Codere — Restructured with new leadership

Codere was founded in 1980 in Spain and is a market leader in the gaming machine industry. In terms of revenues (LTM to March 2019), its core markets are Mexico (22% revenues), Argentina (25%), Italy (23%) and Spain (13%). At the end of Q119, it operated nearly 57,000 slot machines, 30,000 bingo seats and 7,900 sports betting terminals across various gaming venues, including 148 gaming halls, 1,100 arcades, 10,000 bars, 500 sports betting shops and four racetracks. Approximately 78% of revenues are from slot machines. Online gaming comprises 3% of revenues and is offered in Spain, Mexico and Colombia. The company has c 12,000 employees.

Since inception, growth has been achieved through expanding geographically and selectively acquiring gaming businesses. In all its core markets, gaming regulation is established and Codere focuses on achieving robust market positions to leverage scale and benefit from first-mover advantage. A 2018–21 three-year plan includes further consolidation in core markets (specifically Mexico), as well as expansion into the online market (Spain, Mexico and Colombia). Over the past two years, Codere has been investing heavily in both Mexico and Spain and, once the Argentine currency impact has been lapped, we forecast revenue growth of 9% in FY20 and 8.5% in FY21.

Codere listed in Madrid in 2007 and, including the €200m equity IPO, it has raised c €1.5bn from the capital markets since 2005, which has funded expansion through investments and acquisitions. Following adverse macroeconomic conditions and licence renewals in Argentina, the company completed a full debt restructuring in 2016, whereby equity shareholders were diluted to 2% of the company (NB the founding family subsequently acquired back c 20% of the shares). The publicly listed stock is highly illiquid, and most shares are currently traded OTC (often at a different price to the listed stock). The OTC shares (not the publicly listed stock) are subject to restrictions in the shareholders’ agreement.

A new management team has been in place since January 2018 and is instigating numerous efficiency and performance improvement programmes. The board is representative of the shareholder structure and includes representatives of the removed family members, members from the credit funds (specifically Silver Point Capital), as well as two independent members.

Codere’s stock is languishing at c 15% of its 2015 pre-restructuring highs. As a result of the restrictive shareholder agreement, the stock is highly illiquid and mostly trades OTC. Trading in the OTC shares is often at a different price, but for our analysis, we are focusing on the publicly listed shares.

The most straightforward way to value the stock is via a peer group comparison and Exhibit 14 compares it to other gaming operators with a retail presence. Codere trades at 3.9x EV/EBITDA and 7.4x P/E for FY20e, which is a c 42% discount to the peer group average.

Clearly, the shares have suffered from a combination of low liquidity and uncertainty regarding the shareholder agreement. In our view, catalysts for a re-rating include stabilisation in Argentina, meaningful growth in Mexico, a successful refinancing of 2021 senior notes, as well as a potential IPO: a €200m placing would remove key shareholder restrictions (although there is a commensurate risk of share overhang, given the credit fund shareholding).

We have also performed a DCF with a terminal growth rate of 2% and a terminal EBITDA margin of 18% (on a pre-IFRS 16 basis). We assume a terminal capex/sales ratio of 6% (excluding licences) and an effective tax rate of 25% (on EBITDA). Using a WACC of 9% produces a value per share of €8.0. Our core forecasts assume no major FX moves (as witnessed in Argentina in FY18) and no major additional gaming taxes. If we flex the WACC to 10% to account for a higher risk profile, our DCF would be €6.2, which is c 75% above current levels. Please see page 24 for a sensitivity table.

Our core €8.0 per share DCF valuation equates to 5.2x EV/EBITDA and 16.8x P/E for FY20e, which is still lower than the peer group on an EV/EBITDA basis.

FY18 revenues decreased by 9.9% vs FY17 to €1,476.4m, driven by a 30% decline in Argentine revenues (75% decline in the Argentine peso vs the euro), which was partially offset by a 17% revenue increase in Spain. In constant currency terms, FY18 revenues would have grown by 9.3% vs FY17. As shown by the 6.7% revenue decline in Q119, the impact of the Argentine peso devaluation will still be felt in H119 (until the currency devaluation is lapped) and we therefore forecast flat revenues in FY19. Thereafter, we are forecasting 9.0% growth in FY20 and 8.5% in FY21, driven primarily by Mexico and Spain (where the company has recently made significant investments), as well as a return to normal conditions in Argentina.

Despite the FX headwinds in Argentina, FY18 EBITDA increased 3.4% to €282.9m (in line with guidance of €280–285m). Q119 adjusted EBITDA was also 1.3% higher vs the prior period. The improvement was largely due to performance initiatives across the business. Management achieved cost and growth efficiencies of €49.4m in FY18 and is guiding to €41–46m in FY19. The trends for FY19 are therefore similar to FY18, with increased gaming taxes and FX (less extreme in FY19) offset by performance enhancements. Including a positive IFRS 16 contribution of €80m (lower operating costs), our FY19 EBITDA forecast is €361.9m. This excludes €12m of exceptional online marketing costs mainly in Mexico (these are in non-recurring items) and is in line with company guidance of adjusted EBITDA of €280–290m (pre IFRS 16).

Note that Codere has started to report under inflation accounting standards – this is detailed on page 27, and is excluded from our normalised forecasts.

