Street Capitalist: Event Driven Value Investments

A couple of days ago I saw this message on Twitter about Global Cash Access Holdings (NYSE:GCA):

That piqued my interest. I’ve had some success in the past with investing in companies after they lose a major customer. In this case, Harrah’s made up 14% of revenues. So, I decided to hop on the conference call and read through the latest 10-K to get an idea of the business and where it stands after losing Harrah’s.

Here’s how GCA describes their business:

Global Cash Access Holdings, Inc. (Holdings) is a global provider of cash access and data intelligence services and solutions to the gaming industry. The Company’s services and solutions provide gaming establishment patrons access to cash through a variety of methods, including automated teller machine (ATM) cash withdrawals, credit card cash access transactions, point-of-sale (POS) debit card transactions, check verification and warranty services and money transfers. The Company operates ATMs at certain customer gaming establishments, where the gaming establishment provides the cash required for the ATM operational needs.

These are some of my notes from the call:

-no detail yet on the Harrah’s cancellation. Less than 14% of revenues, not above avg margins. No material impact on 2010 results.
-Still have strong cash flows
-Gaming customers are under enormous pressure
-no debt covenants triggered by loss of Harrah’s.
-no debt covenants triggered by loss of Harrah’s. No disclosure on other contract times (e.g. with MGM and others)
-buyback authorization kept in place.

A number of analysts expressed their frustration at the management team’s lack of willingness to discuss current market conditions. Their frustration is understandable. One of the common questions that I’ll ask an executive at a business I am looking to invest in is what they are seeing in their market. You do this for two reasons: One, to get a feel for how they are thinking about the business at that moment in time. Two, to check their views versus a direct competitor. I love to do this because you can see what the similarities and differences are in their statements. That way you can check to see if one company is exaggerating or overly optimistic. GCA said that they couldn’t really discuss because they were still in contract negotiations with customers and those are confidential. That might be understandable, but I still felt that they could have provided us with some color.

Doing more reading about GCA, I learned that when the company went public in 2006 they worked hard to sign a big name customer. In the end, they managed to sign MGM but the casino really onerous — the contract was basically break even for GCA. That MGM contract is up for negotiation this year and it was one of the reasons for an earlier sell off in the stock. Losing Harrah’s is another blow to GCA’s business.

GCA’s competition basically consists of GPN (10% of the market) and then a few start ups. Right now, the Vegas casino operators are really hurting and there’s a good deal of pressure for them to cut costs. I think that it is likely that either Harrah’s plans to take GCA’s business on themselves or chose to contract it out to GPN or another start up. Just as GCA signed a break even contract with MGM, many of these other cash processing businesses might be willing to do the same. I am sure that their thought process is that they can sign one of these major casinos at break even during the trough period and then 3 years later, renegotiate at higher rates. To me, this exposes one of the flaws in GCA’s business model. It lacks a substantial competitive advantage and is at the mercy of casino operators.

Now we don’t know what kind of margin the Harrah’s contract had, but on the conference call the CEO said it was at average to below average margins. On the one hand, this means when modeling for the reduction we can probably reduce revenues by 15% and then apply the previous EBIT margin. But that is thinking backwards when we need to look forwards. The greater threat is margin compression. On the call, the CEO said that in any given year about 1/3rd of contracts are up for negotiation. After seeing Harrah’s leave, I think casino operators might threaten to also leave unless given contracts that provide GCA with substantially lower margins. In this case, your dumbest competitor is also your most deadly competitor.

The other issue I see with GCA is their financing situation. In 2-3 years the company has $272.5M in cash obligations due. Here’s their financing agreement with Bank of America:

Treasury Services Agreement. We obtain currency to meet the normal operating requirements of our domestic ATMs pursuant to the Treasury Services Agreement. Under this agreement, all currency supplied by Bank of America remains the sole property of Bank of America at all times until it is dispensed, at which time Bank of America obtains an interest in the corresponding settlement receivable. Because the cash supplied to us under the Treasury Services Agreement is never an asset of ours, supplied cash is not reflected on our balance sheet. At December 31, 2009, the total currency obtained from Bank of America pursuant to this agreement was $428.3 million. Because Bank of America obtains an interest in our settlement receivables, there is no liability corresponding to the supplied cash reflected on our balance sheet. The fees that we pay to Bank of America for cash usage pursuant to the Treasury Services Agreement are reflected as interest expense in our financial statements for the following reasons:

-the Treasury Services Agreement operates in a fashion similar to a revolving line of credit, in that amounts are drawn and repaid on a daily basis;

-the resource being procured by the Company under the terms of the Treasury Services Agreement is a financial resource and in the absence of such an arrangement, the Company would be required to obtain sufficient alternative financing either on balance sheet or off balance sheet in order to meet its financial obligations;

-the fees of the Treasury Services Agreement are assessed on the outstanding balance during the applicable period and include a base rate which is tied to LIBOR and a spread, similar to a credit spread, of 25 basis points; and

-the fees incurred by the Company under the Treasury Services Agreement are a function of both the prevailing rate of LIBOR as dictated by the capital markets and the average outstanding balance during the applicable period as previously noted. The fees do not vary with revenue or any other underlying driver of revenue such as transaction count or dollars processed as is the case with all costs classified as cost of revenue such as interchange expense, and processing fees.

My issue is that GCA is a company you might have to hold onto for years if their customers start squeezing their margins. The danger of holding it for so long is that interest rates are likely to rise in a few years. So not only would GCA face difficulties getting good prices out of their customers, but they would also have to pay out higher rates to their bankers.

To me, that potential for margin compression creates complications for the company with so much cash being due in just 2-3 years. Now, it is entirely possible that GCA could amend their credit agreements to get terms that are more favorable, especially if the trough market for casino operators persists. But I don’t want to depend on debt negotiations for an investment to work. The other thing that could work in GCA’s favor is if the profits for casino operators return to pre-financial crisis levels. That’s entirely another good possibility and it is something that might be worth watching for — especially when management releases some guidance with more clarity on the state of their market.

For now though, I am putting GCA in the too hard pile. For a different perspective, look to the Inelegant Investor blog for a bull-case on GCA.