Note 14 – Financial Instruments and Fair Value Measurements

Overview

Estimates of fair value for financial assets and liabilities are based on the framework established in the accounting guidance for fair value measurements. The framework defines fair value, provides guidance for measuring fair value and requires certain disclosures. The framework discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow) and the cost approach (cost to replace the service capacity of an asset or replacement cost). The framework utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:

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Level 1: Observable inputs such as quoted prices (unadjusted) in active markets for identical assets or liabilities.

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Level 2: Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.

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Level 3: Unobservable inputs that reflect the reporting entity’s own assumptions.

The Company’s financial instruments consist of cash and cash equivalents, accounts receivable and payable and debt.

For the Company’s cash and cash equivalents, accounts receivable and payable, short-term borrowings, and accrued and other current liabilities, the carrying amounts approximate fair value because of the short duration of these financial instruments. As of December 31, 2016 and December 31, 2015, the fair value of the Company’s long-term debt approximates the carrying value based upon the Company’s expected borrowing rate for debt with similar remaining maturities and comparable risk.

In connection with the Montana Acquisitions, the Company preliminarily recognized the acquired assets at fair value. All amounts were recognized as Level 3 measurements due to the subjective nature of the unobservable inputs used to determine the fair values. Additionally, in connection with the Initial Montana Acquisition, the Company is required to pay the sellers contingent consideration of up to a total of $2.0 million in cash paid in four quarterly payments beginning in September 2017, subject to certain potential adjustments based upon the availability of certain gaming machines and, if applicable, the performance of replacement games. The fair value of the Company’s contingent consideration recorded in connection with the Initial Montana Acquisition was estimated to be $2.0 million as of December 31, 2016 and is recorded in “Other accrued expenses” and “Other long-term obligations” on the Company’s consolidated balance sheet. Changes to the estimated fair value of the contingent consideration will be recognized in earnings of the Company. See Note 3, Merger and Acquisitions, for a discussion of the Montana Acquisitions.

Balances Measured at Fair Value on a Non-recurring Basis

Land, land improvements and building and improvements acquired in connection with the Merger were measured using unobservable (Level 3) inputs at an estimated fair value of $37.8 million. This fair value estimate was calculated considering each of the three generally accepted valuation methodologies including the cost, the sales comparison and the income capitalization approaches. Significant inputs included consideration of highest and best use, replacement cost, recent transactions of comparable properties and the properties’ ability to generate future benefits.

Leasehold improvements, furniture, fixtures and equipment, and construction in process acquired in connection with the Merger were measured using unobservable (Level 3) inputs at an estimated fair value of $45.4 million. Property and equipment acquired in connection with the Montana Acquisitions were measured using unobservable (Level 3) inputs at an estimated fair value of $7.8 million for the Second Montana Acquisition and $2.4 million for the Initial Montana Acquisition. This fair value estimate was calculated with primary reliance on the cost approach with secondary consideration being placed on the market approach. Significant inputs included consideration of highest and best use, replacement cost and market comparables.

The identified intangible assets acquired in connection with the Second Montana Acquisition, Initial Montana Acquisition and Merger have been valued, on a preliminary basis with respect to the Montana Acquisitions, using unobservable (Level 3) inputs at a fair value of $11.1 million, $14.2 million and $80.5 million, respectively. Included in these intangible assets were the following:

Trade names – The trade names acquired as part of the Merger encompass the various trade names utilized by Lakeside Casino & RV Park, Golden Pahrump Nugget and Gold Town Casino, as well as local trade names of our taverns, or derivations of them. These trade names were valued at $12.2 million determined based on the relief-from-royalty method under the income approach, which requires an estimate of a reasonable royalty rate, identification of relevant projected revenues and expenses, and the selection of an appropriate discount rate. Royalty rates of 1.0% to 2.5%, depending on the trade name, were used in the valuations which gave consideration to third-party license agreements that involve trade names and trademarks that can be considered reasonably comparable, the age and profitability of the casinos, nature of the business and degree of competition, and a return on assets analysis to determine an implied royalty rate. The after-tax cash flows were discounted to present value utilizing a range of discount rates from 11.0% to 12.0% depending on the trade name. The trade names associated with the Merger were given an indefinite life.

The trade names acquired with the Montana Acquisitions encompass the various trade names of the acquired distributed gaming businesses. Management intends to discontinue these trade names, but believes that from a market participant standpoint the trade names hold defensive value and are a valuable intangible asset. These trade names were preliminarily valued at $0.7 million determined based on the relief-from-royalty method under the income approach. A royalty rate of 1.0% was used in the valuations which gave consideration to third-party license agreements that involve trade names and trademarks that can be considered reasonably comparable to determine an implied royalty rate. The after-tax cash flows were discounted to present value utilizing a range of discount rates from 12.0% to 16.0% depending on the trade name, which reflects the risk of the cash flows related to the asset and the risk and uncertainty of the cash flows for the trade name relative to the overall business. The trade names associated with the Montana Acquisitions were given a four year useful life.