As we discuss on pages 19–20, Codere successfully completed the restructuring of its balance sheet in 2016 and at Q119, it had net debt of €1,120m (or €811m pre-IFRS 16). Cash was €75.7m at Q119 (€81.8m at FY18), with €153.5m in total liquidity (including the availability under the revolving credit facility). We forecast net cash flow break-even in FY19 (in line with company guidance) and net debt of €1.09bn in FY19. Net cash flow is expected to increase steadily into FY20 and beyond, but we believe this will still be insufficient to refinance the €500m and $300m senior notes due in 2021 and we expect a refinancing in the near term.

IFRS 16 has a significant impact on the financial figures from FY19. Our forecasts have annualised the data provided at Q119 results, with lower annual operating costs (higher EBITDA) of c €80m, higher depreciation and amortisation of c €40m and higher interest costs of c €45m. Total gross debt also increased by €309m to €1,196m at Q119. Net debt at Q119 of €811m therefore rises to €1,120m post IFRS 16 changes.

Codere was founded in Spain in 1980 by the Martinez Sampedro family, following the liberalisation of the Spanish gaming industry in 1977. It began amusement with prize (AWP) slot machine operations in 1981 in Madrid and has since steadily expanded both nationally and into Latin America, through selective investments and acquisitions. As a result, it is now a leading international gaming operator with gaming machines, gaming halls, arcades, sports betting, online gaming offering and racetracks in Mexico, Argentina, Spain, Italy, Colombia, Panama and Uruguay.

At Q119, the businesses in Mexico, Argentina, Italy and Spain comprised 22%, 25%, 23% and 13% of LTM revenues and 37%, 29%, 9% and 11% of LTM EBITDA. We provide further information on each region in separate sections below.

The company’s strategy is based on building leadership positions in attractive markets where it can leverage its knowledge, scale and international exposure. In all its core markets, gaming regulation is established and Codere focuses on establishing robust market positions to benefit from first-mover advantage.

Its three-year plan is to implement performance initiatives (witnessed by the €49m cost efficiencies achieved in FY18), consolidate the Mexican market and expand the online business in Spain, Mexico and Colombia. The key growth opportunities are:

Codere listed in 2007 in Madrid and, before a restructuring programme and refinancing in 2016, it had raised c €200m in equity and c €1bn in debt. Further to another refinancing in 2016, Codere has raised a total of c €1.5bn from capital markets (ie not including bank debt). Over the years, the company has used these funds, combined with internally generated cash, to make a number of acquisitions. We highlight some of the more significant transactions in the table below. These figures do not include licence renewals (significantly, in Argentina).

Following financial and macro difficulties, Codere completed a full restructuring in 2016 (more details below), which resulted in a 98% debt for equity swap, such that credit investors are now major shareholders. There is also a complex shareholder agreement in place, which restricts the transfer of the 98% OTC shares (ie not the publicly listed shares, which are freely traded). The company also completed a full refinancing of its post restructuring debt structure in 2016, issuing €500m (6.750%) and $300m (7.625%) senior secured notes due 2021.

Furthermore, in January 2018, the board removed both members of the Martinez Sampedro family from the executive team and a new chairman and CEO were appointed. This new management team has instigated a thorough review of the business with numerous cost-cutting initiatives now in place.

Codere’s operating revenue is derived from a mix of gaming products in different venues. At Q119, slots comprised 78% of GGR, with the remainder from other products such as sports betting, bingo and tables. 59% of revenues is derived from gaming halls, 26% from the slot route business (bars, restaurants and other retail locations), and the rest from other venues such as arcades, network and online platforms, racetracks and sports-betting shops.

In this section, we highlight the key products and venues that drive revenue and we provide further detail on a country-by-country basis in separate sections.

Gaming machines (or slot machines) offer cash prizes based on bets made by users. The machines are located in entertainment venues including gaming halls, arcades, bingos, casinos or racetracks as well as non-specialised locations such as bars, restaurants or other hospitality locations.

In terms of gaming capacity, the total number of slots increased 0.3% to 56,764 in Q119 vs the prior year, as shown in Exhibit 7. The change was driven by strong growth in Spain and Mexico, which was partially offset by the reduction of machines in Argentina, Italy and other operations. The reduction of machines in Italy is particularly noteworthy, as this is a direct consequence of more stringent gaming regulation (government decree to reduce installed capacity).

The different types of gaming machines are adapted to suit the characteristics of each gaming market and include AWPs, video lottery terminals (VLTs), electronic bingo terminals, casino slots and all other gaming machines that include fully random machines that are not interconnected.

The most important types of machines are AWPs, VLTs and casino slots:

Functionally, the main difference between VLTs and AWPs is that VLTs are connected to a central system that provides the machine with a winning number based on a lottery system that makes the machine more random, whereas AWPs are standalone machines that dispense prizes depending on a pre-determined cycle of game.

By regulation, VLTs have a higher prize pay-out than AWPs and higher prizes. In general terms, VLTs have lower taxes than AWPs and are restricted to being placed in gaming halls, bingo halls and betting shops only. Only network operators are able to obtain permits to install VLTs in Italy.

The useful life of a machine varies from 24–40 months in Europe and from 5–12 years in Latin America. The European machines cost c €2,000–4,000 each, whereas Class III machines (in Latin America) typically cost €9,000–15,000. We note that with 75% import tax in Argentina, machine costs are c $25k in Argentina (where there is also very heavy usage and high revenue per machine).

In terms of venues, 59% of operating revenue is derived from gaming halls, 26% from slot route business (bars, restaurants and other retail locations), and the rest from other venues such as arcades, network and online platforms, racetracks and sports-betting shops.

