Lakes Entertainment, Inc. Rating: Buy

Transcription

1 GAMING Justin T. Sebastiano (212) Company Update September 26, 2008 Key Metrics LACO - NASDAQ $6.27 Pricing Date 09/26/2008 Price Target $ Week Range $10.02-$3.86 Shares Outstanding (mm) 25.0 Market Capitalization ($mm) $ Mo Average Daily Volume 118,450 Institutional Ownership 41% Debt/Total Capital NA ROE NM Book Value/Share $7.90 Price/Book 0.8x Dividend Yield NA LTM EBITDA Margin NM EPS($) FY: December Prior Curr. Prior Curr. 2007A 2008E 2008E 2009E 2009E 1Q-Mar (0.25) -- (0.20)A Q-Jun (0.25)A Q-Sep (0.19) -- (0.66)E Q-Dec (0.21) -- (0.30)E FY (0.65) -- (1.41)E E P/E NM NM 14.2x Revenue($mm) Prior Curr. Prior Curr. 2007A 2008E 2008E 2009E 2009E 1Q-Mar A Q-Jun A Q-Sep E Q-Dec E FY E E 1 Year Price History for LACO Q3 Q1 Q Created by BlueMatrix Company Description: Lakes Entertainment helps develop, finance, and manage tribal casinos. The company earns fee income for said services. Lakes is the majority owner of WPT Enterprises, which develops, produces, and markets televised programs based on gaming, including the World Poker Tour series Lakes Entertainment, Inc. Rating: Buy To The Ohio Ballot We Go; Reiterate Buy Rating and $10 Price Target Investment Highlights: See You In November. This morning, Lakes Entertainment announced that the Ohio Secretary of State certified that the referendum to permit a casino in Ohio will be on the November 4th statewide ballot. This news should come as no surprise since Lakes Entertainment collected over 750,000 signatures, all but ensuring the certification of the 402,000 necessary for the referendum to be placed on the ballot. Our Ohio estimates are conservative. We calculate that the Ohio casino would generate roughly $140 million in EBITDA in year one (likely 2012). We use a win per position per day estimate of $290, which admittedly is conservative. The three casinos (Argosy, Belterra, and Grand Vic) that operate in Indiana near the Cincinnati market generate an average daily win per position of close to $350, with Argosy winning in excess of $400. Ohio casino would be a game changer for Lakes. That said, we believe current operations alone warrant an investment in shares of LACO. Lakes generates fee income from its Four Winds tribal casino management contract (Michigan) and a small consulting fee from the Cimarron tribal casino located in Oklahoma. Additionally, Lakes has three more tribal development and management contracts for casinos. These contracts typically constitute very little, if any, capital investment but have the potential to generate significant cash flow over the term of the contract. We believe the management contracts provide low-cost capital to fund long-term growth of company-owned commercial casino projects. Primed for Growth. We expect Lakes to experience significant topand bottom-line growth in FY09, which is when we expect the Red Hawk tribal casino (in California) to become operational. In our opinion, this is not fully reflected in the current stock price. We believe a sum-of-the-parts valuation approach is the appropriate method with which to value shares of Lakes Entertainment. This is fair, in our opinion, because the stock does not trade on the company's current fundamentals. Using this method we arrive at our price target of $10 a share, which represents over 50% upside from current levels (please see the valuation methodology at the end of the note for our sum-of-the-parts breakdown.). Thus we reiterate our Buy rating. The Disclosure section may be found on pages 6-7 of this report. The Valuation section may be found on page 6 of this report.

