Nantahala Capital was founded in 2004 by Wil Harkey, and three years later he was joined by former college Dan Mack. Two former analysts from Sagamore Hill Capital, the duo apparently “discovered a common affinity not only for the quantitative aspects of making relative-value bets between securities but also for understanding the fundamental reasons mispricings occurred,” according to a 2009 interview in Value Investor Insight.
The hedge fund combines a traditional Ben Graham value approach with “an arbitrageur’s mindset for isolating and offsetting risk.” Simply put, the duo are looking to isolate what they find attractive about each opportunity and use hedges to ensure they’re only exposed to the mispriced factor.
This strategy proved extremely lucrative at first with the fund achieving annualized returns of 19.1% net from inception in August 2004 to April 2009. However, over the last eight years, the firm’s returns have fallen back to earth. To the end of June 2017, the fund’s total return since inception was 284.1%, and annualized net returns were 11%. For the second quarter, Nantahala Capital returned 7.3% net of fees and expenses bringing year-to-date net returns up to 7.6%, according to a letter to investors reviewed by ValueWalk.
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Nantahala’s focus is on small-cap situations, where the firm hopes to compete against a less sophisticated crowd. One small-cap opportunity detailed within the company’s second-quarter letter to investors is Golden Entertainment Inc., a company with a market capitalization of less than $500 million and limited analyst coverage.
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Nantahala Capital: Up 7.6% In H2, Bets On Gaming Machines
Golden Entertainment is a ~$460 million market cap gaming company focused on distributed gaming (e.g., slot machines in bars, grocery and convenience stores) and the Nevada “locals” gaming market. To complement organic growth the firm recently closed the acquisition of American Casino & Entertainment Properties LLC, adding four new Nevada casinos to its portfolio and increasing EBITDA by an estimated 300%.
This adds to the company’s already extensive network of gaming machines distributed throughout stores in Nevada. Golden is the largest slot route operator in Nevada with ~7,500 gaming machines in almost 700 locations, giving the company a large competitive advantage. The company hopes to increase its presence through acquisitions and by using existing scale to expand into other markets. The company either rents space from store owners on a five to seven year contract or signs a 50/50 revenue agreement instead of rent. In addition to the gaming machines distributed around Nevada, Golden also operates 54 of its own taverns in Las Vegas, which are gaming orientated with 15 devices per location aimed at local customers. Higher quality food and loyalty programs are designed to instill a high level of customer loyalty.
The American Casinos & Entertainment will complement Golden’s existing portfolio by adding the Stratosphere Casino on the Las Vegas Strip and three other “locals” casinos. Acquired for 6.8x EBITDA post synergies management appears to have agreed an attractive price. The deal is being funded by debt and according to Nantahala Capital, when all is said and done total net leverage will be 5-5.5x for the group.
Wil and Dan of Nantahala Capital believe the market is ignoring this opportunity and even though shares in Golden have pushed higher recently, they still see value estimating free cash flow yield of 15% at current prices. Further long-term growth is likely through organic and bolt-on growth.