In Q119, the number of gaming halls was 148, sports-betting shops increased to 478 from 443 and bars decreased from 9,999 to 9,898.

Approximately 59% of revenue is derived from the operation of gaming halls, with 14 halls in Europe and 134 halls in Latin America. Gaming halls are entertainment centres where customers bet on various types of gambling for immediate reward, including bingo, sports betting, AWPs and VLTs. Gaming halls typically offer a range of additional services such as restaurants, theatres, hotels and conference rooms and, in some cases, are large leisure centres.

The slot route business is based on the operation of slot machines located in bars and restaurants across Spain and Italy. Largely as a result of an Italian government decree to reduce the number of AWP machines, the number of bars with machines declined from 10,293 in FY17 to 9,940 in FY18 and 9,898 in Q119.

The arcades business is based on the operation of slot machine arcades in Spain and Colombia, where it mainly operates AWPs and self-service terminals (SSTs). At the end of Q119, Codere was present in 1,157 arcades (1,018 in Spain and 139 in Colombia).

Sports betting is the activity of predicting results before or during a sports event and placing a wager on the outcome. At the end of Q119, Codere operated 478 sports betting shops in Spain, Mexico, Colombia, Panama and Uruguay.

The company operates under a ‘racino’ business model that combines horse racing and slot machines in the same venue. Codere operates four racetracks: Racetrack of Las Américas in Mexico and Presidente Remón Racetrack in Panama and, through HRU in Uruguay, it operates the Maroñas and Las Piedras racetracks.

Codere began offering online gaming in 2011 in Spain, with a full commercial launch in November 2016. It also expanded into Mexico in 2016 (multi-channel of current customers) and into Colombia in 2017. In Mexico, the full commercial launch was in Q119.

Online revenues grew from €23.9m at end FY17 to €44.5m in FY18. Q119 LTM revenues were €50.6m, representing c 3% of total operating revenues. While this percentage is significantly below many peers, Codere is actively looking to grow these revenues – as shown by the additional €10–15m marketing spend in Mexico for FY19 and sponsorship of Real Madrid in Spain. As shown in Exhibits 9 and 10 below, at Q119 75% of LTM online revenues were derived from Spain and 70% from the sportsbook. Online gaming EBITDA was €1.2m for Q119, representing a margin of 8%. This compares to a €1.5m EBITDA loss in Q118.

The online business is run from Malta, while the Spanish business is moving to Melilla (Spain) for tax optimisation purposes. Looking ahead, we expect Codere to continue expanding into other regions, as permitted by law. Progress towards regulation is being made in both Argentina (Buenos Aires) and Brazil and Codere would be well positioned if it wins licences in these countries.

Codere began operations in Mexico in 1998 through a management services agreement with Grupo Caliente and expanded in 1999 through an agreement with CIE (ICELA). In both instances, Codere participated in the development of halls and offered traditional bingo products through licences owned by both Grupo Caliente and CIE. Over the ensuing years, Codere has progressively achieved a majority shareholding in both operations.

Codere is the largest operator of gaming venues in Mexico, with 95 gaming halls and a racetrack. The company also holds licences to build and operate 40 additional gaming halls in Mexico. In addition, it has a concession for the operation of an entertainment complex in Mexico City that includes the Las Américas racetrack, an amusement park and the largest convention centre in Mexico. At Q119, Codere’s Mexican business operated a total of 21,917 slot machines, 11,217 bingo seats, 90 sport betting locations (within the halls) and 2,178 table seats. Most of the halls are open 16 hours a day.

The strategy in Mexico is to continue deploying licences, roll-out new gaming halls, expand into online gaming as well as potentially buying out minorities.

As part of its ongoing expansion plan, Codere bought into and steadily increased its stake in Grupo Caliente, which is now a 100% subsidiary (since 2017). ICELA is also 84.8% owned by Codere, with CIE holding the remaining stake. We believe Codere could buy out the minorities in the future, depending on cash constraints.

The gaming halls are mainly in large urban areas of Mexico including 20 in Mexico City, five in Guadalajara, four in Puebla and five in Cancun as well as in several other smaller cities. The majority of the gaming halls of ICELA are in Mexico City, the Federal District and in the metropolitan area in the State of Mexico. Legacy Caliente has fewer gaming halls in this area and instead has gaming halls distributed throughout the country.

Codere owns 135 licences in Mexico, of which 95 are operational. The company’s strategy is to begin deploying its unused gaming licences, through greenfields or acquisitions of existing operators that do not have the appropriate permits. The company opened three new halls in FY18 and we expect a similar level of hall openings annually.

In Mexico, Codere operates on the basis of an 100% customer identification and entirely cashless system, as Mexican gaming regulation prohibits the use of cash slot machines.

Online was commercially launched in Q119 and Codere expects to spend an additional €10–15m on marketing to boost the online segment in FY19.

Revenues: Mexican revenues include the participation in the operating companies of ICELA (85% subsidiary) and in the operating companies of Codere Mexico. Revenues include gaming (subject to gaming tax) as well as other activities such as food and beverage. For FY18, revenue decreased 3.4% to €328m, which equates to a constant currency growth of 2.9%. The growth in local currency was due to a 6.7% increase in average installed capacity (three hall openings in the year), which itself was offset by a 3.7% decrease in unit yields.

