Welcome to the ‘Training Series: Industry Research for Investment Banking’.
In this series we would like to outline a list of key information required to understand the environment in which a company operates. We will be referencing some prior research on the Las Vegas gaming industry as example.
We’d like to note that the purpose of this analysis is to analyze potential corporate finance transactions and not to publish an external report for investment research.
As such, we can consult a broader set of information sources, however, it should always be noted internally where information is anecdotal or difficult to verify. Once you have formed some more concrete directional ideas, you can go back and find publishable sources as required.
Also note that one of the fastest ways to develop or flesh out perspectives, is to sit down with industry experts and pick their brains.
As with all things in life, we recommend breaking research tasks into primary and secondary tasks to ensure primary tasks can be completed quickly and on short notice.
INDUSTRY SIZE AND TREND
We’ll start with some very high-level quantitative research that gives you some idea of market size, dynamics and opportunity.
The two items we recommend focusing on comprise:
- The total size of the market in terms of revenues and other volume metrics. To determine what other metrics might be relevant to measuring total volume, we recommend looking at research analyst reports
- Looking at the top 5-7 main players and identifying the respective market share by revenues or volume. Looking at these players in reasonable detail is an efficient way to build an overall understanding of the industry
The most common information sources for this high-level research include as shown: Company Initiating Coverage Reports (those are extremely useful), Sector Research Reports, Industry Associations, good and faithful Google, Company Investor Presentations and Wikipedia.
So this graphic gives you an example of how the casino gaming industry has been tracking in Las Vegas versus Macau at the time this research was performed.
You might note that while Las Vegas still has greater visitor numbers, gaming revenues in Macau have exponentially increased and exceed those of Las Vegas by a significant multiple.
You can also see that visitor levels and to a lesser extent, gaming revenues, were noticeably impacted by the Great Recession in 2009.
In addition, while MGM Resorts is by far the largest player in Las Vegas following a decade of acquisitions, they have the least exposure to Macau, which is reflected in their lagging share price performance.
On this graphic you will see that MGM’s share price on the top left corner has lagged that of Wynn and Las Vegas Sands in part due to the much smaller exposure to Macau.
However, the overall industry outlook seems to be trending upwards as shown by the revenue and EBITDA growth potential of all of the players. You can also see that once properties are constructed, casino resort operators exhibit healthy operating margins, although these are notably higher in Macau.
This gives you a good starting point for looking at the Las Vegas industry in more detail.
KEY INDUSTRY CHARACTERISTICS
Next, we would like to take a closer at key characteristics of the industry. If you would like to understand why companies in an industry are set up a certain way and what is driving M&A activity, these are the basic factors you may want to be aware of.
The first item is understanding the most fundamental market drivers including supply and demand. This includes reviewing historical and forecasted market sales volumes by region and/or product segment. It also includes knowing the drivers of historical and forecasted product price levels and potential price volatility, which is especially applicable to commodities. The easiest way to understand these topics for any industry is to analyze the sources of supply and demand, which you should be closely familiar with for the industry you are researching.
For the next item would look at the cost structure. Specifically, we’d like to know how capital-intensive the industry is in terms of large capital outlays being required to invest in fixed assets for operations. We’d also want to understand the split between fixed and variable costs as well as the ability to react to changing volumes. The reason why this information is important is because it helps understand the capital needs and risk profile of an industry, which is an important determinant for the size, vertical integration and capital structure of companies.
We would also look at profitability and return on invested capital. In particular, we would like to understand the operating margins (in other words the EBITDA margins) which indicate how much cash flow a business produces on an ongoing basis once the capital investment has been made. And secondly, we’d like to look at the ability and time required to recover the capital investment made upfront (which is sometimes referred to as the payback period); you can also analyze this by looking at the return on assets to see how long it would take to fully pay back a company’s capital investment.
The other factor sometimes driving corporate finance activity is risk & volatility. It’s useful to look at the volatility in both the operating performance as well as the share price performance relative to economic cycles (such as the financial crisis in 2008 & 2009). We would also look at how a company’s risk profile changes as it progresses through its life cycle from the development phase to a mature stage, which may prompt increased levels of vertical integration or consolidation.
