5% are held by another 20 funds. Despite what Pershing and Pearson would like to portray, 28% of the vote isn't the unanimous backing of their offer when over 90% of the shares are held by institutions and funds, of which the top 40 holders represent 2/3 of the shares out. Who knows if Pershing and Valeant will be able to deliver 34.72% of the vote. I'm of the opinion that if they could hit the 34.72% mark, that the large sophisticated holders would have all the back office support to have complied with the necessary disclosures by now if they wanted too, and that without significant churn in the current holders, Pershing and Valeant will fall short of 34.72%, which seems like an odd mark to hit. Although it's an odd mark to hit, its an important one, that as it turns out actually isn't that important, but is still kind of important, which we'll get to.

Allergan has indicated that they found that the requests that had been delivered complied "as to form with Allergan's bylaws from stockholders owning more than 25% of Allergan's shares" and as a result of that opinion, it seems Allergan has no intention of derailing the December 18th by invalidating the requests received so far.

Well, not exactly. Allergan certainly wants to invalidate the 9.72% of the voting shares held by Pershing and Valeant (via PS Fund 1) which they are attempting to do by seeking an preliminary injunction that would block the exercise of the beneficial rights associated with those shares based on the grounds the shares were purchased as a result of violating insider trading laws (Rule 14e-3). Judge Carter is currently setting the schedule that will culminate in the preliminary injunction hearing that will be held on October 28th. What constitutes "a substantial step or steps to commence" a tender offer is not yet being argued before Judge Carter. Keep in mind what is going to happen on October 28th is Judge Carter will determine whether or not to enjoin the rights associated with PS Fund 1's 9.72% stake while the trial moves forward to determine if Pershing and Valeant violated Rule 14e-3. The 34.72% mark is important because theoretically if Pershing fails to deliver more than 34.72% AND Judge Carter enjoins the PS Fund 1's vote, Allergan could call off the special meeting altogether because the number of requests delivered would fall below the 25% threshold set by Allergan's bylaws.

Judge Carter noted that such an injunction could be rendered irrelevant by the marketplace if Pershing and Valeant were able to deliver more than 34.72% because 25% would be delivered in lieu of PS Fund 1's shares. Courts aren't big fans of issuing orders they view as potentially irrelevant (much less potentially irrelevant in less than 2 months) and I can understand Judge Carter's initial reticence to consider such an injunction knowing that once that 34.72% threshold is crossed, the injunction would be useless. Where it gets particularly intriguing is with regards to Allergan's next move. If Allergan is successful on their 14e-3 claim they would then seek a determination that the request forms and proxies to be voted at the special meeting were obtained illegally and that Pershing Square/Valeant violated Rule 14a-9 through material omissions and misrepresentations by failing to disclose that they had violated insider trading laws.

So although the marketplace could certainly decide that >25% of Allergan shareholders (that aren't Pershing Square or Valeant) want the special meeting to proceed and thus cross the threshold of that important mark, the mark itself is not actually important because all of the meeting requests that have been delivered so far would have been obtained through Pershing and Valeant's invalid solicitation.

So even though 34.72% is importantly not important, it still turns out to be important because if Pershing and Valeant fail to deliver 34.72% prior to the October 28th hearing and Judge Carter enjoins the PS Fund 1 shares, the meeting request could be rendered invalid because the 25% threshold has not been reached and Allergan could cancel the December 18th meeting.

I have much greater faith in Allergan's current management's ability to execute, particularly if they queue up $JAZZ$ALKS or another right-sized specialty biopharm acquisition. If you're a Pershing investor, you have to wonder what will happen to Pershing's marks if they are forced to disgorge their Allergan holdings. More immediately though, if you're a Valeant shareholder functioning under the assumption the Allergan acquisition will take place, ignoring the possibility that the FTC would take issue with the proposed merger (as evidenced by their second request), and the special Allergan meeting gets canned, you have to ask yourself just how far forward its rolling solvency and its hotly debated measures of financial health can carry the company in the absence of Allergan's robust cash flows. Valeant may prove to be the house of cards its own bankers alleged it to be.

And in light of yesterday's hearing before Judge Carter, the letter Ackman sent to the Allergan BoD later that same day seems to be a direct response to his own frustration with how he now expects this is going to play out in Judge Carter's courtroom. Ackman seems to be displeased that expedited discovery (including third party depositions) will lead to a preliminary injunction hearing on October 28th. I do agree with Bill that there is a strong smell in his letter, but I think we disagree on its source.

Allergan Sept. 9, 2014 Trascript