Adjusted EBITDA: increased by 14.1% to €105.9m as a result of the cost-cutting initiatives, which offset the decline in revenue. Adjusted EBITDA margin increased from 27.3% in FY17 to 32.3% in FY18 and in constant currency, FY18 adjusted EBITDA in 2018 would have increased 21% to €112.4m. A restructuring programme was initiated in 2013 that involved staff layoffs, reductions in operations and headquarters, reductions in slot product costs and other major procurement costs, which generated substantive cost savings.

Codere estimates it has c 26% market share of the retail market (which we understand is growing at low single-digit rate) and given the company’s consolidation strategy, we believe it will continue to take market share. Hence, revenue growth will come from consolidation rather than market growth.

In Mexico, local and regional authorities have been progressively establishing gaming taxes since 2010 that are only partially deductible, which has slightly increased the total effective gaming tax paid. At FY18, gaming taxes were 10.9% of operating revenues (vs 10.8% in FY17 and 10.4% in FY16).

For the nascent online business (management estimates a market of c €100m gross gaming revenue), we note that Grupo Caliente dominates the market, having enjoyed first mover advantage and operating through a JV with Playtech. Nonetheless, we expect Codere to be able to participate in the growth of the market.

Until 2004, when the Mexican government enacted regulations granting additional gaming hall licences, Codere estimates that halls operated under Grupo Caliente and CIE’s licences constituted the majority of private gaming offered in Mexico. But when the Mexican government granted additional licences in 2005, one-third of these third-party licences were granted to Grupo Televisa, a large Mexican media company, making it a major competitor.

Other competitors include Pringsa with 41 gaming halls, of which 20 are operated by Cirsa, Caliente with 34 bingo halls, Big Bola with 18 bingo halls and Win Pot with 16 gaming halls. In addition, until 2013, there was a proliferation of gaming halls illegally operating without permits. These illegal halls were principally in northern Mexico, particularly in the city of Monterrey, and have progressively been regulated.

Codere entered the Argentine gaming market in the early 1990s and is the largest operator of gaming halls in the Province of Buenos Aires. At the end of Q119, the company operated 13 gaming halls, 6,861 slots and 11,692 bingo seats. Most of the halls are located in the surrounding City of Buenos Aires and are open 24 hours a day.

The majority of Argentine revenues are derived from Class III slot machines (similar to US machines). In addition, Argentine gaming halls contain a limited number of non-slot gaming machines, such as electronic roulette-type machines. These machines are regulated in the same way as slot machines.

For its Argentine operations, Codere buys machines from a variety of US and European manufacturers. These are typically financed over 18–36 months, with each machine costing c $25,000 (including duties, taxes and transportation costs). Since 2008, Codere has implemented a ticket-in-ticket-out (TITO) cashless system and almost 100% of the machines run under this system.

Revenues: Operating revenue in Argentina is principally comprised of revenues from slot machines and from sales of bingo cards after prize pay-outs and revenue from food and beverage. FY18 revenue decreased by 30.0% to €407.7m, due to the significant devaluation of the peso (75.2%), which was more than double the average inflation rate. On a constant currency basis, revenues increased by 18.0%, which was below average inflation of 34.2% and was partly affected by the accounting impact in Q118 of the 0.95% cash-in tax introduced at the end of Q117. Average daily gross win per position in local currency terms increased 18.8% and installed capacity decreased slightly.

Adjusted EBITDA decreased by 28.4% to €96.1m as a result of the devaluation of the Argentine peso and the introduction of the cash-in tax, partially offset by cost efficiencies. The adjusted EBITDA margin was 23.6% in FY18 vs 23.0% in FY17, due to the ongoing cost-cutting measures. Operating expenses decreased by 30.5% driven by reductions across all cost items, including personnel, rentals and gaming taxes, which benefitted from the FX trend. The effective gaming tax decreased 0.2% to 46.1% (as a percentage of revenues). Note that because all machines operating in Argentina are owned and have very high productivity, there are lower than average rental costs.

Codere is subject to a number of different taxes in Argentina:

In total, gaming taxes in FY18 were 46.1% of revenues.

Buenos Aires is currently in the process of regulating online gaming and a number of different operators have applied for licences. To date, Codere is one of the 14 applicants for seven licences in the Province of Buenos Aires and the resolution of the process remains uncertain.

Under Argentine regulation, the number of bingo halls is restricted to 45 licences, which limits direct competition. The main competitors in the Province of Buenos Aires are AGG, Golden Jack, Grupo Midas and Casino Club, which each have three to four halls.

The remainder of the private gaming market in the Province of Buenos Aires is limited to government-owned casinos and racetracks. Casinos in the Province of Buenos Aires are generally located in tourist areas. There are two racetracks in the Province of Buenos Aires where the installation of slot machines is prohibited. In the City of Buenos Aires, there are two casinos operated by Manuel Lao (former Cirsa chairman) and its local partner, Casino Club. In addition to these casinos, Casino Club also operates, with other partners, the Palermo racetrack and casino in the City of Buenos Aires.

Codere entered the Italian bingo market in 2001, initially providing management services to bingo halls operated by Operbingo, and it entered the AWP machine market in 2004. After a series of acquisitions (see Exhibit 4), the company is now one of the top three operators of gaming halls, with 11 gaming halls and is among the top 10 slot route operators.

Since December 2010 Codere has made numerous acquisitions of slot machine providers and at the end of Q119, it operated a total of 8,124 machines in Italy, which we estimate equates to c 3% market share in terms of number of units. At the end of Q119, it operated 7,215 AWPs, 909 VLTs and 5,139 bingo seats.

