INLOT: justifying my projected trading values

I’ve received some great questions on my INLOT presentation since posting it last week and appreciate people taking a look. One recurring question is: how did I come up with my expected post-exchange YTM of 15%? It’s ultimately that assumption that drives my projected IRR for the 2024s, so it indeed is important. That assumption is definitely more art than science, but I’ll walk through my thinking in this post.

One thing that I want to reiterate: my presentation laid out a specific liability management strategy to potentially deal with the 2021s – I think it’s helpful to show a potential path – however I think there are many out-of-court permutations that could work and still be positive for the 2024s. I’ll continue to frame my analysis under the assumption that my illustrative exchange occurs, but the real thesis is predicated on misunderstood asset value.

The 2024s currently trade at 51 with a 22.5% YTM and I anticipate that YTM tightening to 15% post-exchange (implied price of 74). How is that possible with an exchange that is priming the 2024s? My expectation for priming debt is certainly one factor, but it’s not the only thing changing between now and then. To better frame the investment proposition of the 2024s post-exchange, I think it’s helpful to summarize all of the things that I anticipate changing between now and then.

Summary of changes: Q4 2020 vs. today

  • Leverage: I see (i) organic EBITDA growth, (ii) debt pre-pays from asset sale proceeds, and (iii) retiring the 2021s below par reducing net leverage from 8.3x today (Q1 2019) to 6.0x post-exchange
  • EBITDA trajectory: The recent EBITDA trajectory has been horrible lately (Inteltek, Greece, Morocco, FX), however the profile is de-risked following the major re-contracting cycle in 2017-2018 and should resume modest U.S.-driven growth
  • Non-core assets: Following the Hellenic Lotteries sale, Intralot still has two major non-core assets that likely receive minimal value credit today (Gamenet and Peru JV), however I’m optimistic that the company will execute and convert these to cash to help deal with the 2021s; the values are somewhat de-risked by the fact that Gamenet is publicly traded and the Peru JV has a recent private market transaction to guide value
  • FCF profile: I project the company inflecting from burning 16mm cash in 2019 to becoming modestly FCF positive in 2021, enhancing the liquidity profile of the structure
  • U.S. sports betting: this option is still early days today, however it’s likely that there will be greater legislative momentum and contract opportunities by Q4 2020
  • Maturity profile: the 2024s are currently the outside bond, however they will presumably become the inside bond post-exchange
  • Structurally senior debt: the structure is currently entirely unsecured, however I project an incremental 1.1x of net secured leverage ahead of the 2024s post-exchange

To summarize, I expect: (i) leverage levels, (ii) the EBITDA trajectory, (iii) the value “discount” for non-core assets, (iv) the FCF profile, (v) credit for U.S. sports betting, and (vi) the maturity profile all to improve between now and then. The only major negative for the 2024s should be the additional 1.1x of net priming debt, but I personally find that the positives outweigh the modest level of new secured issuance.

Conceptually, the drag from priming debt should be higher (1) with higher levels or priming debt and (2) when the underlying assets have larger degrees of downside risk. My SOTP analysis suggests that this collection of assets is worth 6.8x EBITDA, so our priming debt LTV is only 16%, a reasonable figure. And although Intralot’s asset values have declined materially in recent years, I still believe that the go-forward risk of further declines is much lower following major re-contractings. It’s also worth reiterating that the U.S. assets, major non-core assets (where we have relevant value marks), and parent cash combine to contribute 73% of my midpoint distributable value estimate. If that percentage was <50%, I would view my anticipated level of priming debt more cautiously.

I can now walk through some of the metrics and frameworks that led me to the 15% YTM estimate.

