[December 08, 2020]

Breach Inlet Capital Sends Public Letter to Board of Great Canadian Gaming

Breach Inlet Capital, an investment firm focused on underfollowed and misunderstood small cap equities, delivered a letter to the Board of Directors of Great Canadian Gaming (TSE: GC) today. Breach Inlet Capital outlines the reasons it plans to vote "AGAINST" Apollo's offer of $39 per share.

The full text of the letter follows:

Dear Members of the Board:

Breach Inlet Capital, LP ("BIC") is a long-time shareholder in Great Canadian Gaming Corporation (the "Company" or "GC"). We own more shares than all of the independent members of GC's Board of Directors (the "Board") combined. We also have a history of helping public companies enhance their leadership teams. As a recent example, we were part of a shareholder group that called a Special Meeting at Aimia Inc. that led to replacing 7 of 8 directors as well as the CEO¹. For the reasons set forth below, we will vote "AGAINST" Apollo's proposed acquisition of GC for only $39 per share².

1. We believe $39 per share vastly undervalues GC.

GC effectively has a monopoly of the casino market in the Greater Toronto Area ("GTA (News - Alert)"), which is the third largest and fastest growing city in the US and Canada³. Furthermore, the GTA gaming market appears very underpenetrated implying immense untapped potential. For reference, we estimate the Greater Vancouver Area ("GVA") generated > $500 of Gross Gaming Revenue ("GGR") per capita in 2019⁴, while we estimate the GTA garnered only ~$200 of GGR per capita⁵. GC recently completed its new Durham Live casino and is substantially expanding its Woodbine casino. These world-class casino resorts should arguably attract higher GGR per capita than any casino in the GVA.

In addition, GC has dominant market share in British Columbia ("BC"). Gateway (News - Alert) Casinos is GC's key competitor in both BC and Ontario. Gateway recently received a $200mm loan from the Canadian government⁶. While this loan may help Gateway bridge any potential liquidity issues, it also adds to Gateway's already-large debt burden. Therefore, GC could have the opportunity to: 1) capture market share from Gateway in both BC and Ontario and 2) purchase Gateway's assets at distressed prices if those come for sale.

Lastly from a qualitative perspective, GC should benefit from the potential legalization of single-game sports betting and iGaming next year⁷ given GC's significant market share and long-term government relationships. Score Media and Gaming estimates these markets could generate up to an additional $5.4b of GGR⁸.

From a quantitative perspective, Apollo's offer values GC for only ~8x 2019 EBITDA⁹. Importantly, GC's 2019 EBITDA includes little of the benefit that GC will derive from the ~$650mm of CapEx spent from 1Q19 to 3Q20. This CapEx was primarily spent on building the new Durham Live casino (which has not yet opened) and expanding existing Toronto-area casinos. From 2011 to 2017 (which was prior to GC being awarded the GTA and West GTA ("WGTA") bundles), we estimate GC generated a pre-tax return on invested capital of ~25%¹⁰. Assuming GC produces a 25% pre-tax return on ~$650mm of CapEx and retains ~60% of profits¹¹, this implies incremental EBITDA of ~$100mm. If accurate, Apollo's offer values GC for < 6.5x our estimated pro forma 2019 EBITDA¹². Meanwhile, US regional casino companies trade for an average of ~12.5x 2019 EBITDA¹³. We believe GC should trade at a premium to US regionals because of its monopoly in and growth potential from Toronto. Nonetheless, 12.5x our estimated pro forma 2019 EBITDA implies GC is worth > $85 per share, significantly more than the $39 per share Apollo is offering.

Stated differently, we estimate Apollo's offer values GC for only ~10x 2019 cash EPS¹⁴. Again assuming incremental EBITDA of $100mm as outlined above, this equates to an estimated pro forma 2019 cash EPS of ~$5.00¹⁵. This also implies Apollo's offer values GC for < 8x our estimated pro forma 2019 cash EPS.