The government passed a decree to reduce installed capacity (effective May 2018) and, as a result, Codere’s installed capacity reduced by 16.2% at Q119 vs the prior year. To compensate, there was a 24% improvement on AWP unit yields.

The slot route business is the largest revenue component in Italy. In this business, Codere has installation agreements with thousands of bar and restaurant owners across the country. Codere places its AWP machines at specific sites and provides maintenance services, in exchange for a variable fee that is generally equal to 51% of net revenue after deducting gaming taxes and the cost of the network provision.

At the end of Q119, Codere owned and operated 11 gaming halls in Italy, offering bingo, AWPs and VLT games. The company has owned bingo halls since the acquisition of Operbingo in 2005 and it has since acquired Bingo Palace, Mortara, Maxibingo and Royal (Caserta). Following the enactment of enabling legislation in 2007 and 2010, the company began installing AWPs and VLTs in its halls. The gaming halls are located in various regions throughout the country such as Rome, Parma, Verona, Bologna and Lecce. Each of these halls are open approximately 11 hours a day.

Codere operates a network in Italy as one of 11 network concessionaires for providing machine interconnection and network services. Codere obtained the concession through the purchase of Rete Franco (now Codere Network) in April 2006. The network operator obtains its earnings from two different fees: a canon tax that each machine operator is required to pay to the network, which is approximately €1.0 per machine connected per day; and a fee that varies depending on the contractual arrangements with each machine operator.

At the end of Q119, there were 12,726 AWPs machines and 1,505 VLTs connected to Codere’s Italian network. The current concession as network operator in Italy expires in March 2022 and the network renewal licence fee is €22.5m.

FY18 revenue increased by 0.2% to €336.5m. Average daily wins for AWPs and VLTs increased 8.9% and 1.0%, respectively, whereas average installed capacity continues to reflect the reduction decreed by the government (effective in May 2018). Operating revenue in Italy comprises:

Adjusted EBITDA for FY18 increased 17.0% to €27.6m, with the EBITDA margin rising 1.2% to 8.2%. This increase reflects Codere’s efforts to optimise the AWP portfolio deployment and cost containment (lower rentals and personnel), despite capacity restrictions and increased taxes.

The Italian machine market is heavily taxed (on amounts wagered and winners’ prizes) and is characterised by significant regulatory, tax and operational uncertainty. In FY18, taxes represented 64% of revenues and this is expected to continue rising.

We summarise the main tax changes here:

Competition in the both the gaming hall and slot route market is highly fragmented. For gaming halls, Codere is among the three largest operators. In terms of the AWP slot route market, Codere estimates that the top three operators represent c 14% of the market, measured as number of connected AWPs in the Italian slot route system. The VLT market is more concentrated, as there are only certain networks that have the rights to install VLTs. Competitors include Bplus, Lottomatica, Sisal, Snai group, Gamenet, Admiral, HBG, Global St., Cirsa, NetWin and NTS.

Codere was founded in Spain in 1980 following the liberalisation of the Spanish gaming industry in 1977, initially operating AWPs. The Spanish operations now comprise a slot route business that operates AWP machines, a sports-betting division, including self-service terminals, online gaming, as well as three gaming halls, including the Canoe Gaming Hall in Madrid, in which Codere operates SSTs, slot machines and bingo.

Codere is the second-largest operator of AWPs machines, with 10,298 machines located across bars, restaurants, machine halls and three gaming halls at the end of Q119. It also operates 7,165 sports-betting terminals across its venues, which includes the 62 sports betting shops.

During 2018, Codere completed several acquisitions, including nine arcades and route machines, which collectively operate over 300 machines, for a total consideration of c €10m and at EV/EBITDA multiples between 3.5x and 5.0x.

Codere is a market leader with c 4.7% market share (second largest) by number of machines in the highly fragmented AWPs market in Spain and has a significant presence in most of the regions of Spain, including Madrid, Catalonia and Valencia.

The most important asset in the Spanish AWP business is the relationship with the bar and restaurant owners, where there is typically an installation agreement for about five years. In return, Codere shares the revenue obtained from the machines installed at their location. The AWP business is regulated on a regional level in Spain and the regulations are periodically renewed.

Codere has operated sports betting in Madrid and the Basque region since 2008 and has expanded to all other regions including Catalonia, Valencia, Galicia, Andalucia and the Balearic Islands. These locations include existing gaming venues, sports-betting shops premises, bars, arcades and remotely. Similar to the AWP business, Codere enters into different agreements with bar and gaming hall owners, based on a revenue-sharing agreement.

Codere also operates the Canoe, Oporto and Leganés gaming halls, which have a number of different devices offering various types of games, including traditional bingo, (similar to the game played in other countries as Mexico, Argentina or Italy), slots and sports betting.

Codere holds licences for online gaming at both the national and regional level in Spain. It launched its online site in 2012, offering sports betting, slots and other games. As discussed above, the sponsorship of Real Madrid is indicative of Codere’s ambitions in online gaming.

In FY18, gaming taxes equated to 32% of operating revenues. Gaming machines in Spain are taxed at a fixed rate of c €3,500 per year per machine (varies per region) and online point of consumption taxes have recently been reduced from 25% to 20%.

Competition in the AWP operation market in Spain is highly fragmented. Regionally, the competition is from local operators and the national leader is Cirsa. For sports betting, competition varies by region. In the Basque region, the number of operators is limited to licences that are issued by local regulators. In Madrid and other regions, there is no limit to the number of licensees, as long as they comply with regulatory and technological requirements.