The first methodology was looking at where the market is willing to create these assets today. The blended price of our Senior Debt is currently ~59 cents on the dollar, so our 780mm of Senior Debt is currently being valued at 463mm. After deducting 56mm of parent cash, we can see that creditors are currently valuing these assets at 407mm. Relative to my 2019E prop EBITDA estimate of 87mm, this implies an EV/EBITDA multiple of 4.7x. We can now roll this analysis forward post-exchange. 93mm 2021E prop EBITDA x 4.7x = 438mm of asset value at a constant multiple. After adding my 2020E cash of 71mm and deducting 173mm of new priming debt, we get 336mm of distributable value available for the Senior Debt. Relative to 458mm of pro forma Senior Debt outstanding, this implies a recovery of 73 cents on the dollar, tying to our 15% YTM estimate. Put differently, if the market is simply willing to value these assets at the same multiple of 4.7x (a 30% discount to my fair value of 6.8x), the bonds should gradually trade higher to 73.

Another back-of-the-envelope methodology is to look at what yield credit investors are demanding for given levels of leverage. On one end, the 2024s were issued at par (5.25% YTM) when net leverage was 3.0x. On the other hand, the 2024s are yielding 22.5% when net leverage is 8.3x. We can extrapolate a “fair yield” if Intralot indeed reduces its net leverage to 6.0x (as I anticipate post-exchange), and would similarly estimate a 15% YTM for the bonds. Put differently, this crude analysis suggests that my projected YTM tightening is fair based on my projected reduction in net leverage.

Finally, we can look to comparable credits to see what other investors are demanding. This analysis won’t directly influence the math, but hopefully it should be instructive. I’ll look at the two major levered global gaming companies – IGT and Scientific Games (SGMS). These companies have much greater scale, contract diversification, and fewer issues than Intralot, however both also have their own problems – IGT has 35% exposure to Italy, and 65% of SGMS is cyclical slots and gaming systems. I’m not suggesting that Intralot’s 2024s should trade on top of IGT/SGMS debt – scale matters and both have credible de-leveraging stories – but it’s worth reviewing.

SGMS is a top-heavy capital structure with 4.0x secured leverage, 5.9x through the Senior unsecured, and 6.3x through the subordinated debt. Based on the current market cap, this structure is highly levered with an 84% LTV through the sub debt. Despite this high leverage, its entire structure effectively trades at or above par. And despite having 4.0x of structurally senior secured debt ahead of it, the longest-dated Senior unsecured notes only trade ~200bps wide of comparable secured notes, suggesting minimal penalty for large amounts of incremental priming debt. The highest yielding notes trade at a 6.9% YTW, a reasonably tight level.

IGT’s structure is entirely secured and carries lower leverage levels – 4.5x – however its Italy exposure also weighs on perceived asset values. As a result, this structure is similarly highly levered at a 76% LTV. Nevertheless, IGT’s entire structure also effectively trades at or above par. The highest yielding notes trade at a 5.6% YTW, a reasonably tight level.

IGT and SGMS credit investors are expressing relative comfort with high leverage levels and LTVs for these businesses. Intralot certainly has its own issues, but we’ve also established that most of the value is its higher quality contracted U.S. assets. I tried to spend a lot of time in my original presentation building confidence in those assets for exactly this reason.

I previously mentioned that our 15% YTM assumption implies a 4.7x pro forma multiple. Relative to our SOTP-implied fair value multiple of 6.8x, this represents a 69% market-adjusted LTV ratio. IGT and SGMS investors are expressing comfort at ~80% LTVs, so I don’t think our math is terribly far off.

Finally, I do think there is some slack in this figure in case I’m wrong to a reasonable degree. If the right post-exchange YTM is instead 25%, the bonds would trade at 56 and we’d still make a solid 23% IRR through coupons, modest capital appreciation, and the benefit of asset sale proceed pre-pays. For the trade to be dead-money (0% IRR), we’d need the bonds to be 39 post-exchange. This would create the assets at a punitive 3.0x EBITDA, and is therefore unlikely without unexpected negative developments. Intralot has demonstrated a knack at producing negative surprises, however I continue to believe that the 2024s have an asymmetric payoff profile at current prices.

-Matt