More importantly, we forecast 2019 cash EPS will rise ~85% to ~$7.00 by 2022¹⁶. As articulated above, we think GC can earn a 25% pre-tax return on its GTA/WGTA CapEx. We estimate that GC plans to spend ~$1.7b from 2019 to 2022¹⁷. If GC earns 25% on this CapEx, GC will have earned < 40% pre-tax return on its entire GTA/WGTA investment¹⁸. For reference, we estimate GC earned > 40% pre-tax return on the East bundle¹⁹. Applying 20x to our estimated 2022 cash EPS of ~$7.00 implies GC could be worth ~$140 per share by 2022. Our 2022 estimate could prove conservative because we do not include any benefit from share repurchases, iGaming legalization, sports betting legalization, or growth from 2019 in GC's remaining casinos.

Simplistically, we believe Apollo's offer undervalues GC because $39 per share is below the price where GC repurchased substantial stock. In 2018 and 2019, GC bought back ~$350mm of stock and paid up to $51 per share. Then in February 2020, GC announced a $500mm tender at up to $46 per share. We think it is highly unlikely that COVID or any other factors have materially impacted GC's long-term earnings power. Supporting this notion, several US regional casinos grew 3Q20 EBITDA between 5% and 19% year-over-year²⁰.

GC's "Shareholder Update" presentation²¹ appears to be an attempt to scare shareholders into accepting Apollo's lowball offer by conveniently now claiming that costs in Toronto will rise faster than revenue and specifically pointing to the escalating revenue thresholds. We do not know the thresholds, but we know that: 1) GC's Board wanted GC to repurchase ~20% of its shares at up to $46 per share just this February indicating they thought GC was materially undervalued, 2) US casinos are quickly recovering from COVID implying the same will happen to GC's casinos, and 3) GC's GTA/WGTA agreements were amended "to compensate the Company for its services over the duration of the Pandemic and a period of subsequent ramp up of operations as the business returns to historical levels" by providing "an additional variable component fee"²². In fact, GC receives this "additional" compensation during the 50-guest maximum restriction plus an additional three years.

Digging further into the thresholds, CEO Rod Baker stated on the 3Q18 earnings call: "I am pleased to report that our current GGR run rate already exceeds our peak threshold level that will occur in 4 years from now". We estimate GTA run-rate GGR was ~$1.3b in 3Q18 implying the 2022 GTA threshold is < $1.3b. As outlined above, we estimate GTA GGR would need to grow > 150% to be equivalent to GVA GGR on a per capita basis. If so, then this implies GTA GGR would need to rise to ~$3.3b. GC/Brookfield receive a fixed fee of ~$75mm plus 70% of GGR above the threshold. Coupled with non-gaming revenue growing from 1% of GGR to our estimate of 20% and assuming 40% EBITDA margin, then this would lead to the GTA producing > $800mm of gross EBITDA²³. That would equate to an even larger pre-tax return on capital than the 25% we had assumed above. Either way, we believe the thresholds will not be an issue and GC will rapidly increase profits in the GTA (and WGTA).

2. We think GC's undisturbed share price could have been above Apollo's offer already.

GC's share price closed at $30.25 on August 12, 2020. Later that evening, GC reported +$32mm of Adjusted EBITDA and +$5mm of operating cash flow for 2Q20. These results were remarkably impressive given that all of GC's casinos were closed in 2Q20. GC's 2Q20 EBITDA easily beat consensus' expectations of NEGATIVE $12mm and likely pleasantly surprised most shareholders. Yet, GC's CEO Rod Baker seemed to intentionally express a dire tone during the 2Q20 earnings call. In fact, he used the word "challenging" on seven different occasions. In turn, GC's share price declined and never returned to its August 12^th price until after announcing Apollo's offer. Meanwhile, share prices of US regional peers have increased by ~50% on average since August 12^th. If GC's share price had risen 50% like the US regional casinos, then GC could currently be trading for ~$45 per share.