2 To the Ballot We Go This morning Lakes Entertainment announced that the Ohio Secretary of State certified that the referendum to permit a casino in Ohio will be on the November 4th statewide ballot. This news should come as no surprise since Lakes Entertainment collected over 750,000 signatures, all but ensuring the certification of the 402,000 necessary for the referendum to be placed on the ballot. Reiterate Buy Rating Even If the Ohio Vote Fails The Ohio casino would be a game changer for Lakes Entertainment (we go into greater detail in the section below). That said, we believe current operations alone warrant an investment in shares of LACO. Lakes generates fee income from its Four Winds tribal casino management contract (Michigan) and a small consulting fee from the Cimarron tribal casino located in Oklahoma. Additionally, Lakes has three more tribal development and management contracts for casinos. These contracts typically constitute very little, if any, capital investment but have the potential to generate significant cash flow over the term of the contract. We believe the management contracts provide low-cost capital to fund long-term growth of company-owned commercial casino projects. We expect Lakes to experience significant top- and bottom-line growth in FY09, which is when we expect the Red Hawk tribal casino (in California) to become operational. In our opinion, this is not fully reflected in the current stock price. As a result, we reiterate our Buy rating and $10 price target (please see the valuation methodology at the end of the note for our sum-of-the-parts breakdown.) The Ohio Opportunity Last April, Lakes announced that it had entered into a joint venture with MyOhioNow.com, LLC to develop a $600 million commercial casino in Clinton County, Ohio. We argue that the cost will likely reach about $700 million by the time the casino would be complete. Lakes plans to own 80% of the casino, but expects to sell a portion of its ownership at the opening of the property. We believe Lakes should own roughly 70% of the joint venture after the sale. Commercial casinos are illegal in the state of Ohio. As a result, Ohio voters must approve a referendum in the November election to amend the Ohio constitution to legalize the casino. Ohio residents failed to approve commercial casinos in three previous votes (1990, 1996, and 2006). We disregard the 1990 and 1996 outcomes given the length of time that has elapsed since then. However, we believe the 2006 proposal is a good proxy with which to compare the current attempt. The 2006 Proposal The 2006 proposal sought to permit 31,500 slot machines at seven horse racing tracks and at two Cleveland non-track locations. The gaming revenue tax was set at 45%, with the majority being earmarked for college scholarships for the top-five percent of Ohio high school seniors. The vote finished at 57% against and 43% in support. The argument against the casino was the typical one that anti-gaming groups use in these scenarios: increase in gambling addicts resulting in lost wages and jobs, legalization of Class III gaming will pave the way for the proliferation of tribal casinos, etc. Specifically, most voters realized that only those with children would potentially benefit from the gaming tax revenue and even then, the children would have to be high school seniors in the top-five percent of the state in order to receive scholarship money funded by the gaming tax. In addition, several community leaders, elected officials (including the Governor), and many Ohio newspapers urged a "No" vote. All told, the opposition was just too great to overcome. 2 MORGAN JOSEPH & CO. INC.

3 The 2008 Proposal The 2008 proposal asks for the authorization of one casino in the state of Ohio that would feature gaming activities including any type of card or table games, slot machines, or electronic gaming devices permitted by the state of Nevada or any state adjacent to Ohio, except bets on races or sporting events. The minimum required investment is set at $600 million for the development of the casino, hotel, and other non-gaming amenities ($700 million is more likely). The casino operator would pay a tax of 30% on gross gaming revenues with the majority distributed on a per capita basis among all 88 counties in Ohio after Clinton County (where the casino will be located) takes a 10% share of the tax revenue. Our Take While we believe the 2008 proposal has a much better chance of garnering voter approval than its predecessors, ultimately, we think the odds are against it, at least for now. We list our pros and cons of the proposal below: Pros Only one casino license (4,000-5,000 slot machines) versus nine licenses (31,500 slots) in the 2006 proposal Gaming tax distribution to every county in the state to be used as the counties see fit MyOhioNow.com LLC is run by Ohio residents Cons Same concerns remain: increase in problem gambling, possible proliferation of tribal gaming, etc. The proposal is not supported by community leaders and elected officials. Casino heavyweight Penn National Gaming has come out in strong opposition to the proposals. Penn owns the Argosy Lawrenceburg casino, which pulls from the Cincinnati market. Cincinnati would likely be one of Lakes Ohio's main feeder markets. At this point, we choose not to include the expected value of the casino project in our valuation of Lakes' stock, but we do include the upfront costs associated with the campaign. In an attempt to be conservative, we use what we believe is a worst case scenario. We estimate the company will spend up to $20 million on lobbying efforts (we estimate the company already spent $8 million on the campaign). As such, we believe a worst case scenario would include up-front costs of $18-28 million and a failure at the voting booths. That being said, all of the capital outlays being made by Lakes on the Ohio effort are actually loans to the joint venture that Lakes expects to recoup with 10% interest if the casino does, in fact, open. Below, we have outlined the potential value of a "Yes" vote to the 2008 Lakes Entertainment proposal. Gaming Revenue Calculation Lakes plans to develop a $600 million casino featuring 4,000-5,000 slot machines, table games, a 1,500-room hotel, and several bars, restaurants, and retail shops. The company estimates that the design and development stage would take about months and the construction time line would be 18 months. Using these estimates puts the anticipated opening of the casino in late 2011/early Using data from the U.S. Census Bureau, we created a potential population base of adults age 21 and over that live within 50 miles of where the casino is to be located in Clinton County, Ohio. Next, we used the 3 MORGAN JOSEPH & CO. INC.