Player relationships – The player relationships acquired as part of the Merger relate to both the tavern and Pahrump casinos reporting units and are based on the perceived value that customers obtain from being entertained by the Company and represent the loyalty program members who earn points based on play. These relationships are expected to lead to recurring revenue streams. The player relationships were given a fair value of $7.3 million determined based on the excess earnings method under the income approach. Based on management’s experience with historical attrition rates, an annual attrition range of 10.0% to 20.0% was utilized for tavern player relationships. After-tax cash flows were calculated by applying cost, expense, income tax and contributory asset charge assumptions to the estimated player relationships revenue stream. The after-tax cash flows were discounted to present value utilizing a 12.0% to 14.0% discount rate. The player relationships associated with the Merger were given a useful life of eight years for the taverns and 12 to 14 years for the Pahrump casinos.

Customer relationships – The Company’s customer relationships with third party distributed gaming customers acquired as part of the Merger have been developed over years of service and are based on the perceived value that the Company’s customers obtain from doing business with the Company. These relationships are expected to lead to recurring revenue streams. The $59.2 million fair value of the customer relationships was determined based on the excess earnings method under the income approach. An annual attrition factor range of 5.0% to 12.5% was utilized depending on the specific customer. After-tax cash flows were calculated by applying cost, expense, income tax and contributory asset charge assumptions to the estimated customer relationships revenue stream. The after-tax cash flows were discounted to present value utilizing an 11.0% discount rate. The customer relationships associated with the Merger were given a useful life of 13 to 16 years.

The Company’s customer relationships with third party distributed gaming customers acquired as part of the Montana Acquisitions were derived from continuing relationships with many of its customers, which translates into an expected source of cash flows for the Company. The $18.9 million preliminary fair value estimate of the customer relationships was determined based on the excess earnings method under the income approach. An annual attrition factor of 5.0% was utilized. The after-tax cash flows were discounted to present value utilizing a 12.0% to 14.0% discount rate. The customer relationships associated with the Montana Acquisitions were given a useful life of 15 years.

Gaming and liquor licenses – The gaming licenses acquired as part of the Merger relate to Lakeside Casino & RV Park, Golden Pahrump Nugget and Gold Town Casino (“NV Gaming Licenses”). The $0.9 million fair value of the NV Gaming Licenses was determined based on the cost approach. In performing the cost approach, management used estimates for explicit and implicit costs to obtain the gaming licenses. Additionally, the Company acquired a Montana gaming license as part of the Merger with a fair value of less than $0.1 million determined based on the cost approach. The Company also has various immaterial liquor licenses associated with its tavern operations which values were also determined based on the cost approach. The economic life of the NV Gaming Licenses, Montana gaming license and various liquor licenses are anticipated to be indefinite, as they are easily maintained.

The Company’s Maryland gaming license is associated with Rocky Gap and is subject to amortization as it has a finite life of 15 years. Amortization of the Rocky Gap gaming license began on the date the gaming facility opened for public play in May 2013.

Non-compete agreements – The non-compete agreements acquired as part of the Merger have a fair value of $0.3 million determined based on the lost profits method under the income approach using Level 3 inputs. A “With” scenario was based on projections, which assumed that the non-compete agreements were in place. In contrast, a “Without” scenario assumed the non-compete agreements did not exist and competition began immediately after consummation of the transaction. The difference in after-tax cash flows between the “With” and “Without” scenarios was calculated and then discounted to present value utilizing a 9.8% discount rate, which was based on the Company’s overall internal rate of return. A probability factor of 10.0% was applied to derive the fair value. The non-compete agreements associated with the Merger were given a useful life of two years.

The non-compete agreements acquired as part of the Montana Acquisitions have a preliminary fair value estimate of $5.7 million determined based on the lost profits method under the income approach. The difference in after-tax cash flows between the “With” and “Without” scenarios was calculated and then discounted to present value utilizing a range of 12.0% to 16.0% discount rate depending on the agreement. A probability factor range of 43.8% to 50.0% was applied to the first year, increasing each year after, to derive the fair value. The non-compete agreements associated with the Montana Acquisitions were given a useful life of five years.

Software – The $0.5 million fair value of the software was determined based on the cost approach, which included estimates for fully burdened salaries and the number of hours needed to complete the software as it relates to the latest version of the software. The software was given a useful life of 15 years.

The Company owns various parcels of developed and undeveloped land relating to its casinos in Pahrump, Nevada. The Company performs an impairment analysis on the land it owns at least quarterly and determined that no impairment had occurred as of December 31, 2016 and December 31, 2015. During the fourth quarter of 2016, the Company completed the sale of the parcels of undeveloped land in California held for sale that related to the Company’s previous involvement in a potential Indian casino project with the Jamul Tribe for $5.5 million and recognized a gain on sale of land held for sale of $4.5 million, recorded within “(Gain) loss on disposal of property and equipment” on the Company’s consolidated balance sheet.