3. We are concerned by the troubling process that appears to have led to GC's Board agreeing to Apollo's offer.

First, GC would effectively be selling "at the bottom" given depressed earnings this year yet recently renewed optimism about an earnings recovery in 2021+. Second, GC's Board seemed to rush the process with Apollo, as it took less than 11 weeks from Apollo's initial offer of $38-41 per share to signing a definitive merger agreement. Third and inexcusably, GC's Board did not conduct a sales process or seem to contact any other potential bidders after receiving Apollo's initial offer. Most specifically and during the 3Q20 earnings call, CEO Baker indicated that Brookfield was not contacted about submitting a bid. Given that Brookfield is GC's 50/50 partner in the GTA, we would be surprised if Brookfield did not have an interest in acquiring GC. Instead of seeking to maximize shareholder value, GC's Board appears to have rushed to take the first offer on the table.

4. We believe GC's Board and senior management's interests are not aligned with shareholders.

Even when including DSUs gifted to them, GC's Board (excluding CEO Baker) have only a 0.3% economic interest in the Company. Far more troubling, GC's Board recently issued "long-term" cash incentive awards to CEO Baker and President Terrance Doyle of $6mm and $3mm, respectively²⁴. As if Baker and Doyle were not earning enough with their combined $26mm+ in change of control payments, they will now receive an additional $9mm combined. Given this, we could understand why GC's Board and senior management support Apollo's offer and the prospect of immediate payouts on what were supposed to be long-term incentives. Unfortunately, their personal gains appear to come at the expense of shareholders' best interest.

5. We think the Management Information Circular lacked critical details to support Apollo's offer.

This is the first merger proxy that we have seen that fails to include a forecast, trading comps, or transaction comps. We believe these details may have been intentionally omitted because their inclusion would highlight that Apollo's offer significantly undervalues GC. Further, a multiple of EBITDA is the casino industry's standard method of valuation. Yet bizarrely, even the word "EBITDA" was only referenced in the definitions section and to describe the decline in GC's EBITDA in 2020.

In summary, we plan to vote "AGAINST" Apollo's offer of $39 per share and would likely vote against any offer that is not materially higher for the reasons outlined above. We do not appear alone in opposing Apollo's offer. A ~14% shareholder said "this is a terrible and ridiculous deal" during the 3Q20 earnings call. Another ~4% shareholder followed that comment by saying "I think this transaction materially undervalues the Company, and we have no intention of voting for it". Several weeks later, news outlets reported that a ~10% shareholder submitted a private letter to GC's Board outlining its reasons to vote "AGAINST" Apollo's offer²⁵. Lastly, an ~18% shareholder also reportedly plans to vote against Apollo's offer²⁶. Based on our analysis above, we agree with the conclusions independently reached by these large shareholders.

With sound execution and an improved macroeconomic backdrop, we believe GC could be worth ~$140 per share within two years. We are unlikely to vote "FOR" a transaction until GC's long-term intrinsic value is more accurately reflected in the price offered by Apollo or another potential suitor.

Best Regards,
Chris Colvin, CFA
Founder and Portfolio Manager
Breach Inlet Capital, LP

____________________________________________________

¹ Sources: Aimia Reconstitutes Board; Aimia Announces Transformation

² All $ amounts displayed in CAD

³ Sources: Toronto Fastest Growing; Toronto 3rd Largest

⁴ Source (News - Alert): BCLC 2019/20 Report

~$1.9b 2019 Adjusted BC GGR = ~$1.8b Reported + $75mm impact of COVID (pg. 10 of BCLC report)

~$1.3b 2019 GVA Revenue = ~$1.9b 2019 Adjusted BC GGR x 70% (BIC estimate)

~$515 GGR per Capita = ~$1.3b 2019 GVA Revenue / ~2.6mm GVA population

⁵ ~$200 of GGR per Capita = ~$1.3b GTA GGR (BIC estimate) / ~6.2mm GTA population