The online market (estimated €950m gross gaming revenue) is highly fragmented and Codere therefore remains a small player.

Other operations include results from Panama, Uruguay, Colombia and Brazil. We have not included information on Brazil, as Codere no longer has any significant operations there.

Codere entered the Panama gaming market in 2005 and is now the leader in terms of number of gaming halls. At the end of Q119, it operated 11 gaming halls in Panama with 2,940 slot machines, 306 table seats and eight sports-betting locations. Most casinos are open 24 hours a day and the slot machines have TITO operational systems. Codere also owns and operates the Presidente Remon Racetrack in Panama City, which is the only horse racetrack in Central America.

In 2012, gaming taxes increased from 12.5% to 18% of gross revenue from slot machines. There is also a selective excise tax of 5.5% on amounts cashed out (not applicable to the horse races).

Codere entered the Colombian slot machine market in 1984 and is now focusing on ownership and operation of gaming machines. At Q119, it operated 4,346 gaming machines located in nine halls and 139 arcades. The casino halls are typically open 16 hours per day, whereas arcades are typically open 14 hours per day. There are also 290 sports betting shops and 616 sports betting machines.

The gaming machines in the Colombian market are generally type-C machines, similar to US Class III machines, which do not have maximum wager and prize limits. The Colombian machine market (excluding machines located in casinos) is highly fragmented. The main competitor in the licensed market is Winner Group, which is affiliated with Cirsa. There is also competition from unlicensed gaming machines in Colombia.

In Colombia, regulation was passed in 2014 introducing the obligation to connect online slots machines and amending existing legislation governing the gaming industry. Accordingly, gaming tax payable on slots connected online would be the higher of a flat tax based on the number of gaming machines or 12% of gross win.

The Uruguayan business operates two horse racetracks and six gaming halls, including five gaming halls under HRU (a fully owned subsidiary since 2016). The sixth hall is the Carrasco Hotel; this is wholly owned by Codere, following a chequered history and financial underperformance. In total, Codere has invested $78.8m into the project, which is now finally break-even.

Given the financial difficulties (particularly with Carrasco), Codere reached an agreement with the gaming authority (Intendencia de Montevideo) to modify the gaming tax structure in 2016. This became effective in 2017. As a result, Codere registered an impairment reversal of €37.7m in FY16.

Operating revenue includes the both gaming and non-gaming elements (food and beverage and technological services). Operating revenue decreased by 4.3% to €183.8m. The significant changes were:

Adjusted EBITDA increased by 41.3% to €39.9m, with an EBITDA margin of 21.7% (vs 14.7% in FY17). The main points were:

Following financial difficulties due mainly to imminent licence renewals in Argentina in 2013, the cash acquisition of a stake in ICELA, together with a difficult macroeconomic environment, Codere was unable to service its corporate debt and entered into a financial restructuring process.

The financial restructuring process was completed in April 2016, with highlights detailed below:

Subsequent to the financial restructuring and scheme of arrangement, c 98% of shares are subject to a complex shareholder agreement. The pre-existing shares now represent 2.176% of total issued capital and are not party to the shareholder agreement.

Within the shareholder agreement, there are two specific clauses of importance:

In January 2018, the board removed both members of the Martinez Sampedro family from the executive team and a new chairman and CEO were appointed. This new management team has instigated a thorough review of the business with numerous performance improvement initiatives now in place. Exhibit 12 shows the new organisational chart.

The board is representative of the shareholding and includes the Martinez Sampedro brothers’ representatives (16% shareholding) as well the credit fund investors from the debt for equity swap (specifically Silver Point Capital) and two independent board members, one of which (Norman Sorensen) is the non-executive president of Codere.

The management team is incentivised with a LTIP plan, based on share price performance. 

Macroeconomic changes: in addition to the risk that negative economic conditions could lower consumer spending, Codere has been particularly affected by fluctuations in currency (see below) and inflation in its core Latin American markets, especially Argentina.

FX risk: Codere is heavily exposed to currency risk, given that its reporting currency is euros, while the majority of business (Latin American subsidiaries) trade in other currencies. During FY18, for example, the Argentine peso devalued by c 75%. We note that the Latin American subsidiaries generally operate in their local currency, providing a natural hedge against foreign currency fluctuations, although there are some costs in US dollars (European and US manufactured machines for example). The company has no FX forward contracts in place and does not hedge any of Latin American currencies.

Gaming regulation and increased taxes: the gaming sector is subject to significant taxation and Codere has experienced a series of tax increases, with the most recent examples being in Argentina and Italy. There is also a risk that governments change the minimum pay-out ratios on the machines or decrease the allowed installed capacity (as in Italy).

Licence renewals: Codere’s business is dependent on the granting and timely renewal of the necessary gaming licences. Each region and country has different sanctioning regimes that Codere needs to abide by.

Substantial investment required: to maintain its competitive position, substantial yearly capex is spent on renewing and buying new slot machines, as well as for consolidating the market. This limits Codere’s ability to generate net cash flow, which might otherwise be used to reduce leverage. In FY18, maintenance capex of €82m and growth capex of €81m together comprised 11.1% of sales and (in line with guidance) we forecast €95m of total capex in FY19 and FY20 (6% of sales).

High net debt, with €500m/ $300m senior notes due in 2021: at the end of FY18, Codere reported net debt of €781.6m, which equates to a net debt/adjusted EBITDA of 2.9x. Including the impact of IFRS 16, net debt/LTM EBITDA was 3.1x at Q119. This is well within banking covenants and Codere has sufficient funds to service the debt. We expect the company to deliver net cash flow in FY19 but believe future net cash flow is insufficient to pay down debt. We therefore expect the company to refinance these notes in the near term. Furthermore, licence renewals are due in Argentina and Italy in 2021–24 (c €80m).