4 participation rate and the average number of trips a gaming customer took in 2007, as per the American Gaming Association, to arrive at an estimated annual admissions figure. We turned to the Cincinnati market's 2007 average win per admissions per day, which we discounted to take into account that Clinton County is further from the city of Cincinnati than the three Indiana-based casinos that operate in that market: Argosy Lawrenceburg (owner: Penn National Gaming miles from Cincinnati: 26), Hyatt Grand Victoria (Hyatt, 40 miles), and Belterra Casino Resort (Pinnacle Entertainment, 47 miles). All told, from our first approach, we calculate that the Ohio casino would generate $544 million in gaming revenue in year one. We tried to gauge demand for slots and tables in our second approach to calculate our gaming revenue estimate. We used data from the Indiana Gaming Commission to arrive at a 2007 daily admissions per slot machine figure for the Cincinnati market. Using the same annual admissions estimate that we derived in method one, we calculate demand in Ohio for 4,040 slot machines and 136 table games. If we use the Cincinnati market's daily win figures for slots and tables and the number of slots and tables that we believe Ohio will demand, we arrive at a year-one gaming revenue estimate for Ohio of $571 million. We take an average of our two methods to arrive at a total first-year gaming revenue estimate of $557 million; after we add non-gaming revenues and subtract promotional allowances, we settle on a net revenue estimate of $577 million in year one. The Cincinnati casinos generate EBITDA margins in the 20-30% range. Taking the midpoint brings us to an EBITDA estimate of $144 million. However, Lakes should manage the casino for a fee equal to 1% of the total gaming revenue; adjusting for the management fee brings EBITDA to $139 million. All told, we believe Lakes' 70% share of the casino and its management fee could generate roughly $1.20 a share in EPS in MORGAN JOSEPH & CO. INC.

5 Justin T. Sebastiano Lakes Entertainment Inc. (LACO) Income Statement Model ($ in thousands except per share) Year Ends December 1Q 2Q 3Q 4Q QA 2QA 3QE 4QE 2008E 2009E Management Fees (LACO) ,580 3,230 6,645 4,580 5,867 5,193 5,072 20,712 36,464 License Fees (WPTE) 3,768 6,072 2,695 3,075 15,610 3,576 3,395 3,234 2,306 12,511 14,075 Host Fees, Sponsorship and Other (from WPTE) 755 1,671 1,732 2,040 6,198 1,405 1,697 3,204 3,774 10,080 20,160 Net Revenues 4,972 8,129 7,007 8,345 28,453 9,561 10,959 11,631 11,152 43,303 70,700 Costs and Expenses SG&A 9,741 9,966 10,058 10,305 40,070 10,892 13,943 25,087 14,996 64,918 38,614 Production Costs (from WPTE) 2,152 3,087 1,355 1,630 8,224 2,670 2,784 1,287 1,793 8,534 10,412 Amortization of intangibles related to Indian casinos - - 1,121 1,681 2,802 1,681 1,680 1,690 1,700 6,751 6,800 Total Costs and Expenses 11,893 13,053 12,534 13,616 51,096 15,243 18,407 28,064 18,489 80,203 55,826 Adjusted EBITDA (6,921) (4,924) (5,527) (5,271) (22,643) (5,682) (7,448) (16,433) (7,337) (36,900) 14,874 Adjusted EBITDA margin NM NM NM NM NM NM NM NM NM NM 21.0% Depreciation (195) (191) (192) (179) (757) (188) (211) (200) (200) (799) (1,200) Unrealized Gain on Tribal Notes Receivable 165 8,939 (600) (1,275) 7,229 (1,983) 1, (858) - OPERATING INCOME (6,951) 3,824 (6,319) (6,725) (16,171) (7,853) (6,534) (16,633) (7,537) (38,557) 13,674 Operating margin NM NM NM NM NM NM NM NM NM NM NM Interest income 1,138 5, , ,323 2,000 Interest expense (316) - (330) (305) (951) (367) (347) (409) (491) (1,614) (2,100) Other INCOME BEFORE TAXES (6,219) 9,341 (5,618) (6,075) (8,571) (7,323) (6,273) (16,542) (7,528) (37,666) 13,574 Provision for Income Taxes (322) (348) (453) (1,217) (2,340) (688) (431) (700) (700) (2,519) (6,093) Tax Rate NM NM NM NM NM NM NM NM NM NM NM Minority Interest and other 881 (149) ,293 1,106 1, ,240 3,401 Extraordinary Items (4,161) (2,270) - - (6,431) Discontinued operations GAAP Net Income (Loss) (9,821) 6,574 (5,212) (6,590) (15,049) (6,905) (5,186) (16,377) (7,477) (35,945) 10,882 GAAP EPS ($0.43) $0.28 ($0.21) ($0.27) ($0.63) ($0.28) ($0.21) ($0.66) ($0.30) ($1.45) $0.44 RECONCILIATION TO ADJUSTED EPS Extraordinary items 4,161 2, , Discontinued operations Unrealized gain on tribal notes receivable (165) (8,939) 648 1,530 (6,925) 1,983 (1,125) Adjusted Net Income (Loss) (5,825) (95) (4,564) (5,060) (15,543) (4,922) (6,311) (16,377) (7,477) (35,087) 10,882 Adjusted EPS ($0.25) ($0.00) ($0.19) ($0.21) ($0.65) ($0.20) ($0.25) ($0.66) ($0.30) ($1.41) $0.44 Avg Shares Out 22,970 23,829 24,393 24,513 23,926 24,604 24,928 24,928 24,928 24,847 24,928 Source: Company reports and Morgan Joseph & Co. Inc. estimates 5 MORGAN JOSEPH & CO. INC.