⁶ Source: Gateway Loan

⁷ Source: Sports Betting & iGaming Legalization

⁸ Source: theScore Estimate

⁹ ~$350mm 2019 EBITDA = Reported Adjusted EBITDA - Lease Payments - Minority Interest EBITDA + estimated Minority Interest Lease Payments

~$2.8b Enterprise Value = $39 per share x 56.4mm shares + ~$640mm net debt (excludes an estimated 30% of Ontario Cash and 50% of GTA Debt because controlled by Brookfield)

¹⁰ ~25% PT Return 2011-2017 = ~$80mm growth in EBITDA / ~$310mm capital deployed (CapEx + acquisitions)

¹¹ Brookfield Business Partners ("Brookfield") retains 50% of GTA profits, so we estimate this implies Brookfield receives ~40% of GTA + WGTA profits.

¹² ~$450mm Pro Forma EBITDA = ~$350mm 2019 EBITDA + ~$100mm Incremental EBITDA to GC

~6.2x Pro Forma EBITDA = ~$2.8b EV / ~$450mm

¹³ Tickers for US Regional Casinos: CHDN, CNTY, CZR, FLL, GDEN, MCRI, PENN, RRR

¹⁴ ~$3.80 2019 Cash EPS = (2019 EBITDA - Stock-Based Compensation - Cash Interest Expense (excluding Minority Interest portion) - Taxes - estimated Maintenance CapEx (3.2% of Revenue & excluding Minority Interest portion)) / 56.4mm diluted shares

¹⁵ $5.00 2019 Cash EPS = (~$100mm Incremental EBITDA x (1 - 27% tax rate))/56.4mm shares + 2019 cash EPS

¹⁶ ~$250mm Incremental EBITDA = ~$1.7b CapEx x 25% ROI x 60% (BIC estimate of GC's portion)

~$600mm 2022 EBITDA = ~$350mm 2019 EBITDA + ~$250mm Incremental EBITDA

~$7.00 Cash EPS = (~$600mm 2022 EBITDA - ~$60mm CapEx (10% of EBITDA) - ~$30mm Int Exp (CapEx funded w/FCF) - ~$110m taxes (27% rate & ~$160mm D&A)) / 56.4mm shares

¹⁷ GC disclosed plans to spend: 1) $360mm of CapEx in WGTA in the 3Q18 MD&A and 2) $1.48b at GTA on pg. 74 of Merger Proxy. We estimate GC spent ~$160mm of CapEx on GTA/WGTA in 2018 implying $1.7b to spend from 2019-2022.

¹⁸ ~$2b Total Invested Capital = ~$90mm GTA purchase + ~$100mm WGTA purchase + estimated ~$160mm 2018 GTA/WGTA + estimated $1.7b 2019-2022 GTA/WGTA CapEx

~$760mm Gross GTA/WGTA 2022 EBITDA = ~$340mm 2019 Gross GTA/WGTA EBITDA (BIC estimate) + ~$420 incremental Gross GTA/WGTA EBITDA (~25% x ~$1.7b)

~38% pre-tax return = ~$760mm Gross EBITDA / ~$2b Invested Capital

¹⁹ 42% PT Return on East Bundle = (~$40mm purchase price + ~$80mm CapEx) / ~$50mm 2019 EBITDA

²⁰ 3Q20 EBITDA grew y/y at CZR, GDEN, MCRI, PENN by 10%, 5%, 19%, and 10%, respectively

²¹ Source: GC's Shareholder Update

²² Source: pg. 10 of 3Q20 MD&A

²³ Non-Gaming Revenue was > 15% of GGR at River Rock in the GVA and we think the GTA should be higher because of the amenities being constructed around the GTA casinos. Ontario EBITDA margin was 45% in 2019.

²⁴ Source: Pg. 52 of Merger Proxy

²⁵ Source: 10% Shareholder Opposition

²⁶ Source: 18% Shareholder Opposition

View source version on businesswire.com: https://www.businesswire.com/news/home/20201208006124/en/

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