Litigation: following the financial restructuring and removal of the founding family from management and chair of the board, the Sampedro family has initiated proceedings against the other shareholders and board members. To date, the proceedings have not been successful, but there is another hearing later in 2019 that could result in a different outcome. The company has guided to €10m litigation costs in FY19.

Shareholder structure is very complex: as discussed above, the shareholder structure and agreement are very complex and include share transfer restrictions for shares trading OTC. This naturally limits trading flow but could be resolved by a €200m placing and give mechanisms for debt funds to exit (which also brings the complications of a potential large share overhang).

Codere’s stock is up 8% in the year to date, but still languishing at c 85% below its pre-restructuring highs in 2015. As a result of the restrictive shareholder agreement, the stock is highly illiquid and most shares trade OTC (often at a different price to the listed shares). However, for our analysis we are looking at the listed share price. For FY20e, Codere trades at 3.9x EV/EBITDA and 7.4 P/E.

In our view, catalysts for a re-rating include stabilisation in Argentine revenues, growth in Mexico, a successful refinancing of 2021 senior notes, as well as a potential IPO; a €200m placing would remove key shareholder restrictions (although there is a commensurate risk of share overhang, given the credit fund shareholding).

The most straightforward way to value the stock is via a peer group comparison and Exhibit 14 compares it to many of the listed gaming operators with a retail presence. The limited free float and complicated shareholder agreement have clearly impacted the valuation and Codere trades at the bottom of the range, at a c 42% discount to the peer group average on FY20e EV/EBITDA and P/E.

We have also performed a DCF with a terminal growth rate of 2% and a terminal (pre-IFRS 16) EBITDA margin of 18%, vs 19% in FY18. We assume a terminal capex/revenue ratio of 6% and an effective tax rate (to EBITDA) of 25%. Using a WACC of 9% produces a value per share of €8.0. Our core forecasts assume no major unforeseen FX moves (as witnessed in Argentina in FY18) and no major additional gaming taxes. If we flex the WACC to 10.0% to account for a higher risk profile, our DCF would be €6.2 per share, which is approximately 75% above the current share price.

Our core €8.0 per share DCF valuation is c 130% higher than the current share price and equates to 5.2x EV/EBITDA and 16.8x P/E for FY20e, which is still lower than the peers on an EV/EBITDA basis.

FY18 revenues declined 9.9% vs FY17 to €1,476.4m. This was driven by a 30% decline in Argentine revenues, due to the depreciation of Argentine peso against the euro, which was partially offset by a 17% revenue increase in Spain. In constant currency, revenues were up 9.3% vs the prior year. The impact of the Argentine peso is reflected in our FY19 figures and we forecast flat revenues in FY19, at €1,477.4m. Thereafter, we are forecasting 9.0% growth in FY20 and 8.5% in FY21, particularly driven by Mexico and Spain, as well as a return to normal conditions in Argentina.

Despite the increase in taxes and FX headwinds in Argentina, FY18 EBITDA increased 3.4% to €282.9m (in line with guidance of €280–285m). The improvement was largely due to performance initiatives across the business; management delivered €49.4m of cost and growth efficiencies in FY18 and expects a further €41–46m in FY19.

In FY19 the trends will be similar, with cost controls offsetting rising taxes and FX headwinds. Our FY19 EBITDA forecast is €361.9m, which is positively affected by c €80m in IFRS 16 adjustments (lower operating costs). Note that the adjusted EBITDA also excludes €12m of exceptional online marketing costs in Mexico. This is in line with company guidance of adjusted EBITDA of €280–290m (pre IFRS 16 adjustments).

We summarise our forecast assumptions in Exhibit 16 below; please see the individual country sections for more details on revenue and EBITDA dynamics.

Underlying revenue growth in the Mexican market has historically been around 3%, but we believe this will rise significantly due to ongoing investment and the openings of new halls. For FY19 and FY20, we forecast a c 8% revenue increase to €355.5m and €383.9m, respectively. Management is focusing on cost containment and we forecast a continued strong EBITDA margin of c 45% (note that this now includes an estimated c €38m positive contribution due to IFRS 16 adjustments). For FY19, we forecast additional marketing costs of €12m, but this is included as a non-recurring item.

Given the impact of the devaluation of the peso, we forecast an absolute decline in revenues of 20% in FY19, before returning to 15% growth in FY20 and FY21. This increase is similar to trends from previous periods that followed significant currency devaluations (specifically after 2001), although our forecast revenue of €431.2m in FY21 is still considerably lower than €582.4m revenues achieved in FY17. The impact of the tax increase is estimated at around €10m annually and, together with continued cost controls, we forecast an FY19 EBITDA of €73.6m, rising to €91.0m in FY20. IFRS 16 positively affects EBITDA by an estimated c €7m.

Despite the capacity reductions in Italy in FY18, Codere successfully managed to optimise its portfolio with the result that revenues remained flat. Similar to trends in Q119, we forecast a modest 1.4% revenue growth for FY19 and 2% thereafter. This will be accompanied by steadily rising taxes (as detailed above). Codere has guided to a c €10m reduction in EBITDA, as mitigation will offset some of the increase in taxes. We forecast FY19 EBITDA of €28.6m, which includes a positive estimated impact of c €9m from IFRS 16 adjustments.