6 Required Disclosures Rating and Price Target History for: Lakes Entertainment, Inc. (LACO) as of /22/08 I:Buy:$ Q3 Q1 Q2 Q3 Q1 Q2 Q3 Q1 Q Created by BlueMatrix Price Target Our 12-month price target on LACO shares is $10. Valuation Methodology We believe a sum-of-the-parts valuation approach is the appropriate method with which to value shares of Lakes Entertainment. This is fair, in our opinion, because the stock does not trade on the company's current fundamentals. The following are per-share present values in 2009: tribal management contracts, $7.76; notes receivable from the tribes, $3.09; Lakes' ownership stake in WPT Enterprises, $0.51; net debt, ($0.06); land adjacent to the Jamul casino project site (book value), $0.31; and Lakes' corporate costs, ($2.03). The sum of these parts brings us to our price target of $10 per share. Risk Factors The major risk to owning shares of Lakes Entertainment, in our view, is the possibility that the company's tribal partners do not obtain regulatory approvals and/or financing for their respective casino projects. Additionally, the risks of investment in casino operators include the potential market risks associated with the expansion of gaming in adjoining or existing markets. Moreover, U.S. casino markets are subject to potential regulatory, tax, and legislative changes that could adversely impact the company's profitability. Economic, competitive, and share volatility could also be factors related to investment risk in these companies. I, Justin Sebastiano, the author of this research report, certify that the views expressed in this report accurately reflect my personal views about the subject securities and issuers, and no part of my compensation was, is, or will be directly or indirectly tied to the specific recommendations or views contained in this research report. Research analyst compensation is dependent, in part, upon investment banking revenues received by Morgan Joseph & Co. Inc. Morgan Joseph & Co. Inc. intends to seek or expects to receive compensation for investment banking services from the subject company within the next three months. 6 MORGAN JOSEPH & CO. INC.

7 Investment Banking Services/Past 12 Mos. Rating Percent Percent BUY [B] HOLD [H] SELL [S] Meaning of Ratings A) Buy means reasonable outperformance relative to the market over months. B) Hold means market-type risk adjusted performance; potential source of funds. C) Sell means expected to underperform the market. Other Disclosures The information contained herein is based upon sources believed to be reliable but is not guaranteed by us and is not considered to be all inclusive. It is not to be construed as an offer or the solicitation of an offer to sell or buy the securities mentioned herein. Morgan Joseph & Co. Inc., its affiliates, shareholders, officers, staff, and/or members of their families, may have a position in the securities mentioned herein, and, before or after your receipt of this report, may make or recommend purchases and/or sales for their own accounts or for the accounts of other customers of the Firm from time to time in the open market or otherwise. Opinions expressed are our present opinions only and are subject to change without notice. Morgan Joseph & Co. Inc. is under no obligation to provide updates to the opinions or information provided herein. Additional information is available upon request. Copyright 2008 by Morgan Joseph & Co. Inc. Morgan Joseph & Co. Inc. 600 Fifth Avenue, 19th Fl New York, NY Tel Fax Sales and Trading New York Tel Fax Pittsford Tel Fax MORGAN JOSEPH & CO. INC.