As we will touch on further, the above factors will determine whether companies are likely to raise debt or equity financing, and what type of M&A activity may be prevalent in the industry.
This graphic illustrates the potential upfront capital costs and ongoing cash flows of a casino resort development.
A few items worth noting are:
- The capital investment is very high
- The project generates significant positive cash flows once constructed
- The fixed operating costs are relatively limited
Some background research indicates that revenue and visitor levels are somewhat cyclical and that share price performance is strongly affected by the overall economic outlook (in other words the beta is high). In addition, it should be noted that the competitive threat from existing and new resort developments is very high: for example, Wynn Resorts captured significant market share the moment it opened its doors. This indicates that top line revenues can vary dramatically with the popularity of the resort.
From a corporate finance perspective, this gives rise to a few possible outcomes:
- Developers usually require significant external debt or equity financing to construct a project
- Lenders are usually willing to lend a substantial amount of debt which is secured by the value of the underlying real estate and strong operating cash flows
- Given the large capital requirements and potential volatility in revenues, there are a significant benefits associated with consolidating individual properties into larger conglomerates
These are a few basic considerations to be aware of when looking at corporate finance activity in the gaming space. A similar analysis can be applied to other industries.
CORPORATE FINANCE RESEARCH
After looking at a few key industry characteristics, we can now more specifically research the types of corporate finance activity.
We first suggest taking a closer look at the competitive landscape. One of the best ways to start is analyzing the history and operations of major competitors; at this stage, we would recommend only focusing on readily available data and leaving the remainder for secondary research.
Some initial items to focus on include:
- The 5-10 year historical share-price performance as well as currently outlook
- Historic and forecasted revenues & EBITDA with annual growth rates for 5-year historical and 3-5 year projected performance
- The story behind the formation and evolution of the company including how it was financed and what acquisitions, mergers or divestitures took place
Next we look at the capital structure of companies in this industry: In particular, we want to understand how capital is raised and what financing options and leverage is commonly employed throughout the company’s lifecycle.
For new companies or developments, we may see initial development capital being contributed by entrepreneurs, venture capital firms, private equity firms, large corporations or public market investors through a venture exchange: for example, in the mining industry, a lot of the exploration work to establish new deposits, is conducted by more risky junior exploration companies who are funded by speculative high-return seeking investors.
Depending on the industry, companies may be eligible for debt financing sources based on the market value and ability to generate cashflows to service the debt. This may comes later in the lifecycle of a company but can vary based on the nature of its business. Again, taking the mining industry as an example, a junior miner would need to complete what is called a bankable technical and economic feasibility study on a deposit before being able to qualify for bank financing.
On the other hand for a commercial real estate development, a developer may be able to get construction financing immediately at the start of construction based on the value of the land, building and tenant replacement market. However, in all cases, the amount of debt financing available will depend on the risk profile of the business.
Once a company enters a more mature phase, it often adopts a more permanent capital structure which is reflected in the type and amount of debt raised. In addition, you might see a company becoming increasingly involved in acquiring other businesses to augment internal growth or facilitate vertical integration and consolidation.
To help recognize what corporate finance activities companies may be receptive to, it also helps understanding the evolution and sector trends of an industry including current macro themes. As industries mature or go through economic cycles and technological change, these changes are sometimes accompanied by certainty types of transactions. Examples include IPOs during the dot com boom or leveraged buyouts prior to the financial crisis when low-cost credit was readily available.
Capital structure dynamics and sector trends are often among the most important drivers of corporate finance activity. Once we have developed greater familiarity with these drivers, we can focus specifically on identifying the most common types of corporate finance activities throughout a company’s life cycle. These could include raising venture capital, initial public offerings, private placements, secondary capital raises, debt issuances and refinancings, acquisitions, mergers, divestitures, restructurings and leveraged buyouts, to name the most common ones.