With the increased momentum in sports betting and online, FY18 revenue increased by 17% to €220.0m. From FY19, online will no longer be reported within the Spanish division and we forecast Spanish revenues of €208.0m in FY19. Thereafter, we forecast 15% revenue growth in FY20 and FY21 as investment in the sports betting shops steadily translates to revenue. Our EBITDA forecast goes from €26.4m (12% margin) in FY18 to €49.6m (23.8% margin) in FY19, as the lower margin online is excluded and IFRS 16 contributes an estimated c €8m.

In FY18, other operations were affected by FX and by the closure of underperforming halls, and revenues declined by 4.3% to €183.8m. In line with Q119 trends, our FY19 forecasts assume an 8.1% decline in Panama revenues and a 4% decline in Colombia revenues, offset by a 10.6% increase in Uruguay revenues. Following the closure of underperforming halls in Panama and Colombia, we forecast a return to low single-digit growth in those regions for FY20.

For online, we forecast revenues of €64.2m in FY19 and €73.9m in in FY20, as Codere begins to gain traction in Mexico and Spain in particular. We believe these figures are reasonably conservative and suspect there be upside.

Altogether for other operations, we forecast FY19 revenue growth of 34.1% (which importantly now includes online). Online margins were only 8% in Q119 but, given the cost containments across all geographies and an estimated c €17m increase from IFRS 16 adjustments, our total EBITDA margin for other operations goes from 21.7% in FY18 to 24.7% in FY19.

We include a summary table of the country revenue and EBITDA mix here:

As discussed above, Codere has been facing FX headwinds (particularly in Argentina) and rising taxes in both Argentina and Italy. However, these are expected to be offset by a continued cost-savings programme, with management guiding to €41–46m cost efficiencies for FY19.

Codere’s financial statements are complex and we highlight some of the key income statement items below:

Given that inflation in Argentina reached more than 100% cumulatively over the last three years, the company started to apply IAS 29 (inflation accounting) in Q318. For FY18, Codere provided the impact of this accounting in four line items:

Operating cash flow increased 9.1% to €182.8m in FY18, with the decrease in EBITDA fully offset by lower working capital and a decrease in cash tax paid. We summarise some of the key points here, which notably include capex.

In FY18, the cash interest expense was €68.8m: €53.3m for the senior notes, €13.8m for the OpCo debt (including capital leases) and €1.7m for the credit facility. Our cash interest forecast of €67m for FY19 excludes the non-cash IFRS interest expense on the P&L (c €45m annually).

In FY18, deferred payments increased by €48.2m, consisting of a €2m decrease in authorised deferred gaming taxes in Spain and an increase in deferred payments with capex suppliers of €50.2m, mainly in Mexico and Panama (associated with new supplier financing deals on acquired slot products previously leased). We forecast an associated cash outflow of €20m in FY19, €25m in FY20 and €5m in FY21.

FY18 capex amounted to €163.4m, of which €82.1m was for maintenance and €81.3m for growth.

Exhibit 17 shows the capex profile, split between maintenance and growth. Codere has guided to c €100m for FY19, roughly split between €20–25m growth and €75–80m maintenance. We forecast a total of €95m and note that the lower capex spend in FY19 will enable the company to achieve its goal of turning net cash flow positive.

As we detail on pages 19–20, Codere successfully restructured its balance sheet in 2016 and at the end of FY18, it reported net debt of €781.6m vs €748.6m in FY17. Adjusting for IFRS 16, net debt was €1,120m at Q119, which includes €75.7m cash.

Codere reported total financial debt of €866.6m at Q119, of which €782.7m was from senior notes (from the 2016 refinancing), as well as €85.7m of debt at the operating company level. Including €309.3m of capitalised operating leases, total adjusted debt was €1.2bn at Q119.

As shown in Exhibit 18 below, this resulted in net debt of €810.9m (pre-IFRS), which leads to a net debt/adjusted EBITDA of 2.9x. Post IFRS 16 adjustments, the net debt/adjusted LTM EBITDA was 3.1x. This is comfortably within all its banking covenants and the credit agency ratings are B2 (Moody’s) and B (S&P), both with a stable outlook, suggesting liquidity is regarded as adequate.

Codere expects to generate positive net cash in FY19, which is in line with our forecast of a €5.6m net cash flow in FY19. Assuming no major unforeseen FX changes, we forecast net debt of €1,093m in FY19 and €1,039m in FY20. In terms of cash balance, we assume that the company pays back a net amount of c €20–30m bank debt annually. Note that IFRS 16 has added c €309m to gross debt.

The senior notes are due in 2021 and there are sizeable licence renewals from Argentina and Italy in 2021–24 (c €80m). We therefore expect the company will look to refinance and/or seek an equity issuance before then.

Codere is implementing IFRS 16 accounting for operating leases in 2019. The application of IFRS 16 has a significant impact on its financial statements, as it requires that operating leases (except short-term leases and those related to low-value assets) be capitalised to the balance sheet and expensed (as D&A and interest expense) over the term of the lease.

For Q119, Codere provided a breakdown of the IFRS 16 impact and we have annualised this for FY19 as follows: lower operating expenses of c €80m; higher D&A of €40m; higher financial expense of €45m; an increase of €309m on assets and liabilities (capitalisation of operating leases); and lower corporate income tax of €4.5m.

Altogether, our FY19 EBITDA therefore increases by c €80m and total gross debt is €309m higher.